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Aladdin Knowledge Systems Ltd – ‘20-F’ for 12/31/03

On:  Wednesday, 6/30/04, at 11:27am ET   ·   For:  12/31/03   ·   Accession #:  1178913-4-891   ·   File #:  0-22456

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 6/30/04  Aladdin Knowledge Systems Ltd     20-F       12/31/03   12:1.8M                                   Z-K Global Ltd/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 20-F        Annual Report of a Foreign Private Issuer           HTML   1.32M 
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 20-F

ALADDIN KNOWLEDGE SYSTEMS LTD.
(Exact name of Registrant as specified in its charter and translation of Registrant’s name into English)

Israel
(Jurisdiction of incorporation or organization)

15 Beit Oved Street, Tel Aviv 61110, Israel
(Address of principal executive offices)

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report:

11,477,922 Ordinary Shares

This annual report on Form 20-F includes certain “forward-looking” statements within the meaning of Section 21E of the Securities Exchange Act of 1934. The use of the words “project,” “expect,” “may,” “plan” or “intend”, or words of similar import, identifies a statement as “forward-looking.” There can be no assurance, however, that actual results will not differ materially from our expectations or projections. Factors that could cause actual results to differ from our expectations or projections include the risks and uncertainties relating to our business described in this annual report in Item 3 “Risk Factors.”

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We have prepared our consolidated financial statements in United States dollars and in accordance with accounting principles generally accepted in the United States.  All references herein to “dollars” or “$” are to United States dollars, and all references to “Shekels” or “NIS” are to New Israeli Shekels.

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PART I

Item 1.          Identity of Directors, Senior Management and Advisers

Not Applicable

Item 2.          Offer Statistics and Expected Timetable

Not Applicable

Item 3.          Key Information

A. SELECTED FINANCIAL DATA

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (‘GAAP’).

We derived the selected consolidated statements of operations data set forth below for the years ended December 31, 2001, 2002 and 2003, and the selected consolidated balance sheet data as of December 31, 2002 and 2003, from our audited consolidated financial statements, which are included elsewhere in this annual report. We derived the consolidated statements of operations data for the years ended December 31, 1999 and 2000 and the selected consolidated balance sheet data as of December 31, 1999, 2000 and 2001 from audited consolidated financial statements that are not included in this annual report. Please see Note 2 to our Consolidated Financial Statements for a discussion of our significant accounting policies.

The following selected financial data should be read in conjunction with our consolidated financial statements and notes thereto, included in this annual report. Historical results are not necessarily indicative of any results to be expected in any future period.

2

3

B. CAPITALIZATION AND INDEBTEDNESS
Not applicable.

C. REASONS FOR THE OFFER AND USE OF PROCEEDS
Not applicable.

D. RISK FACTORS

This annual report and statements that we may make from time to time may contain forward-looking information. There can be no assurance that actual results will not differ materially from our expectations, statements or projections. Factors that could cause actual results to differ from our expectations, statements or projections include the risks and uncertainties relating to our business described below.

Risk Factors Related to our Business

Our present assessments of future economic trends may adversely affect the accuracy of our earnings projections and guidance disclosed to the public.

From time to time we release earnings projections and disclose guidance to the public with respect to estimated results of operations. Our current calculations and predictions with regard to future demand and sales of our products are based on estimates derived from present assessments of future economic trends and sales forecasts based on information provided by our existing and potential customers. Such estimates however, remain uncertain. In the event that the economic outlook does not improve in accordance with our economic estimates, the rate of growth of demand for our products may stagnate and consequently, our sales may not increase and may even decrease. In addition, as it is difficult to accurately predict economic conditions and trends, we may not accurately gauge the effect of the general economy on our business. As a result, our actual results of operations may materially deviate from our earlier projections or may not react to such changing conditions in a timely manner and this may result in an adverse impact on our results of operations. Any such adverse deviations from our earlier guidance due to unforeseen changes in the economy may cause the price of our ordinary shares to decline.

4

We face intensive competition in the various industries in which we engage.

We engage in two primary industries: software protection security (or Digital Rights Management or DRM) and Enterprise Security. Each of these industries is highly competitive. In the token-based software security market, our primary direct competitors are Rainbow Technologies, Inc., which was recently acquired by SafeNet, and WiBu Systems. In addition to these primary competitors, we face competition from over twenty other software companies. In the Secure Software Licensing and Distribution Market we provide infrastructure solutions for electronic software distribution and licensing. Our primary competitor in this market is Macrovision Corporation. In addition, Digital River, although being our partner, can also be viewed as a competitor. Since the DRM industry is competitive, we foresee that we will continue to face competition from other software developers. Although we believe that the features and functions of our products are favorably distinguishable from those of our competitors, we cannot be certain that we will be able to further expand our market share or that we will be able to maintain our current market share. Furthermore, we cannot guarantee that we will be successful in our efforts to develop products with innovative features and functions, or that competitive pressures will not result in price reductions that could negatively affect our business in both the token-based software security and the markets for the manage and sale of software products over the Internet.
In the content security and anti-virus market, our primary competitor is Trend Micro Inc. In addition, we face new competition from anti-spam companies that offer e-mail content security solutions with plugs-ins for existing anti-virus products. If we are unable to provide customers with prompt solutions to new viruses and vandals, our current and potential customers may choose to buy products and services from our competitors. Since both anti-virus and anti-vandal software are adaptable to most computer systems and software, customers may change products if they determine that other products better suit their needs.
Furthermore, software developers and operating system vendors such as Microsoft have added security features to new versions of their operating systems and software that are designed to limit intrusions by unauthorized users or viruses and vandals via the Internet. Moreover, Microsoft recently announced that it has acquired anti-virus technology which will eventually be an integral part of the Windows operating system. Stronger security, in future Microsoft platforms, may significantly minimize the vulnerabilities through which virus and vandal penetration is possible. This, in turn, might lower the need to implement anti-virus solutions. As the incorporation of such features in future versions of operating systems and software make these systems less susceptible to outside penetration, there may be a decrease in the demand for our products. Although we believe that these solutions are less attractive than our products because they cannot be upgraded on a timely basis to address new viruses and vandals, we cannot guarantee that we will be able to convince our current and potential customers of the benefits of our dedicated anti-virus and anti-vandal solutions.
Within the Enterprise Security industry we also engage in the strong authentication market. Our main competitors in this area are RSA Security, SafeNet and Activcard. In addition, many other competitors exist, especially in the smart card market.
Many of our competitors in the various industries in which we engage, have substantially greater capital resources, research and development staff, facilities, marketing and distribution networks and name recognition as well as more extensive customer bases. While we plan to continue to improve our products, we cannot guarantee that we will successfully differentiate our products from those of our competitors or that the marketplace will consider our products superior to those of our competitors.

We have a recent history of operating losses.

Though we were profitable in 2003, we have a recent history of operating losses. The revenue and profit potential of three of our products, eSafe, eToken and Privilege, are unproven, and the revenues from these products are difficult to predict. In July 2001, we acquired certain assets of Preview Systems Inc.’s electronic software distribution business, which increased our expenses and has a history of losses. Any revenues from our acquisition of Preview are difficult to predict. We believe that the amount of cash and cash equivalents in our bank account is sufficient to support our current growth plans. We have no commitments to receive additional financing and due to our recent history of operating losses, it may be difficult for us to obtain additional financing.

5

We rely on independent distributors for a portion of our revenues.

Approximately 20.7%, of our revenues in 2003 were generated from sales to our independent distributors. Although none of our distributors accounted for more than 10% of our sales in the year ended December 31, 2003, if we lose or decrease the volume of sales to our distributors, our total sales could materially decrease. Although we maintain control of the distribution codes for some of our customers, our relationship with the end-users of our products is often indirect as we do not directly provide technical support to our end-users, which may impair our ability to effectively respond to end-users’ specific needs. In addition, we intend to sign additional distribution agreements in the future, which may make us more dependent on our distributors. There can be no assurance that our distributors will devote sufficient resources to market and support our products effectively.

We rely on a limited number of suppliers and subcontractors.

Most of the parts and components that are used to manufacture and assemble our software protection products are available from several sources, although we do purchase certain components from single source suppliers. We believe that we have sufficient inventory of these components to meet our foreseeable needs. If we are forced to use alternative parts or components, we might have to make certain changes in the design of products that use such components, which could result in delays and interruptions in shipments and could adversely affect our operating results. We use a single subcontractor to manufacture our proprietary application specific integrated circuits or ASICs. Our Hardlock product also contains proprietary ASICs, which are supplied by additional single source suppliers. As of January 2003, the sole manufacturer of our Hardlock line no longer produces these products. Although we believe we have sufficient stock of these products in our inventory for the foreseeable future, in the event that we fail to obtain in a timely manner, one or more alternate subcontractors to manufacture these products under similar terms as our former manufacturer, such failure could seriously harm our results of operations.

Some of our production costs are fixed.

