1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Quarter ended March 31, 1997 Commission file number: 0-16641

RAINBOW TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)

Delaware 95-3745398
(State of incorporation) (I.R.S. Employer Identification No.)

50 Technology Drive, Irvine, California 92618
(Address of principal executive offices) (Zip Code)

Indicate by check mark whether the Registrant (i) 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 (ii) has been subject to such filing
requirements for the past 90 days.

Yes X No
--- ---

The number of shares of common stock, $.001 par value, outstanding as of March
31, 1997 was 7,812,733.

2
RAINBOW TECHNOLOGIES, INC.

TABLE OF CONTENTS

PART 1 - FINANCIAL INFORMATION

Item 1. Condensed Consolidated Balance Sheets at
March 31, 1997 and December 31, 1996 3

Condensed Consolidated Statements of Income
for the Three Months ended March 31, 1997 and 1996 4

Condensed Consolidated Statements of Cash Flows
for the Three Months ended March 31, 1997 and 1996 5

Notes to Condensed Consolidated Financial Statements 6

Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9

PART 11 - OTHER INFORMATION

Item 1 to 6 - Not applicable

SIGNATURES 11

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

March 31, 1997 December 31, 1996
-------------- -----------------
(unaudited)

A S S E T S

Current assets:
Cash and cash equivalents................................................... $33,782,000 $31,735,000
Marketable securities available-for-sale.................................... 10,970,000 11,437,000
Accounts receivable, net of allowance for doubtful accounts
of $423,000 and $330,000 in 1997 and 1996, respectively................... 12,371,000 15,297,000
Inventories ................................................................ 6,173,000 7,853,000
Unbilled costs and fees..................................................... 3,111,000 2,249,000
Prepaid expenses and other current assets................................... 2,289,000 2,106,000
----------- -----------
Total current assets.................................................... 68,696,000 70,677,000
Property, plant and equipment, at cost:
Buildings................................................................... 8,512,000 9,122,000
Furniture................................................................... 1,164,000 1,200,000
Equipment................................................................... 6,556,000 6,026,000
Leasehold improvements...................................................... 402,000 347,000
----------- -----------
16,634,000 16,695,000
Less accumulated depreciation and amortization.............................. 4,664,000 4,615,000
----------- -----------
Net property, plant and equipment....................................... 11,970,000 12,080,000
Goodwill, net of accumulated amortization of $7,812,000 and
$7,936,000 in 1997 and 1996, respectively.................................... 3,389,000 4,064,000
Other assets, net of accumulated amortization of $2,544,000
and $2,199,000 in 1997 and 1996, respectively................................ 7,432,000 6,543,000
----------- -----------
$91,487,000 $93,364,000
=========== ===========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable............................................................ $ 2,694,000 $ 4,109,000
Accrued payroll and related expenses........................................ 1,960,000 3,339,000
Other accrued liabilities................................................... 1,441,000 1,500,000
Income taxes payable........................................................ 1,575,000 948,000
Billings in excess of costs and fees........................................ 87,000 314,000
Long-term debt, due within one year......................................... 276,000 301,000
----------- -----------
Total current liabilities.............................................. 8,033,000 10,511,000
Long-term debt, net of current portion......................................... 1,930,000 2,145,000
Deferred income taxes ......................................................... 1,241,000 1,515,000
Other liabilities.............................................................. 121,000 117,000
Shareholders' equity:
Common stock, $.001 par value, 20,000,000 shares
authorized, 7,812,733 and 7,775,389 shares issued
and outstanding in 1997 and 1996, respectively............................ 8,000 8,000
Additional paid-in capital.................................................. 31,025,000 30,686,000
Cumulative translation adjustment........................................... (1,903,000) (251,000)
Cumulative difference between cost and market value of marketable
securities................................................................ 121,000 154,000
Retained earnings........................................................... 50,911,000 48,479,000
----------- -----------
Total shareholders' equity............................................ 80,162,000 79,076,000
----------- -----------
$91,487,000 $93,364,000
=========== ===========

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)

Three months ended Three months ended
March 31, 1997 March 31, 1996
------------------ ------------------

Revenues:
Software protection products ........ $ 13,973,000 $ 14,454,000
Information security products ....... 6,810,000 6,127,000
------------ ------------
Total revenues ................. 20,783,000 20,581,000

