SAFENET INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

		For the quarterly period ended March 31, 2004

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

Commission File Number 0-20634

SAFENET, INC.

(Exact name of registrant as specified in its charter)


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

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

410-931-7500
(Registrant’s telephone number)

Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

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

APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuer’s Common Stock as of April 30, 2004 was 23,762,635.

INDEX TO FINANCIAL STATEMENTS


	Page
PART I: FINANCIAL INFORMATION
Item 1: Financial Statements (Unaudited)
Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003		3
Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003		4
Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2004 and 2003		5
Consolidated Statements of Stockholders’ Equity for the three months ended March 31, 2004		6
Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003		7
Notes to Consolidated Financial Statements — March 31, 2004		8
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3: Quantitative and Qualitative Disclosures About Market Risk		25
Item 4: Controls and Procedures		26
PART II: OTHER INFORMATION
Item 1: Legal Proceedings		27
Item 4: Submission of Matters to a Vote of Security Holders		27
Item 6: Exhibits and Reports on Form 8-K		27
SIGNATURES		28
EXHIBITS

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

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


	March 31,			December 31,
	2004			2003
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	75,515		$	21,651
Restricted cash		2,800			2,800
Short-term investments		98,026			92,280
Accounts receivable, net of allowance for doubtful accounts of $2,309 in 2004 and $940 in 2003		32,177			13,191
Unbilled costs and fees		1,837			—
Inventories, net of reserve of $1,457 in 2004 and $1,275 in 2003		15,154			3,123
Prepaid expenses and other current assets		4,815			1,414

Total current assets		230,324			134,459
Property and equipment, net		14,332			3,809
Computer software development costs, net of accumulated amortization of $1,773 in 2004 and $1,696 in 2003		1,893			1,982
Goodwill		306,862			42,407
Other intangible assets, net of accumulated amortization of $11,943 in 2004 and $9,280 in 2003		151,546			23,599
Other assets		1,371			1,900

Total assets	$	706,328		$	208,156

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	11,839		$	3,799
Accrued salaries and commissions		11,821			3,770
Advance payments and deferred revenue		10,142			4,791
Accrued severance and related acquisition costs		5,670			—
Accrued warranty costs		2,882			259
Other accrued expenses		7,854			2,509
Due to former owners of acquired company		2,800			2,800
Accrued income taxes		4,564			2,294
Deferred income taxes		2,572			2,607

Total current liabilities		60,144			22,829
Unfavorable lease liability		4,782			4,149
Deferred income taxes		51,071			2,181
Other		3,198			—

Total liabilities		119,195			29,159

Commitments and contingencies		—			—
Stockholders’ equity:
Preferred stock, $.01 par value per share, authorized 500 shares, no shares issued and outstanding		—			—
Common stock, $.01 par value per share, authorized 50,000 shares, issued and outstanding shares of 23,736 in 2004 and 13,286 in 2003		237			133
Additional paid-in capital		621,169			199,783
Unearned compensation		(12,799	)		—
Accumulated other comprehensive income		5,295			5,394
Accumulated deficit		(26,769	)		(26,313	)

Total stockholders’ equity		587,133			178,997

Total liabilities and stockholders’ equity	$	706,328		$	208,156

See accompanying notes to consolidated financial statements.

-3-

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


	Three Months ended March 31,
	2004			2003
				(Restated - Note 1)
Revenues:
Licenses and royalties	$	2,181		$	1,978
Products		17,857			10,014
Service and maintenance		3,978			1,571

Total revenues		24,016			13,563
Cost of revenues:
Licenses and royalties		1			108
Products		7,443			2,949
Service and maintenance		591			320
Amortization of acquired intangible assets		1,129			1,067

Total cost of revenues		9,164			4,444

Gross profit		14,852			9,119

Operating expenses:
Research and development expenses		4,786			3,256
Sales and marketing expenses		4,213			3,066
General and administrative expenses		2,744			1,697
Write-off of acquired in-process research and development costs		—			7,900
Amortization of acquired intangible assets		1,534			767
Restructuring charge		1,485			—
Costs of integration of acquired companies		584			1,615
Amortization of unearned compensation		361			—

Total operating expenses		15,707			18,301

Operating loss		(855	)		(9,182	)
Interest and other income, net		(136	)		89

Loss before income taxes		(991	)		(9,093	)
Income tax (benefit) expense		(535	)		641

Net loss	$	(456	)	$	(9,734	)

Net loss per common share:
Basic and diluted	$	(0.03	)	$	(1.07	)

Shares used in computation:
Basic and diluted		15,183			9,083

See accompanying notes to consolidated financial statements.