Some of our production costs are fixed costs. Consequently, in the event of an economic slowdown that results in a decrease in the sales of our products, we will not be able to eliminate our fixed production costs. Our inability to reduce our production costs in response to market trends may cause a reduction in our profit margin, which could seriously harm our results of operations.

We are subject to several risks as a result of our international sales.

To date, our products have been sold primarily in Europe, North America, the Far East and Israel. We are subject to all of the risks inherent in international business activities including the following:

6

In addition, if we fail to obtain approvals, especially with respect to encryption, from foreign governmental bodies, our sales revenues and results of operations could be negatively affected.

If our maintenance and upgrades to our product disrupts our customers’ operations, we may suffer lost revenues and harm to our reputation.

We need to upgrade and improve our products periodically. Upgrading or deploying a new version of a product requires the cooperation of our existing customers and their network participants. These network participants may be reluctant to upgrade our product since this process can be complicated and time consuming and poses the risk of network failure. If our periodic upgrades and maintenance cause disruptions, we may lose revenue-generating transactions, our customers may elect to use other solutions and we may also be the subject of negative publicity that may adversely affect our business and reputation.

We may not be successful in keeping pace with the rapid technological changes that characterize our industry.

The markets for our products are characterized by rapid technological change, evolving industry standards, changes in end-user requirements and sophisticated hackers constantly improving their methods of stealing end-user technology and software. Therefore, our future success will depend upon our ability to enhance our existing products and to develop and introduce products that achieve market acceptance. In order to meet this challenge, we put a great emphasis on research and development. These efforts have enabled us to market our products and to concentrate our development activities to introduce new and enhanced releases of our products. However, there can be no assurance that we will timely or successfully complete the development of new or enhanced products or successfully manage transactions from one product release to the next, or that our future product will achieve market acceptance.

We may not be able to protect our intellectual property rights.

Our success and ability to compete greatly depends on our proprietary technology. We rely on a combination of patents and trade secrets, copyright and trademark laws, together with non-disclosure agreements, confidentiality clauses in our agreements and technical measures to establish and protect proprietary rights in our products. As of December 31, 2003, we had 18 registered patents and 34 pending applications in the United States. We also had six registered patents and 27 pending applications outside of the United States.

7

To license our products, we primarily rely on “shrink wrap” licenses that are not signed by the customer and, therefore, we may not be able to enforce our proprietary rights under the laws of certain jurisdictions. During 1988, we became aware of the possibility that Aladdin Systems Inc. was infringing our trademark. We did not, however, file a complaint against Aladdin Systems Inc. until October 2003, when Aladdin Systems Inc. issued a press release announcing its release of a new spam-blocking software product under our trademark. Upon learning of this product, we proceeded to file a complaint and request for preliminary relief against Aladdin Systems Inc., Aladdin Enterprise Solutions Inc. and Aladdin Systems Holding, Inc. We have recently reached a settlement with these companies as well as with Microcomputer Software, Inc., who recently purchased Aladdin Systems Inc. During the recent years we have become aware of and are currently investigating the possibility that one of our former Asian distributors is infringing our intellectual property. We are currently still investigating this possible infringement however, should we come to the conclusion that our intellectual property is being infringed upon, we will take appropriate steps to protect our intellectual property. Both in this specific case and in general, we cannot guarantee that we will successfully protect our technology because:

We may not be able to prevent others from successfully claiming that we infringed their proprietary rights.

Significant and protracted litigation may be necessary to protect our intellectual property rights. The software protection and Internet security industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We have not completed an in-depth exhaustive analysis of such patents or applications. Some of our competitors have extensive patent portfolios with broad claims. As the number of competitors in the market grows and the functionality of our products increases, the possibility of an intellectual property claim against us increases. In addition, because patent applications can take many years to be published, there may be a patent application now pending, of which we are unaware, which will cause us to be infringing when issued in the future.

To address any patent infringement or other intellectual property claims, we may have to redesign our products to avoid infringement or enter into royalty or licensing agreements on disadvantageous commercial terms. We may be unable to successfully redesign our products or obtain a necessary license. We were recently named as defendants in a patent infringement complaint filed in a U.S. court and intend to defend ourselves vigorously (see Item 8: “Financial Information – Legal Proceedings). Any infringement or other intellectual property claims, with or without merit, which are brought against us could be time consuming and expensive to litigate or settle and could divert management’s attention from our business.

8

Some of the products we produce may contain undetected errors or failures.

Software products as complex as those which we offer, may frequently contain undetected errors or failures, especially when first introduced or when new versions are released. Despite the extensive product testing which we conduct, some of our products could contain software errors, defects or viruses, or otherwise fail to meet customer specifications. Any product defects in our existing or new products may result in loss or deferral of our revenues, diversion of our resources, damage to our reputation, or increased service and other costs. Although we attempt to limit our liability, by including in most of our end-user license agreements, our distribution agreements and reseller agreements limitation of liabilities clauses for indirect or incidental damages arising out of the use of our products, there may be certain jurisdictions which will not enforce these clauses, thus exposing us to an adverse non-quantifiable financial risk. As a result, the limitation of liability provisions contained in these agreements may not be effective.

Our software protection products are vulnerable to piracy.

Like the products of other developers of software security products, our software security products do not provide absolute protection against piracy. We, together with our customers, continuously face challenges from computer hackers, who attempt to neutralize the protection our products provide in order to enable unlicensed copying of our customers’ software. In recent years, we have faced increasingly serious hacking problems, resulting from the development by hackers of methods to circumvent some parts of our software protection products. Such methods are often publicized over the Internet, making them readily available to those who wish to make unlicensed copies of our customers’ software. We are constantly in the process of developing and releasing solutions designed to respond to our customers’ complaints and handle hacking problems. Although, to date, we have been successful in developing effective solutions to these problems, we cannot guarantee that hackers will not continue to develop methods to contravene the protection provided by our products. Failure to provide effective software protection solutions could seriously harm our business.

Our content security product is vulnerable to virus attacks.

Like the products of other content security vendors, our content security products do not provide absolute protection against viruses and vandals. We, together with our customers, continuously face challenges from hackers, who attempt to neutralize the protection our products provide in order to penetrate and harm our customers’ networks. Failure to provide effective content security solutions could seriously harm our business.

We may be subject to product liability claims by our customers.

Our Internet content security products, specifically eSafe, are designed to protect our customers’ computer systems and restricted websites from unauthorized access and from malicious and inappropriate content such as vandals, viruses and worms. This malicious content can cause irreparable harm to our customers’ computer systems and businesses. Although we believe that widespread hacking of our products, including eSafe, is not economically feasible based on commercially available computer equipment, should hackers manage to bypass our products’ security features, affected customers could face irreparable harm. In addition, our software protection products are used to protect software from unauthorized use; if our products are ineffective, our customers may lose substantial revenues due to software piracy. As a result of damages they incur or lost revenues, customers may bring product liability and related claims against us. Such claims brought against us, whether valid or not, could negatively affect our business, operating results and our reputation as well as divert management time and resources. Although most of our sales agreements contain provisions designed to limit our exposure to potential product liability or related claims, in selling our products, we rely primarily on “shrink wrap” licenses that are not signed by our customers, which may be unenforceable under the laws of certain jurisdictions. As a result, the limitation of liability provisions contained in these agreements may not be effective.

9

Acquisitions could result in dilution, operating difficulties and other adverse consequences.

We have in the past grown through acquisitions. Our most recent acquisition was of the assets of Preview Systems Inc.’s electronic software distribution business. Any future acquisition on our part, could be affected by the process of integrating any acquired business into our own business and operations, is risky and may create unforeseen operating difficulties and expenditures. The areas in which we may face difficulties include:

Future acquisitions could also result in potentially dilutive issuances of equity securities, the incurrence of additional debt, contingent liabilities or impairment related to goodwill and other intangible assets, any of which could harm our business. Future acquisitions also could require us to obtain additional equity or debt financing, which may not be available on favorable terms or at all and may be dilutive.

We are subject to certain government controls in the export of our technologies and products.

As a result of our research and development activities in Israel, we are required to obtain export permission from the Israeli government before exporting certain technologies.We have received governmental permission to manufacture and export the eToken R2 and eToken PRO. We believe that all other products we currently market do not require such approval. However, we may require approval to sell certain products that are currently under development, including encryption technology and future versions of eToken. In addition, Israeli export regulations are subject to change and updates. We cannot guarantee that we will be successful in obtaining approvals for new products, nor be certain of the amount of time it may take to obtain them. Failure to obtain such approvals in a timely manner could negatively affect our business and operating results.

10

Risks Related to our Ordinary Shares

The market prices of our ordinary shares have been and may continue to be volatile.

The market prices of our ordinary shares are subject to fluctuations. The following factors may significantly impact the market price of our ordinary shares:

Our results are affected by volatility in the securities markets, which may affect our ability to raise additional financing.

Due to the weakening in the world economy, including as a result of the September 11, 2001 terrorist attacks and their aftermath, the securities markets have recently experienced volatility, which has particularly affected the market prices of equity securities of many high-technology companies, including companies having a significant presence in Israel. This volatility is often unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our ordinary shares, regardless of our actual operating performance. Such volatility in relation to our ordinary shares may affect our ability to raise additional financing in the future.

