SAFENET INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004


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

Commission File Number 0-20634

SAFENET, INC.

(Exact name of registrant as specified in its charter)


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

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

443-327-1200
(Registrant’s telephone number)

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuer’s Common Stock as of August 2, 2004, was 23,877,368.

INDEX TO FINANCIAL STATEMENTS


		Page
PART I: FINANCIAL INFORMATION
Item 1:	Financial Statements (Unaudited)
	Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003		3
	Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003		4
	Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2004 and 2003		5
	Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2004		6
	Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003		7
	Notes to Consolidated Financial Statements — June 30, 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		30
Item 4:	Controls and Procedures		30
PART II: OTHER INFORMATION
Item 1:	Legal Proceedings		31
Item 4:	Submission of Matter to a Vote of Security Holders		31
Item 5:	Other Information		31
Item 6:	Exhibits and Reports on Form 8-K		31
SIGNATURES
EXHIBITS

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

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


	June 30,			December 31,
	2004			2003
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	79,208		$	21,651
Restricted cash		2,817			2,800
Short-term investments		98,688			92,280
Accounts receivable, net of allowance for doubtful accounts of $2,711 in 2004 and $940 in 2003		32,783			13,191
Inventories, net of reserve of $893 in 2004 and $1,275 in 2003		13,416			3,123
Unbilled cost and fees		854			—
Deferred income taxes		4,182			—
Prepaid expenses and other current assets		3,926			1,414

Total current assets		235,874			134,459
Property and equipment, net of accumulated depreciation and amortization of $5,788 in 2004 and $6,875 in 2003		14,866			3,809
Computer software development costs, net of accumulated amortization of $1,822 in 2004 and $1,696 in 2003		2,424			1,982
Goodwill		308,413			42,407
Other intangible assets, net of accumulated amortization of $17,410 in 2004 and $9,280 in 2003		146,039			23,599
Other assets		1,465			1,900

Total assets	$	709,081		$	208,156

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	11,167		$	3,799
Accrued salaries and commissions		10,483			3,770
Advance payments and deferred revenue		9,515			4,791
Accrued income taxes		6,723			2,294
Other accrued expenses		5,883			2,509
Accrued severance and related acquisition costs		4,481			—
Due to former owners of acquired companies		3,850			2,800
Accrued warranty costs		3,365			259
Deferred income taxes		7,533			2,607

Total current liabilities		63,000			22,829
Unfavorable lease liability		4,696			4,149
Deferred income taxes		48,398			2,181
Other liabilities		3,147			—

Total liabilities		119,241			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 23,864 in 2004 and 13,286 in 2003		239			133
Additional paid-in capital		622,190			199,783
Unearned compensation		(10,641	)		—
Accumulated other comprehensive income		4,412			5,394
Accumulated deficit		(26,360	)		(26,313	)

Total stockholders’ equity		589,840			178,997

Total liabilities and stockholders’ equity	$	709,081		$	208,156

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


	Three Months ended June 30,						Six Months ended June 30,
	2004			2003			2004			2003
				(Restated - Note 1)						(Restated - Note 1)
Revenues:
Licenses and royalties	$	2,670		$	2,593		$	4,851		$	4,571
Products		46,814			10,994			64,671			21,008
Service and maintenance		4,861			2,924			8,839			4,495

Total revenues		54,345			16,511			78,361			30,074
Cost of revenues:
Licenses and royalties		69			16			70			124
Products		25,000			3,740			32,443			6,689
Service and maintenance		674			319			1,265			639
Amortization of acquired intangible assets		3,258			823			4,386			1,890

Total cost of revenues		29,001			4,898			38,164			9,342

Gross profit		25,344			11,613			40,197			20,732

Operating expenses:
Research and development expenses		6,215			4,149			11,001			7,405
Sales and marketing expenses		7,096			3,813			11,307			6,879
General and administrative expenses		5,247			1,426			7,993			3,123
Costs of integration of acquired companies		2,778			1,374			3,362			2,989
Amortization of acquired intantible assets		2,335			1,269			3,869			2,036
Amortization of unearned compensation		2,158			—			2,519			—
Write-off of acquired in-process research and development costs		—			1,781			—			9,681
Restructuring charge		—			—			1,485			—

