Management's Discussion and Analysis of Financial Conditions and Results of Operations ("MD&A") is designed to provide our shareholders with informative financial disclosures and present an accurate view of our financial position and operating results. Also included, is a narrative from the perspective of our management on our financial condition, results of operations, liquidity and other important factors that may affect our future results.

The following discussion should be read in conjunction with the "Item 8, Consolidated Financial Statements and Supplementary Data" included elsewhere in this Annual Report on Form 10-K. The results shown in this report are not necessarily indicative of the results to be expected in any future periods. This discussion contains forward-looking statements based on current expectations which involve risks and uncertainties. Actual results and the timing of certain events may differ significantly from those projected in such forward-looking statements due to the factors set forth in the section entitled "Item 1A. Risk Factors" and appearing elsewhere in this report. See "Cautionary Statement Regarding Forward-Looking Statements" in Part I of this Annual Report on Form 10-K.

Overview

Hifn is a leading provider of network- and storage-security and data reduction products that simplify the way major network and storage original equipment manufacturers ("OEMs"), as well as small-and-medium-size enterprises ("SMEs"), efficiently and securely share, retain, access and protect critical data. Our products feature industry-recognized patented technology for the continuous protection of information, whether it is in transit on a network or at rest on storage. Hifn's solutions are attractive to customers because their high-performance features, including some of the fastest compression and encryption processing speeds available in the market, multi-protocol capabilities, development tools and card level products with high-levels of integration, help reduce our customers' time-to-market. Our applied services processors ("ASPs") perform the computation-intensive tasks of compression, encryption and authentication, providing our customers with high-performance, interoperable implementations of a wide variety of industry-standard networking and storage protocols. Our network- and security-processors, compression and data reduction solutions are used in networking, security and storage equipment such as routers, remote access concentrators, virtual private networks ("VPN"), virtual tape libraries ("VTL"), nearline storage systems, switches, broadband access equipment, network interface cards, firewalls and back-up storage devices.

Hifn encryption and compression ASPs allow network and storage equipment vendors to add and accelerate security and data reduction functions in their products. Our encryption and compression processors provide industry-recognized algorithms that are used in products, such as VPNs, which enable businesses to reduce wide area networking costs by replacing dedicated leased-lines with lower-cost IP-based networks such as the Internet. Using VPNs, businesses can also provide customers, partners and suppliers with secure, authenticated access to the corporate network, increasing productivity through improved communications. Storage equipment vendors use our compression processor products and Express Data Reduction ("Express DR") cards to improve the performance and capacity of a wide range of disk and tape back-up systems. For example, storage OEMs who design in a Hifn Express DR card can offer their customers a storage solution that more than doubles storage capacity, saving them power, physical space, and operational and capital expenses.

Additionally, Hifn acquired Siafu Software, LLC, a California LLC ("Siafu"), a business related to storage technology, in July 2007, to complement our Express DR and Express Data Security ("Express DS") card business and expand our product offering to include integrated iSCSI network protocol based data encryption and compression software and sub-systems, reducing OEMs time to market in delivering secure and capacity optimized storage systems.

Hifn's network processor technology, acquired from International Business Machines Corporation ("IBM"), complements our security processor business and expands our product offerings to include a programmable, yet deterministic, device that performs computation-intensive, deep packet inspection for high-touch services. The architecture of our network processor is unique and is an architecture used with applications that require high-touch services.

Our principal end customers and their respective contribution to net revenues for the respective periods are as follows:

                                                         September 30,
  Years Ended                                          2008   2007   2006
  Cisco Systems, Inc. and its contract manufacturers   48%    53%    50%
  Huawei Technologies, Inc.                            10%    12%    13%
  EMC Corporation                                      11%      6%    3%
                                                       69%    71%    66%

International sales comprised 56%, 58% and 62% of net revenues for fiscal 2008, 2007 and 2006, respectively, and we anticipate that international sales will continue to grow in the future.

In July 2007, Hifn acquired Siafu, for $4.3 million in cash. Assets acquired included developed and core technology, other intellectual property, goodwill, fixed assets, inventory, certain accounts receivable and certain accounts payables. The acquired assets included in-process research and development of approximately $159,000, which was expensed at the time of the acquisition.