11

We may fail to meet the maintenance standards for the NASDAQ National Market.

Our ordinary shares are currently traded on the NASDAQ National Market. If we are unable to maintain the requirements for continued listing on the NASDAQ National Market, our ordinary shares could be delisted from trading on this market. Consequently, selling (and buying) our securities would be more difficult because of:

These factors could result in lower prices and larger spreads in the bid and ask prices for our ordinary shares than might otherwise be obtained.

If our ordinary shares were delisted from the NASDAQ National Market, we would seek to have the ordinary shares traded in the NASDAQ SmallCap Market or another national securities exchange. However, there is no certainty that we would be able to obtain an alternative listing for our ordinary shares.

Risks Related to our Operations in Israel

We benefit from certain tax benefits that may change or be withdrawn.

Four of our six expansion programs are currently eligible for certain tax benefits under The Law of Encouragement for Capital Investments (see Item 10: “Additional Information- Taxation” and Note 13a. to our Financial Statements). To be eligible for these tax benefits, we must continue to meet certain conditions, including making certain specified investments in property and equipment out of our own equity. If we fail to meet such conditions in the future, we could be required to pay certain taxes. There can be no assurance that such tax benefits will be continued in the future, at the current levels or otherwise. The termination or reduction of certain tax benefits could have a material adverse effect on our business, results of operations and financial condition.

Security, political and economic instability in Israel may harm our business.

Most of our manufacturing facilities and our corporate headquarters are located in Israel. Accordingly, security, political and economic conditions in Israel may directly affect our business, results of operations and financial condition.
Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors, as well as incidents of civil unrest. In addition, Israel and companies doing business with Israel have, in the past, been the subject of an economic boycott. Although Israel has entered into various agreements with Egypt, Jordan and the Palestinian Authority, there has been an increase in unrest and terrorist activity which began in September 2000 and which has continued with varying levels of severity into 2004. Certain parties with whom we do business have declined to travel to Israel during periods of heightened unrest or tension, forcing us to make alternative arrangements where necessary. We do not believe that the political and security situation has had any material impact on our business to date as a large portion of our business is overseas; however, we can give no assurance that security and political conditions will have no such affect in the future. Any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could adversely affect our operations and could make it more difficult for us to raise capital.In addition, Israel has recently experienced a wave of unionized general strikes, in connection with economic reforms being passed into legislation. Due to the fact that our products are manufactured in Israel and, for the most part, sold to customers outside of Israel, a prolonged general strike in which ports are shut down would affect our ability to deliver our products to our non-Israeli customers. Although, we have a contingency plan that would allow us to manufacture our products in Germany, we cannot guarantee that a prolonged general strike would not have a material adverse effect on our business, results of operations and financial condition.

12

Many of our employees in Israel are obligated to perform military reserve duty.

In the event of severe unrest or other conflict, many of our Israeli male employees could be required to serve in the military for extended periods of time. In response to the increase in terrorist activity and the renewed Palestinian uprising, there has been a significant call up of military reservists, and it is possible that there will be additional call-ups in the future. While we have operated effectively despite these conditions in the past, we cannot assess what impact these conditions may have in the future, particularly if emergency circumstances arise.

Our operations may be affected by negative economic conditions in Israel.

Israel has been going in recent years through a period of recession in economic activity, resulting in low growth rates and growing unemployment. Our operations could be adversely affected if the economic conditions in Israel continue to deteriorate. In addition, due to significant economic measures proposed by the Israeli Government, there have been several general strikes and work stoppages in 2003 and 2004, affecting all banks, airports, ports and other essential services. These strikes have had an adverse effect on the Israeli economy and on business, including our ability to deliver products to our customers or to receive raw materials from our suppliers in a timely manner. Following the passing by the Israeli legislature to implement the economic measures, the Israeli trade unions have threatened further strikes or work-stoppages, and these may have a material adverse effect on the Israeli economy and us.

If we are considered to be a passive foreign investment company, either presently or in the future, U.S. Holders will be subject to adverse U.S. tax consequences.

We will be a passive foreign investment company, or PFIC, if 75% or more of our gross income in a taxable year, including our pro rata share of the gross income of any company, U.S. or foreign, in which we are considered to own, directly or indirectly, 25% or more of the shares by value, is passive income. Alternatively, we will be considered to be a PFIC if at least 50% of our assets in a taxable year, averaged over the year and ordinarily determined based on fair market value and including our pro rata share of the assets of any company in which we are considered to own, directly or indirectly, 25% or more of the shares by value, are held for the production of, or produce, passive income. If we were to be a PFIC, and a U.S. Holder does not make an election to treat us as a “qualified electing fund,” or QEF, or a “mark to market” election, “excess distributions” to a U.S. Holder, and any gain recognized by a U.S. Holder on a disposition or our ordinary shares, would be taxed in an unfavorable way. Among other consequences, our dividends, to the extent that they constituted excess distributions, would be taxed at the regular rates applicable to ordinary income, rather than the 15% maximum rate applicable to certain dividends received by an individual from a qualified foreign corporation, and certain “interest” charges may apply. In addition, gain on the sale of our shares would be treated in the same way as excess distributions. The tests for determining PFIC status are applied annually and it is difficult to make accurate predictions of future income and assets, which are relevant to the determination of PFIC status. In addition, under the applicable statutory and regulatory provisions, it is unclear whether we would be permitted to use a gross loss from sales (sales less cost of goods sold) to offset our passive income in the calculation of gross income. In light of the uncertainties described above, we have not obtained an opinion of counsel with respect to our PFIC status and no assurance can be given that we will not be a PFIC in any year. If we determine that we have become a PFIC, we will then notify our U.S. Holders and provide them with the information necessary to comply with the QEF rules. A U.S. Holder who makes a QEF election is taxed currently on such holder’s proportionate share of our earnings. If the IRS determines that we are a PFIC for a year with respect to which we have determined that we were not a PFIC, however, it might be too late for a U.S. Holder to make a timely QEF election, unless the U.S. Holder qualifies under the applicable Treasury regulations to make a retroactive (late) election. U.S. Holders who hold ordinary shares during a period when we are a PFIC will be subject to the foregoing rules, even if we cease to be a PFIC, subject to exceptions for U.S. Holders who made a timely QEF or mark-to-market election, or certain other elections.

13

Israeli courts may not enforce judgments rendered outside of Israel.

Service of process upon our directors and officers, all of whom reside outside the United States, may be difficult to effect within the United States. Furthermore, since the majority of our assets are located outside the United States, any judgment obtained against us in the United States may not be enforceable outside the United States. There is doubt as to the enforceability of civil liabilities under the Securities Act and the Exchange Act in original actions instituted in Israel. However, subject to certain time limitations, Israeli courts may enforce United States final executory judgments for liquidated amounts in civil matters obtained after due trial before a court of competent jurisdiction (according to the rules of private international law currently prevailing in Israel) which enforces similar Israeli judgments, provided that certain procedural and legal requirements are adhered to.

Item 4.          Information on the Company

History and Development of the Company

Aladdin Knowledge Systems Ltd. is engaged in Software Security (or Digital Rights Management, or DRM) and Enterprise Security.
Within Software Security, Aladdin develops and markets the following products: HASP® (Hardware Against Software Piracy), HASP DocSeal, Hardlock® and Privilege™. HASP, Hardlock and DocSeal include both software and hardware components to protect our customers’ software against unauthorized copying and illegal use. By requiring software users to insert our tokens into their computers before they can use the protected software, it protects our customers’ intellectual property from unauthorized use. Privilege is a revenue-enabling software security platform that enables software publishers to distribute secure software via CD, ESD, or peer-to-peer networks; protect software copyright and intellectual property; reduce distribution/operational costs; and integrate with in-house or hosted Web stores and shopping carts. Privilege customers can choose and implement which path is right for them—lower cost, expanded distribution, and/or new licensing models.

Within Enterprise Security, Aladdin develops and markets eSafe® and eToken™. eSafe is a gateway-based, integrated content security solution and service that proactively protects networks against viruses, worms, spam and non-productive content; enables real-time inspection of Internet traffic without reducing network performance; reduces the risk of security exploits, P2P, IM and blended threats; and enables lower total cost of ownership with an integrated, modular design.

eToken is a USB based smart card device, the size of a house key, for cost-effective strong authentication and ecommerce that provides enhanced network/application security and ensures safe information access by authorized users; improved and cost-effective password and ID management; and secure mobility of digital credentials/certificates and keys. The eToken product line is composed of eToken R2, eToken Pro, and eToken Enterprise. A Software Developers Kit is available for creating custom eToken applications.

14

Our legal and commercial name is Aladdin Knowledge Systems Ltd. We were incorporated in Israel in 1985. Our principal executive offices are located at 15 Beit Oved Street, P.O. Box 11141, Tel Aviv, Israel 61110, and our telephone number is 972-3-636-2222. Our Internet addresses are: http://www.eAladdin.com, and http://www.aks.com. Information on our web site is not incorporated by reference in this annual report.