Operating expenses:
Cost of software protection products 4,181,000 4,375,000
Cost of information security products 5,711,000 5,168,000
Selling, general and administrative . 5,265,000 4,781,000
Research and development ............ 1,381,000 1,484,000
Goodwill amortization ............... 412,000 452,000
------------ ------------
Total operating expenses ....... 16,950,000 16,260,000
------------ ------------
Operating income ....................... 3,833,000 4,321,000
Interest income ........................ 426,000 434,000
Interest expense ....................... (70,000) (87,000)
Other income (expense) ................. (144,000) 74,000
------------ ------------
Income before provision for income taxes 4,045,000 4,742,000
Provision for income taxes ............. 1,613,000 1,909,000
------------ ------------
Net income ............................. $ 2,432,000 $ 2,833,000
============ ============
Net income per common and common
equivalent share .................... $ 0.30 $ 0.35
============ ============
Weighted average common and common
equivalent shares outstanding ....... 8,058,000 8,059,000
============ ============

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

Three months ended Three months ended
March 31, 1997 March 31, 1996
------------------ ------------------

Cash flows from operating activities:
Net income ......................................................... $ 2,432,000 $ 2,833,000
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization .................................................... 766,000 735,000
Depreciation .................................................... 409,000 395,000
Change in deferred income taxes ................................. 20,000 (689,000)
Allowance for doubtful accounts ................................. 100,000 60,000
Loss from retirement of property, plant, and equipment .......... 41,000 --
Write-down of long-term investment .............................. 75,000 50,000
Share in investee's loss ........................................ 120,000 --
Changes in operating assets and liabilities:
Accounts receivable ......................................... 2,587,000 (964,000)
Inventories ................................................. 1,631,000 (2,569,000)
Unbilled costs and fees ..................................... (862,000) 940,000
Prepaid expenses and other current assets ................... (132,000) (22,000)
Accounts payable ............................................ (1,410,000) 1,924,000
Accrued liabilities ......................................... (1,402,000) (811,000)
Billings in excess of costs and fees ........................ (227,000) --
Income taxes payable ........................................ 664,000 1,887,000
----------- -----------
Net cash provided by operating activities ............ 4,812,000 3,769,000

Cash flows from investing activities:
Purchase of marketable securities ................................. (561,000) (338,000)
Sale of marketable securities ...................................... 995,000 500,000
Purchases of property, plant, and equipment ........................ (913,000) (596,000)
Other long-term assets ............................................. (851,000) (1,056,000)
Capitalized software development costs ............................. (532,000) --
----------- -----------
Net cash used in investing activities ................ (1,862,000) (1,490,000)
Cash flows from financing activities:
Exercise of common stock options .................................. 158,000 932,000
Payment of long-term debt .......................................... (71,000) (76,000)
----------- ------------
Net cash provided by financing activities ............ 87,000 856,000
Effect of exchange rate changes on cash ............................... (990,000) (201,000)
----------- ------------
Net increase in cash and cash equivalents ............................ 2,047,000 2,934,000
Cash and cash equivalents at beginning of period ...................... 31,735,000 25,330,000
----------- ------------
Cash and cash equivalents at end of period ............................ $33,782,000 $ 28,264,000
=========== ============
Supplemental disclosure of cash flow information:
Income taxes paid .................................................... $ 1,292,000 $ 70,000
Interest paid ........................................................ 77,000 86,000

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
(Unaudited)

1. Basis of presentation

The accompanying financial statements consolidate the accounts of Rainbow
Technologies, Inc. (the Company) and its wholly-owned subsidiaries. Amounts for
the three month period ended March 31, 1996 have been restated to reflect the
acquisition of Software Security, Inc. (SSI) which has been accounted for using
the pooling-of-interest method (Note 5). All significant inter-company balances
and transactions have been eliminated.

In the opinion of the Company's management, the accompanying condensed
consolidated financial statements include all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the financial
position at March 31, 1997 and results of operations for the three months ended
March 31, 1997 and 1996. The condensed consolidated financial statements do not
include footnotes and certain financial information normally presented annually
under generally accepted accounting principles and, therefore, should be read in
conjunction with the Company's December 31, 1996 Annual Report on Form 10-K.
Results of operations for the three months ended March 31, 1997 are not
necessarily indicative of results to be expected for the full year.

The Company has subsidiaries in the United Kingdom, Germany, France and Belarus.
The Company utilizes the currencies of the countries where its foreign
subsidiaries operate as the functional currency. In accordance with Statement of
Financial Accounting Standards No. 52, the balance sheets of the Company's
foreign subsidiaries are translated into U.S. dollars at the exchange rates at
the respective dates. The income statements of those subsidiaries are translated
into U.S. dollars at the weighted average exchange rates for the respective
periods presented.