In December 2003, Hifn acquired certain assets and intellectual property valued at $15.9 million, including acquisition related costs. Assets acquired included inventory, fixed assets, developed and core technology and contract backlog. The acquired assets included in-process research and development of approximately $3.3 million, which was expensed at the time of the acquisition.

Hifn's quarterly and annual operating results are affected by a wide variety of factors that could materially and adversely affect net sales, gross margins and operating income. These factors include the volume and timing of orders received, changes in the mix of proprietary and second source products sold, market acceptance of our and our customers' products, competitive pricing pressures, our ability to introduce new products on a timely basis, the timing and extent of research and development expenses, fluctuations in manufacturing yields, cyclical semiconductor industry conditions, our access to advanced process technologies and the timing and extent of process development costs. Historically in the semiconductor industry, average selling prices of products have decreased over time. If we are unable to introduce new products with higher margins, maintain our product mix between proprietary and second source products, or reduce manufacturing cost to offset decreases in the prices of our existing products, then our operating results will be adversely affected. Our business is characterized by short-term orders and shipment schedules, and customer orders typically can be canceled or rescheduled without penalty to the customer. Since most of our backlog is cancelable without penalty, we typically plan our production and inventory levels based on internal forecasts of customer demand. Customer demand remains highly unpredictable and variances to the forecast can fluctuate substantially. The recent lack of liquidity in U.S. and international credit markets, and the additional impact of the uncertainty in economic conditions worldwide, may have an adverse effect on the spending patterns of our customers in future periods. In addition, because of high fixed costs in the semiconductor industry, we are limited in our ability to reduce costs quickly in response to any revenue shortfalls. As a result of the foregoing or other factors, we have experienced, and may in the future experience, material adverse fluctuations in our operating results on a quarterly or annual basis, which have in the past, and would in the future, materially affect our business, financial condition and results of operations.

Critical Accounting Policies

The financial statements included in this report are prepared in conformity with accounting principles generally accepted in the United States of America and require management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements and related footnotes. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue recognition. We derive our revenue from the sale of processors, cards, storage appliances and software license fees. Customers comprise primarily OEMs and, to a lesser extent, distributors. Revenue from the sale of processors, cards and storage appliances is recognized upon shipment when persuasive evidence of an arrangement exists, legal title and risk of ownership has transferred to the customer, the price is fixed or determined and collection of the resulting receivables is reasonably assured. Revenue from processors sold to distributors under agreements allowing certain rights of return is deferred until the distributor sells the product to a third party. At the time of shipment to distributors, we record a trade receivable for the purchase price based on the Company's legally enforceable right to payment. Additionally, since legal right for the inventory transfers to the distributors, inventory is relieved at the carrying value of the products shipped. The related gross margin is recognized as a liability and recorded as deferred income.

Software license revenue is generally recognized when a signed agreement or other persuasive evidence of an arrangement exists, vendor-specific objective evidence exists to allocate a portion of the total fee to any undelivered elements of the arrangement,

the software has been shipped or electronically delivered, the license fee is fixed or determinable and collection of the resulting receivables is reasonably assured. Returns, including exchange rights for unsold licenses, are recorded based on agreed-upon return rates or historical experience and are deferred until the return rights expire. To the extent we experience increased levels of returns, revenue will decrease resulting in decreased gross profit.

We receive software license revenue from OEMs that sublicense our software shipped with their products. The OEM sublicense agreements are generally valid for a term of one year and include rights to unspecified future upgrades and maintenance during the term of the agreement. License fees under these agreements are recognized ratably over the term of the agreement. Revenues from sublicenses sold in excess of the specified volume in the original license agreement are recognized when they are reported as sold to end customers by the OEM. Our deferred software license revenue balance as of September 30, 2008 was $299,000 and included approximately $60,000 in exchange rights for unsold licenses.

Management judgments and estimates must be made regarding the collectability of fees charged. Should changes in conditions cause management to determine the collectability criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

Inventories. We value our inventory at the lower of cost (determined on a first-in, first-out cost method) or market. Inventories are comprised solely of finished goods, which are manufactured by third party foundries for resale by us. We provide for obsolete, slow moving or excess inventories, based on forecasts prepared by management, in the period when obsolescence or inventory in excess of expected demand is first identified. Reserves are established to reduce the cost basis of inventory for excess and obsolete inventory. In fiscal year 2008 we recorded, as a charge to cost of revenues, an additional $139,000 for excess inventory and we recognized gross margin benefits of $123,000, as a result of the sale of inventories that had been previously written down. As of September 30, 2008, inventories at an original purchase price of $675,000, which were subsequently written down, were still on hand. Subsequent increases in projected demand will not result in a reversal of these reserves until the sale of the related inventory.