Capital Expenditures

During the past three years, our capital expenditures amounted to approximately $3.3 million. The focus of our capital expenditure program primarily included investment in back-office IT systems, equipment for research and development and testing purposes, general computer software and hardware, investment in additional financial modules for our global ERP and leasehold improvement in our offices.

B. BUSINESS OVERVIEW

Our Products

Software DRM (Digital Rights Management)

Development of software applications requires software developers to make major investments in time, money and other resources. Software piracy reduces revenues of software developers and returns on their investment. In addition, it harms paying customers who ultimately bear a substantial portion of the cost of illegal use in the form of higher license fees. Software piracy can occur in many forms, including:

According to the eighth annual independent study on global software piracy commissioned by the Business Software Alliance in June 2003, the global software industry’s losses due to the illegal use and duplication of business software reached $13.08 billion in year 2002. North America, Asia, and Western Europe accounted for the vast majority (84%) of revenue losses as these regions are the predominant users of software. The countries with the highest dollar losses due to software piracy, in descending order, were China, the United States, Japan, Germany, France and Italy. The total revenue loss for these countries was $8.0 billion or 60% of the worldwide losses in the year 2002.

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Due to the risk of substantial loss of revenue as a result of software piracy, software developers have a need to protect their software against unauthorized use. However, developers of low cost, “shrink wrap” software generally do not find the use of sophisticated mechanisms to protect their software cost-effective. Most users of sophisticated protection products today are software developers that sell products at relatively higher price levels, typically in excess of $250 per unit. These software developers range from smaller operations developing applications for specific vertical markets, to large software developers creating sophisticated enterprise-wide applications for distributed systems.

The need for software protection has led to the development of several methods to prevent the illegal use and duplication of software products. These methods include threats or institution of legal proceedings, which is often costly and time-consuming, and conditioning of product support on product registration. Neither of these methods effectively prevents illegal use or duplication of software products. Many software-based protection solutions use authorization codes to prevent unauthorized access to a program. Authorization codes are unreliable and inconvenient, due to the need to reauthorize or reassess the program for each use and for each user on a network.

Token-Based Security Software Solutions

Our security token-based products combine proprietary software and hardware components to prevent the unauthorized use of computer software. The software component enables the developer to integrate special software procedures into a protected program either directly by accessing the software or through the creation of protected versions of the software. These procedures check whether the appropriate token is connected to the computer’s USB, parallel or serial port. Each software developer is assigned a unique code which is embedded in an ASIC contained in the token and which must be verified by the protected software before the software can be activated.

During the development cycle of the software program, the developer inserts special instructions into the program, pursuant to which the program will automatically send a code, or “challenge”, to the token at any point in the program chosen by the developer. If the appropriate token is in place, it will automatically supply the proper return code, or “response”, to the challenge, thereby enabling the protected program to continue to operate. The challenge/response procedure is transparent to the end-user if the program is being run with the appropriate token in place. However, if there is no token in place, or the incorrect token is installed, the program will not operate. Each developer determines how the program will react to the failure to provide the appropriate response; for example, it can immediately cease operating, activate only specific modules or switch to a demonstration mode.

At the option of the customer, our software protection systems can also be implemented automatically - via the “Envelope” utility. This method of protection does not require the software developer to access the source code, and it is therefore available for use by software resellers. The Envelope utility creates a protected version of the original program, which will only run if the appropriate token is connected to the computer.

We believe that our token-based software security product lines offer several advantages compared to other software security devices, including other hardware-based devices manufactured by our direct competitors. These advantages include:

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We currently offer two lines of token-based software security systems: HASP and Hardlock In the past, we also used to offer MicroGuard.

HASP Product Line

Our initial software security product was HASP. The standard HASP model has undergone several upgrades and we now market it as HASP4. This token offers the primary security features that we develop, including an advanced ASIC chip with an on-chip encryption engine based on a proprietary algorithm, an Envelope tool for automatic protection and an Application Programming Interface (API) for customized protection.

The following chart sets forth information regarding our principal HASP4 products that support Windows 3.x, 95/98/ME/2000/NT/XP, Linux, Mac OS 8.6-9.x and Mac OS 10.x.:

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Hardlock Product Line

The following chart sets forth information regarding our principal Hardlock products, which support Windows 95/98/ME/2000/XP and Linux and use an on-chip encryption engine based on a proprietary algorithm:

Microguard Product Line

In the past, we sold an additional product line, MicroGuard, however the sales from this product line have become negligible.

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Secure Software Licensing  and Distribution Products

Privilege Software Commerce Platform

We believe that Privilege is one of the most comprehensive and flexible infrastructure solutions for managing, selling, and distributing software over the Internet. Through digital delivery, software is immediately and widely accessible, always in stock, and up to date. In addition, digital delivery of software saves printing, packaging and shipping expenses, inventory and warehousing costs, while ensuring the protection of our customer’s intellectual property.

Privilege is composed of three principle components:

The Builders –a suite of tools (some standard and some optional) that prepare software for electronic distribution, add mechanisms for protecting intellectual property, and set usage rights for software after installation.

The Commerce Server – the “back-end” component that manages and stores the digital inventory, and ensures secure, automated, and reliable fulfillment of software product and license orders.

The Storefront Engine – the “front-end” component that provides an access mechanism from a merchant’s on-line storefront to software warehoused on Commerce Servers, in order to sell and distribute software products to consumers.

The architecture of Privilege allows for the Storefront Engine to be operated either by a software publisher for direct sales or by an on-line reseller/retailer for “channel” sales. The Commerce Server is operated by either a software publisher or a software distributor. A Storefront Engine can connect to multiple Commerce Servers and a Commerce Server can connect to both multiple Storefront Engines and other Commerce Servers, creating a virtual software supply chain.

Privilege is tailored to the customer’s requirements based upon the core technology and the latest product release. In general, Privilege enables software publishers, distributors, and retailers to:

Enterprise Security

Content Security Products

Today’s anti-virus software products are able to cope with all existing and known viruses and virus technologies. The penetration and success of the Internet and its innovative active content technologies such as Java, ActiveX and HTML scripts have created a new type of Internet-specific threat collectively called malicious content or Vandals. In addition, numerous security holes discovered in various Internet enabled applications and even in Microsoft Windows operating systems, were immediately exploited by Vandals in order to penetrate and infect organizations. Unfortunately, existing anti-virus software products are not designed to deal with these new threats.  Since vandals use the Internet to travel from one infected computer to the other, they are effectively able to get into such computers before reactive signature-based security and anti-virus solutions receive an update and are able to block them.

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Signature-based anti-virus software has been widely used since 1990 and today more than 90% of corporate users have some sort of anti-virus protection deployed throughout their organization. However, anti-virus software operates by scanning files and trying to detect the signature of viruses from the database of known viruses and relies heavily on the anti-virus vendor that must continue to update the database in a timely manner in order to be protected against the new viruses. In the Internet age, one cannot afford to be merely defensive and risk becoming the first victim to be hit. Proactive solutions that provide real-time protection against unknown potential threats by enforcing content security policies at the gateway level are therefore critical.

eSafe Family of Products

The eSafe solution is based on a multi-tiered content security architecture, protecting the Enterprise on the following levels:

     eSafe Gateway

eSafe Gateway is an integrated proactive content security and an anti-virus solution for Internet gateways, eSafe Gateway manages Internet-borne information flow based on corporate policies for content that is inappropriate, nonproductive or contains malicious code such as vandals, viruses and worms. eSafe Gateway supports HTTP (web browsing), FTP (file download), and POP3/SMTP (e-mail) protocols and can be configured to operate in any network with or without a firewall. 

The following are eSafe Gateway’s unique features:

     eSafe Mail

eSafe Mail is a subset of eSafe Gateway that provides proactive content security for e-mail only (SMTP). In addition, we sell an add-on module of Advanced Anti Spam to our eSafe Mail product.

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     eSafe Web

eSafe Web is a subset of eSafe Gateway, that provides proactive content security for browsing (HTTP) and file downloading (FTP).

eSafe’s Unique technologies

     Virtual Appliance™

The Virtual Appliance concept is the industry’s first content security and anti-virus gateway and mail inspection product that is delivered as a CD image,  pre-loaded with a hardened Linux OS and eSafe content security applications. It can be easily installed on any hardware of customers’ choice, thus turning it instantly into a security appliance.

     MacroTerminator™

By using pattern-matching exact behavior analysis (heuristic algorithms), MacroTerminator is capable of detecting, with a high degree of accuracy, macro viruses that are so new that they have not yet been individually analyzed. Macro viruses are written in a high-level VBA (Visual Basic for Applications) language. High-level languages are subject to heuristics, which enables high accuracy of hostile activity detection, while maintaining an extremely low level of false positives (false alarms). Macro Terminator can recognize all known malicious macro families (such as Melissa), and therefore can block the majority of new, yet unknown variants/mutations of these families. Macro Terminator also has a high detection rate of new, unknown malicious macros, which are not variants of known macro families.