2. Earnings per share

Earnings per share are based on the weighted average number of common and common
equivalent shares outstanding during each period. Common equivalent shares
include the potential dilution from the exercise of stock options.

In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS No. 128).
SFAS No. 128 redefines the standards for computing earnings per share and is
effective for the company on December 31, 1997. The company believes adoption of
SFAS No. 128 will not have a material impact on future earnings per share
calculations.

3. Government Contracts

The Company is both a prime contractor and subcontractor under fixed-price and
cost-plus-fixed-fee contracts with the U.S. Government (Government). At the
commencement of each contract or contract modification, the Company submits
pricing proposals to the Government to establish indirect cost rates applicable
to such contracts. These rates, after audit and approval by the Government, are
used to settle costs on contracts completed during the previous fiscal year.

To facilitate interim billings during the performance of its contracts, the
Company establishes provisional billing rates, which are used in recognizing
contract revenue and contract accounts receivable amounts

7
in these financial statements. These provisional billing rates are adjusted to
actual at year-end and are subject to adjustment after Government audit.

The Company has unbilled costs and fees at March 31, 1997 of $3,111,000. Based
on the Company's experience with similar contracts in recent years, the unbilled
costs and fees are expected to be collected within one year.

4. Inventories

Inventoried costs relating to long-term contracts are stated at the actual
production costs, including pro-rata allocations of factory overhead and general
and administrative costs incurred to date reduced by amounts identified with
revenue recognized on units delivered. The costs attributed to units delivered
under such long-term contracts are based on the estimated average cost of all
units expected to be produced.

Inventories, other than inventoried costs relating to long-term contracts, are
stated at the lower of cost (first-in, first-out basis) or market. Inventories
consist of the following:

March 31, 1997 December 31, 1996
-------------- -----------------

Raw materials $ 704,000 $ 908,000
Work in process 1,043,000 819,000
Finished goods 2,936,000 3,211,000
Inventoried costs related
to long-term contracts 1,490,000 2,915,000
---------- ----------
$6,173,000 $7,853,000
========== ==========

5. Acquisitions

On October 4, 1996, the Company acquired Software Security, Inc. ("SSI") in a
merger transaction resulting in SSI becoming a wholly-owned subsidiary of
Rainbow. SSI, headquartered in Darien, Connecticut, designs, develops and
manufactures software security products to prevent the unauthorized use of
intellectual property. These products are sold in the U.S. and Europe.
Shareholders of SSI received 0.35 shares of Company common stock for each share
of issued and outstanding SSI common stock. Accordingly, the Company issued
336,511 shares of its common stock to SSI shareholders in exchange for all
outstanding SSI shares. In addition, 4,366 shares of Rainbow common stock were
reserved for issuance upon the exercise of assumed SSI options. The merger was
accounted for as a pooling-of-interests. Expenses associated with the merger of
approximately $191,000 were included in the consolidated results of operations
for the year ended December 31, 1996. There were no significant intercompany
transactions between Rainbow and SSI during any period presented.

On March 6, 1996 the Company entered into an agreement to acquire up to 58% of
Quantum Manufacturing Technologies, Inc. ("QMT") of Albuquerque, New Mexico. QMT
has recently obtained the exclusive worldwide license from Sandia National
Laboratories for the commercial use and exploitation of patented pulsed power
ion beam surface treatment technology known as "IBEST". IBEST technology
benefits and enhances the durability and utility of a large number of industrial
and consumer products at relatively low cost and without creating any impact on
the environment.

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On June 1, 1995, the Company acquired Mykotronx in a merger transaction
resulting in Mykotronx becoming a wholly-owned subsidiary of Rainbow. Mykotronx,
headquartered in Torrance, California, designs, develops and manufactures
information security products to provide privacy and security for voice
communication and data transmission. These products are sold to the U.S.
Government and customers in the aerospace and telecommunications industries.
Shareholders of Mykotronx received 2.64 shares of Company common stock for each
share of issued and outstanding Mykotronx common stock. Accordingly, the Company
issued 1,620,564 shares of its common stock to Mykotronx shareholders in
exchange for all outstanding Mykotronx shares. In addition, 195,096 shares of
Rainbow common stock were reserved for issuance upon the exercise of assumed
Mykotronx options. The merger was accounted for as a pooling-of-interests.