There is a risk that we will not be able to sell our inventories due to factors such as technological change, new product developments by our competitors, and product obsolescence. Actual demand may differ from forecasted demand and such differences may have a material effect on our financial position and results of operations.

Valuation of long-lived and intangible assets and goodwill. We evaluate the recovery of finite lived intangible assets and other finite long-lived assets, including property and equipment, acquired intangible assets and licensed intellectual property, whenever events or changes in circumstances indicate that their carrying value may not be recoverable through the estimated undiscounted future cash flows resulting from the use of the assets. If we determine that the carrying value of intangible assets and other long-lived assets may not be recoverable, we measure impairment by using the projected discounted cash flow method. Our judgments regarding the existence of impairment indicators are based on market conditions and operational performance of our business.

Factors we consider important which could trigger an impairment review include
(i) significant underperformance relative to historical or projected future operating results, (ii) significant changes in the manner of our use of the acquired assets or the strategy for our overall business, and (iii) significant negative industry or economic trends.

In accordance with SFAS 142, "Goodwill and other intangible assets," goodwill is deemed to have an indefinite life and is no longer amortized but rather is subject to annual impairment tests or interim impairment tests whenever events or circumstances indicate that the carrying value may not be recoverable. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess.

As of September 30, 2008, the carrying value of intangible assets and goodwill was $3.0 million and $1.4 million, respectively. During the quarter ended September 30, 2008, we evaluated and concluded there had been a triggering event indicating the carrying value of acquired developed and core technology may not be recoverable. This event was primarily related to the change in management's plans for the use of the acquired developed and core technology. We performed an estimate of future undiscounted cash flows associated with the use of the intangible asset and concluded that such cash flows exceeded its carrying value; accordingly, there was no impairment charge recorded. The estimate of undiscounted cash flows involves significant judgment and estimates by management, including assumptions about revenue and revenue growth rates, and operating margins. Actual cash flows could be less than those estimated, which could result in impairment to the intangible asset in the future.

As of September 30, 2008, Hifn's market capitalization was below its net book value. As a result, we compared Hifn's market capitalization after consideration of a control premium to its net book value and concluded that the second step in the goodwill impairment assessment was not required. We estimate fair value by reference to Hifn's market capitalization. Accordingly, further reductions in Hifn's market capitalization may result in further goodwill impairment that could have a material effect on our consolidated financial position and results of operations.

Allowance for doubtful accounts receivable. We estimate uncollectible accounts receivable at each reporting period. Specifically, we analyze the aging of accounts receivable, bad debt history, payment history, customer concentration, customer credit-worthiness, and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Account payables and other liabilities. Additionally, we review our accounts payable and accrued liabilities balances at each reporting period, and accrue liabilities as appropriate. Our analysis includes consideration of items such as product design and manufacturing activities, commitments made to or the level of activity with vendors, payroll and employee-related costs, historic spending and anticipated changes in the cost of services.

Accounting for income taxes. As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes, which involve estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Significant management judgment is required to assess the likelihood that our deferred tax assets will be recovered from future taxable income. Continuing losses in recent reporting periods increase the uncertainties regarding realizability of deferred tax assets. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination is made.

Litigation. From time to time, we may become involved in litigation relating to claims arising from the ordinary course of business. Management considers such claims on a case-by-case basis. We accrue for loss contingencies if both of the following conditions are met: (a) information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements; and (b) the amount of loss can be reasonably estimated.