     GhostMachine™

Using this unique technology, all members of the eSafe family of products have the ability to increase detection rates for polymorphic viruses. Polymorphic viruses are computer viruses that encrypt or “cloak” themselves while hiding in a computer’s memory. These viruses need to decrypt themselves, or “de-cloak” in order to attack their intended targets. Ghost Machine creates a simulated, virtual machine in a computer’s memory, fooling polymorphic viruses into “de-cloaking” themselves, at which point they become visible and therefore vulnerable to the eSafe anti-virus scanning engine.

     SmartScript™ Filtering

eSafe is able to intelligently filter content from scripts embedded in Web pages. These scripts can be programmed in JavaScript, JScript, and/or VBScript.  eSafe will, if configured to do so, automatically strip out only those scripts that contain malicious commands (such as a command to access the hard drive of a local system).

Smart Script filtering can recognize all known malicious script families and can therefore block a majority of new, yet unknown variants/mutations of these families. It also has a high detection rate of new, unknown malicious scripts, which are not variants of known script families.

     XploitStopper™

The virus and Internet worm outbreaks in the last three years (Kaza, Nimda, Sircam, BugBear, etc.) were able to cause worldwide damage that is estimated at billions of US Dollars by industry experts.  All those outbreaks were caused because viruses and worms were able to exploit existing security holes in various Internet applications (Outlook, IIS, etc.).  eSafe’s new and innovative XploitStopper™ technology is designed to look for known security holes that can be exploited by malicious code and block them before the virus is able to enter the organization.  This unique approach minimizes the threat from new and unknown viruses and Internet worms.

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     NitroInspection™

eSafe Gateway uses NitroInspection technology to provide superior protection with little or no impact on network performance and the end-user experience. This technology is built around a concept similar to the “stateful” inspection technologies pioneered by Check Point’s Firewall-1 line of firewall products.

This method of scanning files is far superior to the older proxy method. Alternative proxy-based products require the content security device to receive the entire file and scan or approve it before allowing any traffic to reach the requesting client. This caused time-outs, user complaints, and bandwidth utilization problems.

Anti-Spam

The phenomenon of spam is growing rapidly. It is estimated that over 50% of today’s business e-mail is spam. Spam forces Internet service providers to cope with increasing amounts of e-mail traffic, and the bandwidth of businesses is largely consumed by it, impacting resources and productivity. According to International Data Corporation, spam is no longer just a nuisance; it is quickly becoming both a potential legal liability and a major productivity drain for both corporate information technology departments and corporate users.  Spam not only drains worker productivity and consumes valuable information technology resources such as disk storage, central processing unit cycles, and network bandwidth, but it can also expose the organization to legal liability due to the offensive nature of some messages.  We provide solutions to these problems by utilizing multiple layers of anti-spam technology ranging from basic solutions that are built into our product to offering our customers a sophisticated anti-spam service, which is based on our original equipment manufacturer (OEM) relationship with Cobion, a German company that specializes in anti-spam and web filtering technologies.

Strong Authentication Products

     eToken Family of Products

The growth of both the Internet and mobile computing are continuously challenging and redefining data security requirements. Corporations are caught between the need for remote, convenient access and the need for protection from vandalism, espionage and theft. Conventional password schemes alone are not effective in protecting systems and are very costly to manage.

During 1999 and 2000, we released the eToken R2 and the eToken Pro, secure authentication devices which are the size of a house key, and the accompanying software, eToken Enterprise.  eToken ensures that only legitimate users gain access to network or PC resources by requiring that the token be inserted into the computer’s USB port before allowing the computer or application to operate. Our eToken technology offers users with solutions and tools, including authentication, encryption and secure certificate storage capabilities, all housed within the small, portable eToken.  In addition, eToken provides user flexibility in deployment through advanced smartcard technology.  eToken’s versatile architecture  enables organizations  to  use  both existing authentication systems  or introduce new ones  based  on  advanced  technology, while maintaining a similar end-user experience. Support for standard security interfaces, coupled with the ability to cache user passwords, enables the eToken solution to be operated with almost any authentication system.

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Our eToken technology allows for concurrent storage of multiple private keys, passwords and digital certificates for use in a wide variety of applications. eToken can be used as an authentication device for e-banking, virtual private networks, extranets and wide area networks and as an enabler for e-Commerce. eToken serves as an encryption device that enables companies to verify the identity of individuals who request access to protected content or applications provided over their networks or websites.  eToken can be used to protect sensitive data and resources by performing file encryption and access control functions. eToken can also be used in conjunction with third-party software to digitally sign and/or encrypt electronic messages so that they cannot be modified or intercepted. eToken does not require an additional reader to effectively control any user within the network.  eToken links to USB ports in PC’s and laptops of all major manufacturers.

International Data Corporation predicts that USB tokens and smartcards will become interoperable because USB tokens also have PKI (Public Key Infrastructure) and digital-certificate capability.  As the technology develops, USB keys will be able to provide an integrated solution that could only previously have been provided through separate authentication devices.  We are currently developing expanded functionality for the eToken in order to simplify password management by allowing the eToken to store multiple log-on credentials, such as different passwords, which can then be automatically entered into the application without needing the user to remember or manually type it in.

In the first quarter of 2004 we entered into an agreement with VeriSign, Inc., according to which, VeriSign will use our eToken™ NG with One-Time Password (OTP) functionality for its strong authentication service beta program, which began testing in April 2004.

Marketing and Promotion

We conduct a number of marketing programs to support the sale and distribution of our products. These programs are designed to inform existing and potential customers about the capabilities and benefits of our products. Our marketing activities include:

We sell our products directly through subsidiaries, value-added resellers, original equipment manufacturers and through independent distributors in over 50 countries worldwide.  We believe that our success and ability to market our products will depend, to a significant degree, on our subsidiaries and independent distributors and resellers.  In the years ended December 31, 2003, 2002, and 2001, approximately 20.7%, 22.6% and 19.4%, respectively, of our consolidated revenues were generated from sales to our independent distributors. During these periods, no single distributor accounted for more than 10% of our sales. We generally have short-term written agreements with our distributors and resellers, all of which are non-exclusive.

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In 2001, we entered into distribution agreements with leading distributors in Europe (Articon-Integralis) and the United States (Westcon Group).  We have continued our relationship with these distributors in 2002 and into 2003. The Alasso unit of Articon-Integralis was recently sold by Articon-Integralis to InTechnology plc and we have maintained our relationship with Alasso.  We have also entered into an agreement with Digital River, Inc., which allows us to offer our products and services to their customers at our standard rates. We intend to continue to target resellers and system integrators that focus on providing security solutions to enterprises. In addition, we launched in 2001 Aladdin Security Alliance, our solution partner program. In this program we present joint solutions that are offered to the market by both our partners and our distribution channels. These distribution channels include vendors in areas such as PKI, VPN (Virtual Private Network), Access Control, Web Access, PC Security and more.

Maintenance and Support

We believe that providing a high level of customer service and support is essential to our success. Outside of Israel, the first-line of support is provided by our subsidiaries and distributors, while we provide the second-line of support.

     HASP and Hardlock – Token-Based Security Software Solutions

We, together with our subsidiaries and distributors, provide maintenance and support services for our software security products free of charge.  These maintenance and support services include a “hot-line” telephone number that can be used by customers during business hours to assist them in solving problems.  We also support customer inquiries via fax and e-mail, and provide additional technical information on our Internet home page. In addition, software developers who have purchased our token-based software security products can download software updates from our FTP (File Transfer Protocol) Internet site free of charge.

     Privilege - Secure Software Licensing and Distribution Products

The license agreement for Privilege SCP includes a maintenance and support component. The standard maintenance and support package provides free access to product updates along with access to our support centers worldwide, during set hours.  The support centers are accessible to our customers via e-mail or telephone. 

Managed Privilege is our managed service which hosts the software publisher’s store. Our Managed Privilege customers receive two levels of support. The first level includes free access to product updates along with access to our support centers.  The second level includes various management and administrative options to ensure Web site availability, prepare products for distribution, and track the success of product promotions.

     eSafe - Content Security Products

We generally provide maintenance and support services for our Internet security products during the first 12 months following the installation of the product, depending on the terms of each particular sale and the warranty that we provide.  These maintenance and support services include a “hot-line” telephone number during business hours, fax and e-mail support and product updates.  After the expiration of the warranty period, each of our Internet security customers is offered a long-term maintenance agreement with us, or with one of our subsidiaries or distributors, as the case may be. These maintenance agreements include the same services provided during the warranty period. The maintenance agreements generally have one-year terms and in some cases are automatically renewable.

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     eToken - Enterprise Security Products

We generally provide a 12-month manufacturer’s hardware warranty on eToken products.  During this warranty period, we replace any eToken that fails as a result of a recognized manufacturer’s defect with a like replacement. We provide eToken users that have purchased a support service with technical support via phone, fax and e-mail from our Tel Aviv headquarters and through our subsidiaries.  We also offer a comprehensive web site containing technical support information on eToken.