6. Other assets

Included in other assets are certain investments in early-stage companies
including a minority interest investment in Vendor Systems International
("VSI"). The Company closely monitors the operations and cash flows of these
companies to evaluate their status and ensure that amounts reported for these
investments do not exceed net realizable value. If the Company determines that
impairment in the investment of any such company exists, an adjustment would be
made to reduce the investment amount to net realizable value.

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RAINBOW TECHNOLOGIES, INC.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is management's discussion and analysis of certain significant
factors which have affected the consolidated results of operations and the
consolidated financial position of the Company during the periods included in
the accompanying condensed consolidated financial statements. This discussion
should be read in conjunction with the related condensed consolidated financial
statements and associated notes. Prior period financial statements have been
restated to reflect the acquisition of SSI, which has been accounted for using
the pooling-of-interest method.

RESULTS OF OPERATIONS
(dollars in thousands)

Three Months Ended March 31,
----------------------------
1997 1996
---- ----

Revenues
Software Protection Products $13,973 $14,454
Information Security Products 6,810 6,127
------- -------
Consolidated $20,783 $20,581
======= =======

Operating Income
Software Protection Products $ 3,024 $ 3,399
Information Security Products 809 922
------- -------
Consolidated $ 3,833 $ 4,321
======= =======

SALES

Revenues from software protection products decreased by 3% to $13,973,000, when
compared to the same period in 1996. The decrease in sales was primarily due to
the delay in the anticipated orders from major accounts. The average selling
price per product in the quarter ended March 31, 1997 increased approximately 7%
when compared to the same period in 1996. Unit volume for the three months ended
March 31, 1997 decreased by 11% when compared to the corresponding 1996 period.
The increase in the average selling price and the decrease in unit volume is due
to a change in customer mix. Major accounts were a main source of revenues in
the quarter ended March 31, 1996 while base accounts comprised a major portion
of revenues in the quarter ended March 31, 1997. Major accounts buy in higher
unit volume with deeper discounts than base accounts.

Revenues from information security products also increased by 11% to $6,810,000,
when compared to the same period in 1996. The revenue growth was primarily due
to the continued strong performance in the space communication security products
business with high volume deliveries of cryptographic black boxes on board
spacecraft.

GROSS PROFIT

Gross profit from software protection products for the quarter ended March 31,
1997 remained unchanged at 70% of revenues compared to the quarter ended March
31, 1996.

Gross profit from information security products for the quarters ended March 31,
1997 and 1996 was 16% of revenues.

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10
SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses for the three months ended March
31, 1997 increased by 10% when compared to the corresponding 1996 period. The
increase was due to increased staffing, increased amortization of other assets
and higher marketing expenses for the license management and internet security
products.

RESEARCH AND DEVELOPMENT

Total research and development expenses for the three months ended March 31,
1997 decreased by 7% when compared to the corresponding 1996 period. The
decrease was due to the capitalization of certain computer software development
costs of $532,000.

OTHER INCOME (EXPENSE)

Interest income for the quarter ended March 31, 1997 decreased by 2% to $426,000
because of lower interest rates.

The Company's share of operating losses in QMT during the quarter ended March
31, 1997 amounted to approximately $120,000. The Company holds a minority
investment in QMT.

PROVISION FOR INCOME TAXES

The effective tax rate was 40% for the three months ended March 31, 1997 and
1996.

LIQUIDITY AND CAPITAL RESOURCES

The Company's principal sources of operating funds have been from operations and
proceeds from sales of the Company's equity securities. The Company's cash flow
from operations for the three months ended March 31, 1997 and 1996 were
$4,812,000 and $3,769,000, respectively.

The Company intends to use its capital resources to expand its product lines and
for the acquisition of additional products and technologies. The Company has no
significant capital commitments or requirements at this time.

The Company's use of cash include purchases of property, plant and equipment,
repayment of long-term debt and investment in long-term assets.

Management believes the Company's current working capital of $60,663,000 and
anticipated working capital to be generated by future operations will be
sufficient to support the Company's requirement for at least the next twelve
months.

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PART II OTHER INFORMATION

Item 6 Exhibits and Reports on Form 8-K

(a) Exhibits

27 Financial Data Schedule

(b) Reports on Form 8-K

None

SIGNATURES

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

Dated: May 14, 1997

RAINBOW TECHNOLOGIES, INC.

By: /s/ WALTER STRAUB
-------------------------------------
Walter Straub
President and Chief Executive Officer