Total operating expenses		25,829			13,812			41,536			32,113

Operating loss		(485	)		(2,199	)		(1,339	)		(11,381	)
Interest and other income, net		1,360			154			1,224			242

Income (loss) before income taxes		875			(2,045	)		(115	)		(11,139	)
Income tax expense (benefit)		467			397			(68	)		1,038

Net income (loss)	$	408		$	(2,442	)	$	(47	)	$	(12,177	)

Net income (loss) per common share:
Basic	$	0.02		$	(0.24	)	$	(0.00	)	$	(1.26	)

Diluted	$	0.02		$	(0.24	)	$	(0.00	)	$	(1.26	)

Shares used in computation:
Basic		23,801			10,232			19,492			9,661
Diluted		25,653			10,232			19,492			9,661

See accompanying notes to consolidated financial statements.

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Six Months Ended June 30, 2004
(Unaudited, in thousands)


											Accumulated
	Common stock				Additional						other						Total
					paid-in			Unearned			comprehensive			Accumulated			stockholders'
	Shares		Amount		capital			compensation			income (loss)			deficit			equity
Balance as of January 1, 2004		13,286	$	133	$	199,783		$	—		$	5,394		$	(26,313	)	$	178,997
Costs incurred in connection with the registration of common stock issued for the asset acquisitions of Raqia Networks, Inc. and Rainbow Technologies, Inc.		—		—		(925	)					—			—			(925	)
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		—		—		—			2,519			—			—			2,519
Issuance of common stock under Employee Stock Purchase Plan		11		—		262			—			—			—			262
Issuance of common stock for stock option exercises		241		3		3,445			—			—			—			3,448
Issuance of common stock for stock warrants exercised		20		—		—			—			—			—			—
Foreign currency translation adjustment		—		—		—			—			(982	)		—			(982	)
Net loss		—		—		—			—			—			(47	)		(47	)

Balance as of June 30, 2004		23,864	$	239	$	622,190		$	(10,641	)	$	4,412		$	(26,360	)	$	589,840

See accompanying notes to consolidated financial statements.

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


	Six Months Ended June 30,
	2004			2003
				(Restated - Note 1)
Cash flows from operating activities:
Net loss	$	(47	)	$	(12,177	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Write-off of acquired in-process research and development costs		—			9,681
Depreciation and amortization of property and equipment		2,089			513
Amortization of computer software development costs		126			161
Amortization of other intangible assets		8,255			3,926
Amortization of unearned compensation		2,519			—
Income tax benefit related to stock option exercises		—			2,535
Restructuring charge		1,485			—
Deferred income taxes		(2,757	)		(1,227	)
Amortization of unfavorable lease liability		(469	)		(360	)
Changes in operating assets and liabilities:
Accounts receivable, net		(2,412	)		535
Inventories, net		(313	)		1,930
Prepaid expenses and other current assets		322			643
Accounts payable		(1,643	)		2,872
Accrued salaries and commissions		(3,175	)		(4,124	)
Accrued income taxes		2,609			455
Other accrued expenses		(1,700	)		(2,485	)
Advance payments and deferred revenue		418			336

Net cash provided by operating activities		5,307			3,214

Cash flows from investing activities:
Sales of available for sale securities		32,375			39,278
Purchases of available for sale securities		(38,463	)		(18,881	)
Purchases of property and equipment		(3,258	)		(1,598	)
Expenditures for computer software development		(568	)		(1,057	)
Cash received upon acquisition of Rainbow, net of cash paid		60,052			—
Cash paid for acquisition of Cylink and SSH, net of cash received		(447	)		310
Cash paid for Raqia, net of cash acquired		—			(1,240	)
Change in other assets		(74	)		655

Net cash provided by investing activities		49,617			17,467

Cash flows from financing activities:
Proceeds from stock options exercised and issuance of stock under Employee Stock Purchase Plan		3,710			6,666
Costs incurred in connection with the registration of common stock issued for the Rainbow, Cylink, SSH, and Raqia acquisitions		(925	)		—

Net cash provided by financing activities		2,785			6,666

Effect of exchange rate changes on cash		(152	)		(172	)

Net increase in cash and cash equivalents		57,557			27,175
Cash and cash equivalents at beginning of period		21,651			3,399

Cash and cash equivalents at end of period	$	79,208		$	30,574

See accompanying notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2004

(Unaudited, in thousands except per share amounts)

(1) BASIS OF PRESENTATION

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

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

(2) BUSINESS

SafeNet is a global leader in information security. Founded more than 20 years ago, the company provides complete security utilizing its encryption technologies to protect communications, intellectual property and digital identities, and offers a full spectrum of products including hardware, software, and chips.