Government Controls

As a result of our research and development activities in Israel, we are required to obtain export permission from the Israeli government before exporting certain technologies. We have governmental permission to manufacture and export the eToken R2, and eToken PRO, and we have renewed the governmental permission to manufacture and export eToken R2, and eToken PRO, including the most up to date releases of these products. In addition we have recently received governmental permission to manufacture and export eToken NG / PRO. We believe that all of the other products that we currently market do not require such approval.  However, we may require approval to sell certain products currently under development that include encryption technology as well as future versions of eToken. 

Sales of our products in Europe are subject to various regulations, including directives adopted by the European Community. These directives provide, among other things, that we comply with International Standard ISO 9000 (European Standard EN 29000) entitled “Model for Quality Assurance in Design, Development, Production, Installation and Servicing.” In March 2003, we received ISO 9001-2000 certification, which is valid until March 31, 2006. We have consistently passed the semiannual ISO audit.

In addition, we receive certain tax benefits and reduced tax rates from the government of Israel (See Item 10: “Additional Information - Taxation.” and Note 13a to our Financial Statements).  The entitlement to these benefits is conditional upon our fulfillment of the conditions stipulated by the law, regulations published thereunder and the instruments of approval for the specific investments including investments from equity.  In the event of a failure to comply with these conditions, the benefits could be canceled and we would be required to refund the amount of benefits, in whole or in part, with the addition of linkage difference and interest.

Customers

We sell our software security products primarily to software developers and distributors.  No one customer accounted for more than 10% of our net sales in 2003, 2002 and 2001.  The following is a breakdown of our sales by geographic market:

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Manufacturing, Testing and Suppliers

Our manufacturing, system integration and testing operations for our HASP, Hardlock, and eToken products are located in Kiryat Gat, Israel. Certain components of our Hardlock & HASP line of products are manufactured on a sub-contracting basis in Germany.

Our HASP, Hardlock and eToken manufacturing operations consist primarily of assembling finished goods from components. We seek to monitor quality with respect to each stage of the production process, including the selection of component suppliers, the assembly of finished products and final testing, packaging and shipping. We use an automated surface-mounted technology to produce substantially all of our HASP, Hardlock and eToken products. We perform testing and quality assurance procedures with respect to the components and subassemblies, which are incorporated into our final products and with respect to the final products ourselves. We believe that our in-house manufacturing capabilities with respect to our HASP, Hardlock and eToken product lines have been instrumental in achieving a high degree of reliability for our products.

We generally fill our typical order for products within several hours to several days after receipt of a firm purchase order. Due to the nature of our sales and marketing efforts and our close contact with our customer prior to the receipt of a purchase order, we can often plan production and order the components necessary to enable us to deliver products in a relatively short time after our receipt of a purchase order. 

Most of the parts and components that we use to manufacture and assemble our products are available from several sources, although we do purchase certain components from single source suppliers and prices may fluctuate due to changes in the market. Currently, we buy most of our raw materials from Philips, Elmos, Fairchild, Seiko, Infinion, Cypress, Samsung and Motorola. To ensure the supply and price of components which we purchase from single source suppliers, these components are purchased under long term contracts with our suppliers that ensure supply and price for periods of a year and more. We also hold safety stocks of such components to ensure steady supply in the event our supplier experiences difficulties or delays. Furthermore, we split the storage of critical components amongst different locations to ensure that there is always a readily available supply of critical components.

We have implemented a contingency plan to support the ability to produce and supply goods to our customers in the event that one of our sites is shut down. The contingency plan covers physical production and software recovery. It has been tested and is operative. The safety stock which is held by our subsidiaries is part of our contingency plan.

C. ORGANIZATIONAL STRUCTURE

We have three wholly owned subsidiaries: Aladdin Knowledge Systems, Inc., a United States subsidiary incorporated in the state of New York; Aladdin Japan & Co. Inc., a Japanese subsidiary; and Aladdin Western Europe Ltd. (formerly known as Aladdin Knowledge Systems UK Ltd.), a United Kingdom subsidiary incorporated in England and Wales. These subsidiaries are all involved in distribution, support and management for our products.

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In addition we have a wholly owned holding company, Hafalad BV, which is incorporated in Holland. Through Hafalad we wholly own Aladdin Western Europe BV (formerly known as Aladdin Knowledge Systems BV), Aladdin Western Europe (Aladdin France S.A.R.L.) (formerly known as Aladdin France S.A) and Aladdin Knowledge Systems Deutschland GmbH incorporated in Germany. Aladdin Western Europe BV is incorporated in Holland and Aladdin Western Europe (Aladdin France S.A.R.L.) is incorporated in France. We have finalized the process of reorganizing the management of activities in France, the Netherlands and the United Kingdom, under the single management of Aladdin Western Europe Ltd. In addition to engaging in distribution, support and management, our German subsidiary and Portland, Oregon office provide research and development services, however we have nearly finalized the process of closing our Portland, Oregon office and have transferred the research and development operations conducted in our Portland office to Tel Aviv. In addition, we have recently established Aladdin Asia Limited, a Hong Kong based subsidiary owned by us and by Hafalad BV.

D. PROPERTY, PLANTS AND EQUIPMENT

Our executive, research and development offices and certain of our production facilities are located in Tel Aviv, Israel. We currently lease a total of approximately 2,300 square meters of space from an unaffiliated entity, at an aggregate base monthly rent of approximately $17,500, which lease expires in 2006 with an option for one additional year.

Most of our production facilities are located in Kiryat Gat, Israel. We currently lease a total of approximately 976 square meters in Kiryat Gat, which lease expires on September 30, 2005, for an aggregate monthly rent of approximately $6,300.In addition, we lease approximately 725 square meters in Haifa, Israel, where our Internet security research and development activities are headquartered, at a monthly rent of approximately $5,500. Our lease in Haifa expires on February 29, 2005.

We lease space for our operations in the United States, Germany, United Kingdom, Japan, the Netherlands and France. Aggregate monthly lease payments under these leases are approximately $97,000. Our leases in these locations expire between 2004 and 2007.

Our aggregate lease expenses (including motor vehicles) for the years 2003, 2002 and 2001 were $2,570,000,$2,514,000 and $2,423,000, respectively. We believe that our facilities are adequate for our current needs. In the event that additional facilities are required, we believe that we could obtain such additional facilities at commercially reasonable prices.

Item 5.          Operating and Financial Review and Prospects

Critical Accounting Policies

We have identified the following policies as critical to the understanding of our financial statements. Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, based upon information available at the time that they are made, historical experience and various other factors that are believed to be reasonable under the circumstances. These estimates are evaluated by us on an on-going basis. Actual results may differ from these estimates under different conditions.

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We believe that the application of the following critical accounting policies entails the most significant judgments and estimates used in the preparation of our consolidated financial statements

Revenue recognition. Our products are generally a bundled hardware and software solution that are delivered together. Revenues from products are recognized in accordance with Staff Accounting Bulletin No. 104 when the following criteria are met: persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collectibility is probable and we do not have any obligation to customers after the date in which products are delivered.

We generate revenues from licensing the right to use our software products, from the sale of products, maintenance and updates directly to end-users and indirectly mostly through value-added resellers, original equipment manufacturers and independent distributors (all of them are considered end users).

Revenues from software license agreements are recognized, in accordance with Statement of Position 97-2, “Software Revenue Recognition”, as amended (“SOP 97-2”). SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair value of the elements. In addition the Company has adopted Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, “(“SOP 98-9”). SOP 98-9 requires that revenue be recognized under the “residual method” when Vendor Specific Objective Evidence (“VSOE”) of Fair Value exists for all undelivered elements and VSOE does not exist for all of the delivered elements. Under the residual method any discount in the arrangement is allocated to the delivered elements.

Revenue from license fees is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant obligations with regard to implementation remain, the fee is fixed or determinable, and collectibility is probable.

Maintenance and support revenue included in multiple element arrangements is deferred and recognized on a straight-line basis over the term of the maintenance and support agreement. The VSOE of fair value of the undelivered elements (maintenance, support and services) is determined based on the price charged for the undelivered element when sold separately.

Time-based licenses include maintenance and on-going support. VSOE of fair value does not exist for the related support arrangement as maintenance is not priced or offered separately for such arrangements. In these cases, we recognize the license and maintenance revenue ratably over the period of each arrangement.

Deferred revenues include unearned amounts received under maintenance contracts, and amounts billed to customers but not yet recognized as revenues.

Accounts Receivable. We are required to perform ongoing credit evaluations of our trade receivables. We maintain an allowance for doubtful accounts. Management exercises its judgment as to our ability to collect outstanding receivables. Provisions are made based upon a specific review of all the outstanding invoices.In determining the provisions, we analyze our historical collection experience and current economic trends. If the financial condition of our customers in general deteriorates, our revenues growth might be limited and additional allowances might be required.