Results of Operations

The following table sets forth certain statement of operations data as a percentage of total revenue for the periods indicated:

                                                                            September 30,
  Years Ended                                                    2008           2007           2006
  Net revenues:
  Processors                                                          93 %           94 %           92 %
  Software licenses and other                                          7              6              8
         Total net
revenues                                                             100            100            100
  Costs and operating expenses:
  Cost of revenues -
processors                                                            34             32             34
  Cost of revenues - software licenses and
other                                                                  1              1              1
  Research and
development                                                           35             30             48
  Sales and
marketing                                                             27             19             17
  General and
administrative                                                        17             20             16
  Amortization of
intangibles                                                            8              7              7
  Impairment of
assets                                                                 -              -              1
  Purchased in-process research and development                        -              -              -
  Total costs and operating
expenses                                                             122            109            124
  Loss from
operations                                                           (22 )           (9 )          (24 )
  Interest and other income,
net                                                                    2              4              4
  Loss before income
taxes                                                                (20 )           (5 )          (20 )
  Provision for income
taxes                                                                  -              -              -
  Net loss                                                           (20 )%          (5 )%         (20 )%

Net Revenues.

Net revenues by category, as a percentage of total net revenues and the
year-over-year change were as follows:

                                                                                 September 30,
                                          2008                    2007                                 2006               2008 vs.   2007 vs.
                                              % of net                                                        % of net      2007       2006
Years Ended                                   revenues              % of net revenues                         revenues     Change     Change
                                                                                ($ in thousands)
  Processors                       $ 36,702      93%     $ 40,191          94%                     $ 40,262      92%        (9)%         -
  Software licenses and other         2,716       7%        2,776            6%                       3,502       8%        (2)%       (21)%
                                   $ 39,418     100%     $ 42,967         100%                     $ 43,764     100%        (8)%        (2)%

Net revenues decreased by $3.5 million in fiscal 2008 as compared to fiscal 2007. Our processor revenues decreased $3.5 million, primarily due to a decrease in chip sales, partially offset by increased card sales. Also contributing to the overall decrease in net revenues was a $60,000 decrease in revenues from software licenses and royalties, which are generally dependent upon variability in the mix and demand for and timing of customer purchases of certain of our licensed software products.

Net revenues decreased by $797,000 in fiscal 2007 as compared to fiscal 2006. The decrease reflects the net effect of a decrease in software license and royalties of $726,000. The minor decrease in processor revenues was mainly attributable to new additions to Hifn's product lines, which result in lower sales volume at higher sales prices. The average gross margin of these products remained at relatively the same levels. The decrease in revenues from software licenses and royalties resulted from variability in demand for and timing of customer purchases of certain of the Company's licensed software products.

Semiconductor and software sales to our principal end customers and their respective contribution to net revenues for the respective periods are as follows:

                                                         September 30,
  Years Ended                                          2008   2007   2006
  Cisco Systems, Inc. and its contract manufacturers   48%    53%    50%
  Huawei Technologies, Inc.                            10%    12%    13%
  EMC Corporation                                      11%      6%    3%
                                                       69%    71%    66%

No other customers accounted for more than 10% of revenues in the periods presented.

Cost of Revenues.

Cost of revenues by category, as a percentage of the respective revenue category
and the year-over-year change were as follows:

                                                                     September 30,
                                        2008                  2007                  2006
                                              % of                  % of                  % of     2008 vs.   2007 vs.
                                            revenue               revenue               revenue      2007       2006
  Years Ended                               category              category              category    Change     Change
                                                                   ($ in thousands)
  Processors                     $ 13,214     36%      $ 13,903      35%     $ 15,001     37%        (5)%       (7)%
  Software licenses and other         609     22%           329      12%          506     14%         85%      (35)%
                                 $ 13,823     35%      $ 14,232      33%     $ 15,507     35%        (3)%        (8)%

Cost of revenues consists primarily of semiconductors which were manufactured to our specifications by third parties for resale by us. During fiscal 2008 cost of processor revenues as a percentage of net processor revenues increased one percentage point as compared to the same period in fiscal 2007. The increase in cost of sales reflects the increase in sales of lower margin cards

and a $123,000 increase in reserves for obsolescence, partially offset by a higher proportion of high margin processer sales. Operational costs decreased $1,000, mainly as a result of reductions in headcount, miscellaneous and other costs, partially offset by higher average salary rates in connection with employee performance reviews in October 2007.

Cost of processor revenues as a percentage of net processor revenues decreased two percentage points for fiscal 2007 as compared to the same period in fiscal 2006. During fiscal 2007 we recorded, as a benefit to cost of sales, $107,000 (net of a $68,000 provision) for the sale of excess inventory previously written down, as compared to a charge of $603,000 in fiscal 2006. Operational costs . . .