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Three Months Ended March 31, 2004
(Unaudited, in thousands)




		Common stock			Additional paid-in			Unearned			Accumulated other comprehensive			Accumulated			Total stockholders’
	Shares		Amount		capital			compensation			income (loss)			deficit			equity
Balance as of January 1, 2004		13,286	$	133	$	199,783		$	—		$	5,394		$	(26,313	)	$	178,997
Costs incurred in connection with the registration of common stock issued for the asset acquisition of Raqia Networks, Inc.		—		—		(153	)		—			—			—			(153	)
Issuance of common stock in connection with the acquisition of Rainbow Technologies, Inc.		10,306		103		375,025			—			—			—			375,128
Assumption of stock options in connection with the acquisition of Rainbow Technologies, Inc.		—		—		44,600			(13,160	)		—			—			31,440
Amortization of unearned compensation		—		—		—			361			—			—			361
Issuance of common stock under Employee Stock Purchase Plan		11		—		262			—			—			—			262
Issuance of common stock for stock option exercises		113		1		1,652			—			—			—			1,653
Issuance of common stock for stock warrants exercised		20		—		—			—			—			—			—
Foreign currency translation adjustment		—		—		—			—			(99	)		—			(99	)
Net loss		—		—		—			—			—			(456	)		(456	)

Balance as of March 31, 2004		23,736	$	237	$	621,169		$	(12,799	)	$	5,295		$	(26,769	)	$	587,133

See accompanying notes to consolidated financial statements.

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


	Three Months Ended March 31,
	2004			2003
				(Restated - Note 1)
Cash flows from operating activities:
Net loss	$	(456	)	$	(9,734	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Write-off of acquired in-process research and development costs		—			7,900
Depreciation and amortization of property and equipment		2,324			509
Amortization of computer software development costs		77			119
Amortization of other intangible assets		2,663			1,923
Amortization of unearned compensation		361			—
Income tax benefit related to stock option exercises		—			1,375
Restructuring charge		1,485			—
Deferred income taxes		(842	)		(588	)
Amortization of unfavorable lease liability		(179	)		—
Changes in operating assets and liabilities:
Accounts receivable, net		(2,144	)		(1,892	)
Inventories, net		(1,940	)		1,359
Prepaid expenses and other current assets		174			391
Accounts payable		(1,262	)		2,598
Accrued salaries and commissions		(2,306	)		(3,059	)
Accrued severance and related acquisition costs		509			—
Accrued income taxes		226			455
Other accrued expenses		239			(1,361	)
Advanced payments and deferred revenue		368			554

Net cash (used in) provided by operating activities		(703	)		549

Cash flows from investing activities:
Maturities of held to maturity securities		—			7,961
Purchases of available for sale securities		(22,825	)		(4,511	)
Proceeds from sales of available for sale securities		17,398			—
Purchases of property and equipment		(1,132	)		(658	)
Expenditures for computer software development		(57	)		(110	)
Cash received upon acquisition of Rainbow, net of cash paid		60,344			—
Cash received upon acquisition of Cylink, net of cash paid		—			310
Deferred acquisition costs		(447	)		—
Cash paid for Raqia, net of cash acquired		—			(1,240	)
Other assets		(771	)		629

Net cash provided by investing activities		52,510			2,381

Cash flows from financing activities:
Proceeds from stock options exercised and issuance of stock under Employee Stock Purchase Plan		1,915			262
Costs associated with the registration of shares		(153	)		—

Net cash provided by financing activities		1,762			262

Effect of exchange rate changes on cash		295			(191	)

Net increase in cash and cash equivalents		53,864			3,001
Cash and cash equivalents at beginning of period		21,651			3,399

Cash and cash equivalents at end of period	$	75,515		$	6,400

See accompanying notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004

(Unaudited, in thousands except per share amounts)

(1) BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals) which are, in the opinion of management, necessary to present a fair statement of results for the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The results of operations for the interim period are not necessarily indicative of results to be expected in future periods.

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

(2) BUSINESS

SafeNet, Inc. (“SafeNet” or the “Company”) delivers a widely deployed Virtual Private Network, or VPN, technology for secure business communications over the Internet, offering both Original Equipment Manufacturer (“OEM”) technology and end-user products for VPN and e-commerce applications. The Company provides its network security solutions worldwide for financial, enterprise, telecommunications and government use. The Company’s technology is sold and licensed in various formats, including software, hardware, silicon chips, and intellectual property.

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

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

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

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

(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

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

Certain products are designed, developed and produced by the Company for use in U.S. Government and commercial high assurance applications. The products consist of application specific integrated circuits (“ASICs”), modules, electronic assemblies and stand-alone products to protect information. Catalog product revenues and revenues under certain fixed-price contracts calling for delivery of a specified number of units are recognized as deliveries are made. Revenues under cost-reimbursement contracts are recognized as costs are incurred and include estimated earned fees in the proportion that costs incurred to date bear to total estimated costs. Certain contracts are awarded on a fixed-price incentive fee basis. Incentive fees on such contracts are considered when estimating revenues and profit rates and are recognized when the amounts can reasonably be determined. The costs attributed to units delivered under fixed-price contracts are based on the estimated average cost per unit at contract completion. Profits expected to be realized on long-term contracts are based on total revenues and estimated costs at completion. Revisions to contract profits are recorded in the accounting period in which the revisions are known. Estimated losses on contracts are recorded when identified. For research and development and other cost-plus-fee type contracts, the Company recognizes contract earnings using the percentage-of-completion method. The estimated contract revenues are recognized based on percentage-of-completion as determined by the cost-to-cost basis whereby revenues are recognized as contract costs are incurred.

Product Warranties

The Company offers warranties on its products ranging from ninety days to two years. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the Company does business. The Company estimates the costs that may be incurred under its warranties and records a liability at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims and the estimated cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. While warranty costs have historically been within management’s expectations, it is possible that warranty rates will change in the future based on new product introductions and other factors. The balance of the Company’s warranty accrual totaled $2,882 and $259 at March 31, 2004 and December 31, 2003, respectively. The significant increase in the accrual during the quarter resulted from the acquisition of Rainbow, which had a significantly higher concentration of product-related sales.

Employee Stock-Based Compensation

As of March 31, 2004, the Company had five stock-based employee compensation plans. The Company accounts for those plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation cost is reflected in the statements of operations.

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


	Three Months Ended March 31,
	2004			2003
				(Restated - Note 1)
Net loss, as reported	$	(456	)	$	(9,734	)
Add: Stock-based employee compensation expense included in net loss, net of taxes		166			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of taxes		(799	)		(656	)

Pro forma net loss	$	(1,089	)	$	(10,390	)

Loss per share:
Basic and diluted—as reported	$	(0.03	)	$	(1.07	)

Basic and diluted—pro forma	$	(0.07	)	$	(1.14	)

For purposes of the pro forma disclosures above, the estimated fair values of options granted are amortized to expense over the options’ vesting periods. During the three months ended March 31, 2004, the Company did not grant any options to employees with the exception of the options assumed in connection with the acquisition of Rainbow (see Note 4).

Reclassifications

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

(4) ACQUISITIONS

Rainbow Technologies, Inc.

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

The aggregate purchase price was $411,692, consisting primarily of 10,306 shares of common stock valued at approximately $375,052, 1,944 options to purchase common stock with an aggregate value of the vested portion of $31,440, and estimated direct costs of the acquisition of $5,200. The fair value of the common stock issued was determined based on the average market price of the Company’s common stock over the period including three days before and after the terms of the acquisition were agreed to and announced.

The following table summarizes the preliminary estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The Company is in the process of obtaining third-party valuations and finalizing its estimates of the direct cost of the acquisition, thus, the allocation of the purchase price is subject to refinement:


Cash and cash equivalents	$	60,815
Short-term investments		319
Accounts receivable, net		16,909
Unbilled cost and fees		1,780
Inventories		10,088
Prepaid expenses		2,723
Other current assets		786
Property and equipment		11,722
Goodwill		264,813
Intangible assets subject to amortization (8 year weighted average life)		117,277
Intangible assets not subject to amortization		13,520
Other assets		516

Total assets acquired		501,268

Accounts payable		9,306
Accrued salaries and commissions		10,371
Other accrued expenses		9,603
Other liabilities		4,649
Accrued income taxes		2,052
Deferred income taxes		49,703
Other current liabilities		1,945
Accrued warranty costs		1,511
Accrued restructuring costs		436

Total liabilities assumed		89,576

Net assets acquired	$	411,692

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

The Company has preliminarily assigned $166,832 of goodwill to the Embedded Security segment and $97,981 to the Enterprise Security segment. Of the $264,813 of goodwill, none is expected to be deductible for tax purposes. The primary factors contributing to a purchase price for Rainbow that resulted in the recognition of goodwill included the belief that the combined strengths of the two companies enable them to compete more effectively than SafeNet could alone, the belief that the merger allows the combined company to grow its base of government and commercial customers, enhance its product line, expand its international sales and provide broader technology and expertise to its customers, and the impact of anticipated operating efficiencies.

The following unaudited consolidated pro forma results of operations of the Company for the three month periods ended March 31, 2004 and 2003, give effect to the March 15, 2004 acquisition of Rainbow and the February 6, 2003 acquisition of Cylink as though they had both occurred on January 1, 2003 (in thousands, except per share amounts):


	2004			2003
Revenues	$	52,184		$	50,087

Loss from continuing operations		(3,425	)		(13,472	)
Loss from discontinued operations, net of applicable taxes		—			(86	)

Net loss	$	(3,425	)	$	(13,558	)

Loss per common share — basic and diluted
Continuing operations	$	(0.15	)	$	(0.73	)
Discontinued operations		—			—

Net loss	$	(0.15	)	$	(0.73	)

The loss from discontinued operations during the three months ended March 31, 2003 related to the acquired Rainbow business. The November 2003 acquisition of SSH would not have materially affected the reported results of operations for the three months ended March 31, 2003 had the acquisition occurred on January 1, 2003.

The pro forma results include the estimated amortization of intangibles subject to amortization. The Company does not record amortization expense related to goodwill, but rather reviews the carrying value of the asset for impairment at least annually in accordance with the provisions of FASB Statement No. 142, Goodwill and Other Intangible Assets, the provisions of which the Company adopted effective January 1, 2002. The pro forma results are not necessarily indicative of the results that would have occurred if the acquisition had actually been completed on January 1, 2003, nor are they necessarily indicative of future consolidated results.

(5) RESTRUCTURING CHARGE

In connection with the acquisition and integration of Rainbow on March 15, 2004, the Company reevaluated all of its current leased and owned facilities to determine whether any were duplicative and where new needs for expansion should be directed. Based on the amount of available leased and owned property acquired in connection with Rainbow, the Company determined that it would cease use of certain existing leased facilities that were obtained in connection with the acquisition of Cylink. In accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, a liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit should be recognized and measured at its fair value when the company ceases using the right conveyed by the contract. The fair value of the liability at the cease-use date was determined based on the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, and included common area maintenance costs, real estate taxes and other costs that the Company is contractually obligated to pay over the remaining lease term under the provisions of the lease contact. The Company calculated an estimated liability of $6,190 as of March 16, 2004 based on current expectations of market rates for subleasing the property and the anticipated amount of time required to sublease the property. This amount was reduced by the remaining unfavorable lease liability of $4,705 recorded by the Company for this property in connection with Cylink purchase accounting, yielding a net charge during the period of $1,485 which is included in the results of operations of the Enterprise division. As of March 31, 2004, the liability is classified as an unfavorable lease liability in the accompanying consolidated balance sheet, including the current portion of $1,408 that is included in other accrued expenses.

(6) INVENTORIES

Inventories consisted of the following:


	March 31,			December 31,
	2004			2003
Raw materials	$	7,187		$	2,158
Work in progress		739			—
Finished goods		2,186			2,240
Inventoried costs relating to long-term contracts, net of amounts attributable to revenues recognized to date		6,499			—

		16,611			4,398
Reserve for excess and obsolete inventory		(1,457	)		(1,275	)

	$	15,154		$	3,123

(7) PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:


	March 31,			December 31,
	2004			2003
Furniture and equipment	$	11,073		$	7,442
Buildings		5,013			—
Computer software		2,548			2,501
Leasehold improvements		1,733			741

		20,367			10,684
Accumulated depreciation and amortization		(6,035	)		(6,875	)