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Inventories. Inventories are stated at the lower of cost or market value. Cost is determined by the average cost method. We periodically evaluate our quantities on hand relative to current and historical selling prices and historical and projected sales volume. Based on these evaluations, inventory write-offs and write-down provisions are provided to cover risks arising from slow moving items. If the future market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

Deferred tax. We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is likely to be realized. In assessing the need for a valuation allowance, we consider all positive and negative evidence, including reversals of existing deferred tax liabilities, estimated future taxable income, prudent and feasible tax planning strategies, and recent financial performance. Due to the history of losses in most of our subsidiaries and the estimation that it is more likely than not that the net deferred tax assets related to our subsidiaries’ loss carry-forwards and other reserves and allowances will not be utilized, we concluded that a valuation allowance of $8.2 million against our net deferred tax assets related to our subsidiaries’ loss carry-forwards and other reserves and allowances, at December 31, 2003 was appropriate. If, in the future, we believe that a deferred tax asset will be realized, for which we currently have a valuation allowance, we will be required to reverse the valuation allowance, which could result in an income tax benefit in the period of such determination.

Goodwill. Under Statement of Financial Accounting Standard No.142, “Goodwill and Other Intangible Assets” (“SFAS No, 142”), goodwill acquired in a business combination which closes on or after July 1, 2001 is deemed to have indefinite life and will not be amortized. SFAS No.142 requires goodwill to be tested for impairment on adoption and at least annually thereafter or between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by comparing the fair value of the reporting unit with its carrying value. Fair value is determined using the income approach. Significant estimates used in the methodologies include, estimates of future cash flows and estimates of discount rates. We have performed impairment tests on our goodwill and as of December 31, 2003, no impairment losses have been identified. In assessing the recoverability of our goodwill and other intangible assets, we must make assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

A. OPERATING RESULTS

The following table sets forth certain statement of operations data as a percentage of revenues for the years indicated:

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Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Revenues. Revenues increased approximately 10.5% to $54.72 million during 2003 compared with revenues of $49.52 million during 2002. This increase was primarily a result of worldwide growth across all our product lines. 2003 Software Security (Digital Rights Management) sales were $43.52 million, an increase of 8.6% over 2002. Enterprise Security Sales reached $11.20 million, an increase of 18.9% over 2002.

Cost of revenues. Cost of revenues primarily includes the manufacturing cost of the hardware and overhead related to manufacturing activity. Cost of revenues was approximately $9.80 million during 2003 compared with $10.24 million in 2002, a decrease of 4.3%. The main reasons for this were the increase of our software based products, in dollars and as percentage of revenues and the efficiencies in manufacturing processes caused by lower overhead costs. The software based products offer a lower percentage of costs in terms of dollars than the hardware based products. Since the cost of revenues is different for all of the products we produce, a change in the mix of products we produce in any given year will subsequently change our cost of revenues in that year. Cost of revenues, as a percentage of total revenues, decreased to 17.9% in 2003 from to 20.7% in 2002.

Research and development expenses. Research and development expenses consist primarily of compensation and related costs of employees engaged in on-going research and development activities, costs of subcontractors and related expenses. Research and development expenditures increased 4.2% to approximately $12.76 million during 2003, as compared to $12.24 million during 2002. As a percentage of revenues, research and development expenses, decreased to 23.3% in 2003 from 24.7% during 2002. This increase in terms of dollars is due to our need to continue investing costs to update current products and develop new products to remain competitive. Accordingly, we expect to expand our research and development efforts, and we are currently developing new products that incorporate both technology presently used in our products and technology that we are developing for new applications.

Selling and Marketing expenses. Selling and marketing expenses consist primarily of compensation for sales and marketing personal, exhibitions, travel and related expenses. Selling and marketing expenses were stable in 2003 as compared to expenses in 2002 and totaled approximately $22 million. As a percentage of revenues, selling and marketing expenses, decreased to 40.2% in 2003 from 44.4% during 2002. This level of stability of the selling and marketing expenses was a result of the continuation of the implementation of our marketing plan with respect to the various products of the Company.

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General and administrative expenses. General and administrative expenses consist primarily of compensation for finance and human resources, allowance for bad debt, goodwill amortization as well as professional and legal service expenses. General and administrative expenses increased to approximately $7.7 million during 2003 as compared to $7.2 million during 2002. As a percentage of revenues, general and administrative expenses, decreased to 14.1% in 2003 from 14.6% during 2002. The most significant reason for this increase was, our professional and legal related costs that were increased due to legal procedures that the Company has been involved in, as a plaintiff or as a defendant. (See item 8: “Financial Information--Legal Proceedings”)

Restructuring charges. As a result of the downturn in the global economic conditions, the decline in overall business levels and the related impact on our operations, we implemented during 2002 a worldwide restructuring and cost reduction plan, including at the level of our subsidiaries. In 2002 we, together with our subsidiaries, recorded expenses of approximately $1.12 million, out of which $467,000 were included in research and development expenses, $500,000 in selling and marketing expenses and $156,000 in general and administrative expenses. These costs were associated primarily with a reduction in work force and general reduction in all operating expenses. There were no restructuring charges in 2003.

Financial income, net. Financial income consists primarily of interest derived from cash and cash equivalents, net of bank charges, gain (loss) from exchange rates difference and impairment of the Company’s investment in equity securities. Financial income in 2003 was $480,000 compared with financial income of $491,000 in 2002. The interest derived from cash and cash equivalents remained relatively constant throughout the periods presented. The Euro, the British Pound and the Japanese Yen currencies continued to strengthen against the dollar and continued generating gains from exchange rates in 2003.

Other expenses, net. Other expenses, net, were approximately $5,000 in 2003 compared with $932,000 in 2002. Other expenses in 2003 were primarily generated by national insurance costs from prior years, which partially offset by gain from selling of motor vehicles. Other expenses in 2002 were primarily generated by the write off of our investment in Tamir Fishman Ventures II.

Taxes on income. Taxes on income were approximately $49,000 in 2003 compared to approximately $2.7 million in 2002. Taxes on income in 2003 were primarily due to an income tax provision from ongoing operations of approximately $399,000 and deferred tax income of approximately $350,000 regarding carry-forward losses. Taxes on income in 2002 were primarily due to an income tax provision from ongoing operations of approximately $200,000 and due to the increase of the valuation allowance for deferred tax assets of approximately $2.5 million. The increase of the valuation allowance is due to the fact that the Company’s ability to use the remaining net operating loss carry forward is dependent upon future taxable income.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenues. Revenues increased approximately 6.2% to $49.52 million during 2002 compared with revenues of $46.6 million during 2001. This increase was primarily a result of increases in sales of Privilege products (following the Preview asset acquisition) and in sales of our eToken products due to increased market penetration.

Cost of revenues. Cost of revenues primarily includes the manufacturing cost of the hardware and overhead related to manufacturing activity. Cost of revenues was approximately $10.2 million during 2002 compared with $9.3 million in 2001. This slight increase was due to our producing a slightly different mix of products in 2002. Since the cost of revenues is different for all of the products we produce, a change in the mix of products we produce in any given year will subsequently change our cost of revenues in that year. Cost of revenues, as a percentage of total revenues, increased to 20.7% in 2002 as compared to 20% in 2001.

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Research and development expenses. Research and development expenses consist primarily of compensation and related costs of employees engaged in on-going research and development activities, costs of subcontractors and related expenses. Research and development expenditures increased 10.9% to approximately $12.24 million during 2002, as compared to $11.04 million during 2001. As a percentage of revenues, research and development expenses, increased to 24.7% in 2002 from 23.7% during 2001. This increase was due to an increase in compensation expenses resulting from the hiring of new research and development personnel, primarily for the development of eToken and for our new research and development center that we opened in connection with the Preview acquisition.

Selling and Marketing expenses. Selling and marketing expenses consist primarily of compensation for sales and marketing personal, exhibitions, travel and related expenses. Selling and marketing expenses slightly decreased to approximately $22 million during 2002 as compared to $22.5 million during 2001. As a percentage of revenues, selling and marketing expenses, decreased to 44.4% in 2002 from 48.2% during 2001. This level of stability of the selling and marketing expenses was a result of the continuation of the implementation of our marketing plan with respect to the eSafe, eToken and Privilege product lines.

General and administrative expenses. General and administrative expenses consist primarily of compensation for finance and human resources, allowance for bad debt, good will amortization as well as professional service expenses. General and administrative expenses decreased to approximately $7.24 million during 2002 as compared to $8.88 million during 2001. As a percentage of revenues, general and administrative expenses, decreased to 14.6% in 2002 from 19% during 2001. This decrease in general and administrative expenses resulted primarily from the fact that goodwill amortization in 2002 decreased by $1.96 million as compared to 2001. This decrease in goodwill amortization was due to our adoption of SFAS No. 142, “Goodwill and Other Intangible Assets”, whereby we ceased amortizing goodwill and performed an annual impairment test in accordance with SFAS 142 (see Note 2 to our consolidated financial statements).