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

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

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

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

(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

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

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

Product Warranties

The changes in the carrying amount of product warranties from December 31, 2003 to June 30, 2004 are as follows:


Balance as of December 31, 2003	$	259
Balance acquired from Rainbow		3,423
Cash payments made		(317	)

Balance as of June 30, 2004	$	3,365

The Company offers warranties on its products ranging from ninety days to two years. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the Company does business. The Company estimates the costs that may be incurred under its warranties and records a liability at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims and the estimated cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. While warranty costs have historically been within management’s expectations, it is possible that warranty rates will change in the future based on new product introductions and other factors.

Employee Stock-Based Compensation

As of June 30, 2004, the Company had five stock-based employee compensation plans. The Company accounts for those plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation cost is reflected in the statements of operations, in general and administrative costs.

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 June 30,						Six Months Ended June 30,
	2004			2003				2004			2003
				(Restated - Note 1)							(Restated - Note 1)
Net income (loss), as reported	$	408		$	(2,442	)		$	(47	)	$	(12,177	)
Add: Stock-based employee compensation expense included in net loss, net of taxes		885			—				1,033			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of taxes		(2,368	)		(1,082	)			(3,167	)		(1,738	)

Pro forma net loss	$	(1,075	)	$	(3,524	)		$	(2,181	)	$	(13,915	)

Income (loss) per share:
Basic — as reported	$	0.02		$	(0.24	)		$	(0.00	)	$	(1.26	)

Diluted — as reported	$	0.02		$	(0.24	)		$	(0.00	)	$	(1.26	)

Basic — pro forma	$	(0.05	)	$	(0.34	)		$	(0.11	)	$	(1.44	)

Diluted — pro forma	$	(0.05	)	$	(0.34	)		$	(0.11	)	$	(1.44	)

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 six months ended June 30, 2004, the Company granted 628 options to employees.

Reclassifications

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

(4) ACQUISITIONS

Rainbow Technologies, Inc.

On March 15, 2004, SafeNet acquired 100% of the outstanding common shares of Rainbow 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 provided information security solutions for mission-critical data and applications used in business, organization and government computing environments. As a result of the acquisition, the Company believes that it will be able to accelerate growth in the government security market, strengthen the Company’s competitive position in the commercial market, leverage SafeNet’s distribution platform and realize substantial economies of scale and synergy opportunities.

The aggregate purchase price was $412,636, consisting primarily of 10,306 shares of common stock valued at approximately $375,128, 1,944 options to purchase common stock with an aggregate value of the vested portion of $31,440, and estimated direct costs of the acquisition of $6,068. The fair value of the common stock issued was determined based on the average market price of the Company’s common stock over the period including three days before and after the terms of the acquisition were agreed to and announced.

The following table summarizes the preliminary estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The Company is in the process of completing certain analyses and obtaining certain third-party valuations primarily related to deferred income taxes and leased and owned properties. The Company is also finalizing its estimates of the direct costs of the acquisition, and thus, the allocation of the purchase price is subject to refinement.


Cash and cash equivalents	$	60,815
Short-term investments		319
Accounts receivable, net		16,862
Unbilled cost and fees		1,780
Inventories		9,980
Prepaid expenses		2,847
Property and equipment		9,837
Deferred income taxes		4,182
Goodwill		266,486
Intangible assets subject to amortization (8 year weighted average life)		117,277
Intangible assets not subject to amortization		13,520
Other assets		513

Total assets acquired		504,418

Accounts payable		9,022
Accrued salaries and commissions		9,905
Other accrued expenses		8,151
Other liabilities		3,187
Accrued income taxes		1,828
Deferred income taxes		53,885	&nb