Restructuring charges. As a result of the downturn in the global economic conditions, the decline in overall business levels and the related impact on our operations, we implemented during 2002 a worldwide restructuring and cost reduction plan, including at the level of our subsidiaries. In 2002, we, together with our subsidiaries, recorded expenses of approximately $1.12 million, out of which $467,000 were included in research and development expenses, $500,000 in selling and marketing expenses and $156,000 in general and administrative expenses. These costs were associated primarily with a reduction in work force and general reduction in all operating expenses.

Impairment of intangible assets. Impairment of intangible assets in 2001 consisted of the impairment of $5.2 million of goodwill. There was no impairment of intangible assets in 2002.

Financial income (expenses), net. Financial income (expense) consists primarily of interest derived from cash and cash equivalents and marketable debt securities, net of bank charges, gain (loss) from exchange rates difference and loss on decreases in value of the Company’s investment in equity securities. Financial income in 2002 was $491,000 compared with financial expenses of $410,000 in 2001. This increase was primarily generated by foreign currency gains, due to the increase in exchange rate of Euros and Japanese Yen to the dollar and the weakening of the New Israeli Shekel to the dollar, partially offset by continued decrease of interest derived from cash and cash equivalents.

Other expenses, net. Other expenses, net, were approximately $932,000 in 2002 compared with $3.4 million in 2001. Other expenses in 2002 were primarily generated by the write off of our investment in Tamir Fishman Ventures II. Other expenses in 2001 were primarily generated by the write off of our investment in FAST Multimedia Inc. (See Item 7: “Related Party Transactions”).

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Taxes on income. Taxes on income were approximately $2.7 million in 2002 compared to an income tax benefit of approximately $347,000 in 2001. Taxes on income in 2002 were primarily due to an income tax provision from ongoing operations of approximately $200,000 and due to the increase of the valuation allowance for deferred tax assets of approximately $2.5 million. The increase of the valuation allowance is due to the fact that the Company’s ability to use the remaining net operating loss carry forward is dependent upon future taxable income. Taxes on income in 2001 were primarily due to an income tax provision from ongoing operations of approximately $139,000 offset by a deferred tax income benefit of approximately $486,000 regarding carry-forward losses.

B. LIQUIDITY AND CAPITAL RESOURCES

Since our inception, our operations have been funded through capital contributions, cash flow from operations and capital gains from sales of marketable securities. Our business is not capital intensive. Generally, we invest our excess cash in instruments that are highly liquid.

As of December 31, 2003, we had cash and cash equivalents and marketable securities aggregating approximately $19.5 million. Our marketable securities, as of December 31, 2003, amounted to approximately $1.23 million. Accumulated unrealized holding gains from available-for-sale securities (which are presented as part of shareholders’ equity until realized) amounted to approximately $193,000 as of December 31, 2003. At December 31, 2003, we had equity investments in Comsec Information Security Ltd. and Tamir Fishman Ventures II Ltd., Israeli companies publicly traded on the Tel Aviv Stock Exchange.

Our operating activities provided cash in the amount of $5.90 million in 2003 primarily due to a decrease in inventories, an increase in deferred revenues, an increase in accrued expenses and other accounts payable, and depreciation and amortization which was partially offset by a decrease in trade receivable and an increase in deferred income tax. Our operating activities provided cash in the amount of $4.24 million in 2002 primarily due to a decrease in other accounts receivable and prepaid expenses, a decrease in inventories, a decrease in deferred income tax, equity in losses of an affiliate, impairment of investments and depreciation and amortization which was partially offset by our net operating loss. Our operating activities used cash in the amount of $5 million in 2001 primarily due to our net operating loss and a decrease in income taxes payable which was offset by an increase in accrued expenses and other liabilities, equity in losses of an affiliate, impairment of marketable securities, depreciation and amortization. The improvement in 2003 compared with 2002 and 2001 was primarily attributable to our moving from a net loss to a net income position.

Our investing activities used cash in the amount of $2.58 million in 2003 primarily due to purchase of property and equipment, investment in and loans to affiliates. Our investing activities used cash in the amount of $2.51 million in 2002 primarily due to purchase of property and equipment, investment in and loans to affiliates. Our investing activities provided cash in the amount of $3.4 million in 2001 primarily due to proceeds from sale of available for sale marketable securities, that was offset by purchase of property and equipment, investment in affiliates and payment for the purchase of assets from Preview Systems.

Our financing activities provided cash in the amount of $456,000 in 2003 due to proceeds from exercise of stock options by employees. In 2002, our financing activities did not use or provide any cash. Our financing activities used cash in the amount of $261,000 in 2001 due to purchase of treasury shares.

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We had working capital of approximately $26.62 million at December 31, 2003, $22.66 million at December 31, 2002 and $24.65 million at December 31, 2001. Our ratio of current assets to current liabilities was 3.3 at December 31, 2003, 3.4 at December 31, 2002 and 3.9 at December 31, 2001.

We believe that our accumulated cash, in conjunction with cash generated from operations and available funds, will be sufficient to meet our cash requirements for working capital and capital expenditures for at least the next 12 months. Thereafter, if cash generated from operations is insufficient to satisfy our liquidity requirements, we may sell additional equity or debt securities or obtain credit facilities.

C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.

The software industry is characterized by rapid product change resulting from new technological developments, performance improvements and lower hardware costs. We believe that our future growth depends to a large extent on our ability to be an innovator in the development and application of hardware and software technology utilizing, among other things, our advanced security algorithms. We work closely with our customers and prospective customers to determine their requirements and to design enhancements and new features to meet their needs. We intend to expand our research and development efforts, and are currently developing new products that incorporate both technology presently used in our products and technology developed for new applications. Our research and development activities have led to periodic releases of improved versions of our HASP, HARDLOCK, Privilege and eSafe products, which offer increased functionality. In addition, our research and development efforts have resulted in the release of eToken in June 2000. We intend to expand our research and development efforts, and we are currently developing new products that incorporate both technology presently used in our products and technology that we are developing for new applications.

Research and development expenditures increased to approximately $12.75 million during 2003, as compared to $12.24 million during 2002 and $11.04 million during 2001. This increase was due to our need to continue investing costs to update current products and develop new products to remain competitive. Accordingly, we expect to expand our research and development efforts, and we are currently developing new products that incorporate both technology presently used in our products and technology that we are developing for new applications.

D. TREND INFORMATION

There is a trend toward integration of security software inside pre-configured, easy to install hardware appliances. Although Aladdin does not have its own hardware appliance, we have introduced an innovative Virtual Appliance concept that easily allows integration of eSafe products with almost any hardware appliance. We are also working on strategic alliances with major hardware manufacturers to ensure that eSafe’s Virtual Appliance platform works with their high-end hardware appliances. In addition there is an element of service that must be provided to customers when selling hardware devices.

The Internet has become a critical tool for many companies. The importance of the Internet, coupled with the fact that advanced technology has enabled the development of vandals and viruses that can travel over the Internet at the speed of light, causes companies to demand of us increasingly fast and effective responses to these vandals and viruses. In order to meet this challenge, we are working on the development of enhanced versions of eSafe Gateway and eSafe Mail products. We are also continuing to invest in research and development in order to improve the quality of our products and to introduce new more effective products that will deliver more proactive solutions for blocking vandals/viruses and spam.

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A substantial portion of our revenues each year are generated by repeat orders from our existing customer base. Software developers that have integrated HASP and Hardlock products into their software packages, generally continue to purchase our products. We expect that we will continue to generate substantial revenues from sales of our software security products to current customers.

The introduction of Active Directory technology by Microsoft and the usage of their Certificate Server as a mainstream authentication platform has opened up the market to mainstream usage of Smartcard based technology. Active Directory is Microsoft’s trademarked directory service, an integral part of the Windows 2000 architecture. Like other directory services Active Directory is a centralized and standardized system that automates network management of user data, security, and distributed resources, and enables interoperation with other directories. Active Directory is designed especially for distributed networking environments. There is a clear increase in adaptation of Public Key Infrastructure (PKI) technology and usage of Token / Smartcard for authentication of users’ access to the network. PKI enables users of an essentially non-secure, public network such as the Internet to securely and privately exchange data and money through the use of a public and a private cryptographic key pair that is obtained and shared through a trusted authority. The public key infrastructure provides for a digital certificate that can identify an individual or an organization and directory services that can store and, when necessary, revoke the certificates.

E. OFF-BALANCE SHEET ARRANGEMENTS

We are not a party to any material off-balance sheet arrangements. In addition, we have no unconsolidated special purpose financing or partnership entities that are likely to create material contingent obligations.

F.  TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

The following table summarizes our contractual obligations and commercial commitments as of December 31, 2003:

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G. SAFE HARBOR

All information that is not historical in nature disclosed under “Item 5. Operating and Financial Review and Prospects—Off-Balance Sheet Arrangements” and “—Tabular Disclosure of Contractual Obligations” is deemed to be a forward-looking statement.

Item 6.          Directors, Senior Management and Employees

A. DIRECTORS AND SENIOR MANAGEMENT

As of May 1, 2004, our directors, senior management and key employees are as follows: