Form 10-Q - RSA Security Incorporated

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)


þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2006


o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 000-25120

RSA Security Inc.

(Exact Name of Registrant as Specified in Its Charter)


Delaware		04-2916506
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

174 Middlesex Turnpike
Bedford, Massachusetts 01730
(Address of Principal Executive Offices)

Registrant’s Telephone Number, Including Area Code: (781) 515-5000

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

þ Large accelerated filer o Accelerated filer o Non-accelerated filer

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

As of April 28, 2006, there were outstanding 75,481,070 shares of the Registrant’s Common Stock, $0.01 par value per share.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

RSA SECURITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except share data)


	March 31,			December 31,
	2006			2005
ASSETS
Current assets
Cash and cash equivalents	$	57,226		$	69,050
Marketable securities		150,996			118,702
Accounts receivable (less allowance for doubtful accounts of $1,565 in 2006 and $1,600 in 2005)		49,556			55,738
Inventory		6,143			4,813
Prepaid expenses and other assets		13,411			14,211

Total current assets		277,332			262,514


Property and equipment, net		71,064			69,764

Other assets
Deferred taxes		8,108			8,108
Intangible and other assets		40,327			41,534
Goodwill		274,456			275,864

Total other assets		322,891			325,506

Total assets	$	671,287		$	657,784


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable, accrued expenses and other liabilities	$	50,474		$	53,212
Current portion of accrued restructurings		7,178			5,962
Income taxes accrued and payable		15,503			18,442
Deferred revenue		47,391			47,453

Total current liabilities		120,546			125,069


Accrued restructurings, long-term		8,765			9,793
Deferred revenue, long-term		8,649			7,429
Other		6,079			8,633

Total liabilities		144,039			150,924


Commitments and contingencies
Stockholders’ equity
Common stock, $0.01 par value; authorized, 300,000,000 shares; issued, 72,732,368 and 71,836,757 shares in 2006 and 2005, respectively; outstanding, 72,732,368 and 71,026,880 shares in 2006 and 2005, respectively		727			718
Additional paid-in capital		126,655			122,150
Retained earnings		401,107			395,777
Treasury stock, at cost; zero shares in 2006 and 809,877 shares in 2005		—			(10,107	)
Accumulated other comprehensive income (loss)		(1,241	)		(1,678	)

Total stockholders’ equity		527,248			506,860

Total liabilities and stockholders’ equity	$	671,287		$	657,784

See notes to condensed consolidated financial statements.

RSA SECURITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share data)


	Three Months Ended
	March 31,
	2006		2005
Revenue
Products	$	61,508	$	54,634
Maintenance, professional and managed services		25,999		20,984

Total revenue		87,507		75,618


Cost of revenue
Products		12,744		8,532
Maintenance, professional and managed services		7,369		6,092
Amortization of technology related intangible assets		1,020		183

Total cost of revenue		21,133		14,807

Gross profit		66,374		60,811


Costs and expenses
Research and development		17,268		15,954
Marketing and selling		29,303		29,142
General and administrative		11,519		8,347
Amortization of intangible assets		254		—
Restructurings		2,624		—

Total		60,968		53,443


Income from operations		5,406		7,368

Interest income and other		1,460		1,891

Income before provision for income taxes		6,866		9,259

Provision for income taxes		1,536		2,037


Net income	$	5,330	$	7,222


Basic earnings per share
Per share amount	$	0.07	$	0.10

Weighted average shares		71,829		71,462

Diluted earnings per share
Per share amount	$	0.07	$	0.10

Weighted average shares		71,829		71,462
Effect of dilutive equity instruments		1,838		2,973

Adjusted weighted average shares		73,667		74,435

See notes to condensed consolidated financial statements.

RSA SECURITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)


	Three Months Ended
	March 31,
	2006			2005
Cash flows from operating activities
Net income	$	5,330		$	7,222
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		4,072			2,895
Excess tax benefit from exercise of stock options		—			819
Stock-based compensation		2,784			—
Deferred taxes		(504	)		—
Increase (decrease) in cash from changes in:
Accounts receivable		6,131			7,333
Inventory		(1,337	)		(98	)
Prepaid expenses and other assets		(709	)		727
Accounts payable, accrued expenses and other liabilities		(2,378	)		(9,571	)
Accrued restructurings		188			(1,305	)
Refundable income taxes and income taxes accrued and payable		(2,948	)		(781	)
Deferred revenue		1,195			(2,397	)

Net cash provided by operating activities		11,824			4,844

Cash flows from investing activities
Purchases of marketable securities		(66,903	)		(64,325	)
Sales and maturities of marketable securities		34,674			57,234
Purchases of property and equipment		(3,904	)		(2,209	)
Other		(983	)		(636	)

Net cash used for investing activities		(37,116	)		(9,936	)

Cash flows from financing activities
Proceeds from exercise of stock options and purchase plans		10,224			3,620
Share repurchase		(1,216	)		(12,441	)
Excess tax benefit from exercise of stock options		4,447			—

Net cash provided by (used for) financing activities		13,455			(8,821	)

Effect of exchange rate changes on cash and cash equivalents		13			(134	)

Net decrease in cash and cash equivalents		(11,824	)		(14,047	)
Cash and cash equivalents, beginning of period		69,050			68,210

Cash and cash equivalents, end of period	$	57,226		$	54,163

Cash flow information:
Cash payments for income taxes	$	974		$	1,822

See notes to condensed consolidated financial statements.

RSA SECURITY INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands, except share and per share data)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of RSA Security Inc. and its wholly- owned subsidiaries and have been prepared in accordance with generally accepted accounting principles and pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K, as amended by Amendment No.1 on Form 10-K/A, filed for the year ended December 31, 2005.

In the opinion of our management, the accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements, and reflect all adjustments of a normal recurring nature considered necessary to present fairly the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year.

Principles of Consolidation – The unaudited condensed consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated.

Reclassification — The amortization of technology related intangible assets has been reclassified in the 2005 financial statements to conform to the 2006 presentation.

Use of Estimates – The preparation of our unaudited condensed consolidated financial statements is in conformity with accounting principles generally accepted in the United States of America, and requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results could differ from those estimates.

Revenue Recognition – Revenue is recognized when earned. We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We recognize revenue from licensing other intellectual property when evidence of an arrangement exists, the fee is fixed or determinable and collection is considered probable. We reduce revenue by provisions for estimated returns. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. For arrangements containing multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until vendor specific objective evidence of fair value exists or all elements have been delivered. We recognize revenue upon the shipment of product to our stocking distributors, net of estimated returns. We defer maintenance services revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, generally twelve months.

Some of our arrangements contain bundled products that include a term software license, an RSA SecurID^® authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

Some of our solutions are available as a centrally hosted service. In most cases, these arrangements include initial set-up fees coupled with a continuing payment stream. We defer revenue from up-front fees billed during the setup phase and recognize this revenue on a straight line basis over the service term of the contract. The continuing payment stream may be fixed, variable based on contract defined activity, or a combination of fixed and variable amounts. Generally, we recognize these fees monthly in arrears.

and collection is considered probable. The ongoing royalties are recognized at the time a reliable estimate can be made of the actual usage that has occurred, provided collection is probable. Annual license fees or onetime license fee arrangements typically contain non-refundable terms; therefore, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable.

We recognize revenue allocated to professional service elements as the services are performed. When customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method, which requires revenue to be recognized as a percentage of the project completed. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns and Rebates – We record allowances for estimated sales returns and allowances on products and maintenance and professional service revenue in the same period as the related revenue is recorded. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry and other known factors. Allowances for estimated rebates are recorded in the same period as the related revenue. We base these estimates on historical rebates, analysis of sales data, current economic trends, and other known factors. The allowance for sales returns and rebates was as follows:


	Three Months Ended
	March 31,
	2006			2005
Balance, beginning of period	$	2,526		$	2,490
Provision for sales returns and rebates		1,812			1,640
Deductions		(1,772	)		(1,851	)

Balance, end of period	$	2,566		$	2,279

Allowance for Doubtful Accounts – We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, changes to customer creditworthiness, concentration levels, current economic trends, regional factors, other known factors, and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Bad debt expense, if any, is included in marketing and selling expenses in the condensed consolidated statements of income. The allowance for doubtful accounts is included in accounts receivable in the condensed consolidated balance sheets and was as follows:


	Three Months Ended
	March 31,
	2006			2005
Balance, beginning of period	$	1,600		$	1,672
Write-offs		(41	)		(25	)
Recoveries of accounts previously written off		6			82

Balance, end of period	$	1,565		$	1,729

Allowance for Warranty Obligations – Our standard practice is to provide a warranty on all RSA SecurID^{^®} hardware authenticators for the customer selected programmed life of the authenticator (generally two to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a warranty for product defects for a specified period, generally ninety days. We provide reserves for warranty obligations based on historical failure and defective return rates and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

We monitor warranty claims and address defects through our quality and design processes, which are managed by our product engineering, quality control and technical support organizations. During the last several years, we have increased resources and initiated new programs to build an expanded family of high performance authentication solutions. These programs have resulted in the redesign and re-engineering of our authenticator products to improve their performance and reliability by incorporating new microprocessors, electronics, firmware and batteries with longer lives.

Accrued warranty reserve is included in accrued expenses and other liabilities in the condensed consolidated balance sheets. The following table presents changes in the warranty reserve:


	Three Months Ended
	March 31,
	2006			2005
Balance, beginning of period	$	1,303		$	1,899
Provision for warranty expense		36			94
Deductions		(140	)		(371	)

Balance, end of period	$	1,199		$	1,622

Income Taxes – We provide for income taxes for interim periods based on the estimated effective tax rate for the full year. We record cumulative adjustments to tax provisions in the interim period in which a change in the estimated annual effective rate is determined. The effective tax rate calculation does not include the effect of discrete events that may occur during the year. The effect of these events, if any, is reflected in the tax provision for the quarter in which the event occurs and is not considered in the calculation of our annual effective tax rate.

Earnings Per Share – We compute basic earnings per share using the weighted average number of common shares outstanding. We compute diluted earnings per share using the weighted average number of common shares outstanding plus the effect of potential outstanding shares, including options and warrants, using the “treasury stock” method.

Equity instruments that were considered antidilutive and therefore were not included in the computation of diluted earnings per share include the following shares of our common stock:


	Three Months Ended
	March 31,
	2006		2005
Employee stock options		8,353,133		4,676,625

Stock-Based Compensation – Effective January 1, 2006 we account for stock-based compensation expense in accordance with the Financial Accounting Standards Board No. 123(R), “Share-Based Payment” (SFAS 123R). Prior to that date, we accounted for stock-based compensation using the intrinsic value method. Under SFAS 123R, stock-based compensation expense reflects the fair value of stock-based awards measured at the grant date, is recognized over the relevant service period, and is adjusted each period for anticipated forfeitures. We estimate the fair value of each stock-based award on the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model incorporates assumptions as to stock price volatility, the expected life of options, a risk-free interest rate and dividend yield. Many of these assumptions are highly subjective and require the exercise of management judgment. Our management must also apply judgment in developing an estimate of awards that may be forfeited. If our actual experience differs significantly from our estimates and we choose to employ different assumptions in the future, the stock-based compensation expense that we record in future periods may differ materially from that recorded in the current period.

Share Repurchase Authorization – We have had a common stock repurchase program in place since September 2004, under which our Board of Directors has authorized us to repurchase up to 8,700,000 shares of our common stock through June 30, 2008. We may make repurchases in the open market or through negotiated transactions from time to time depending on market conditions. During the three months ended March 31, 2006, we repurchased 82,300 shares for $1,216. As part of the total program, we have repurchased an aggregate of 2,287,029 shares for $30,189 as of March 31, 2006.

2. Stock-based Compensation

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R). This Statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and its related implementation guidance. SFAS 123R requires a company to measure the grant date fair value of equity awards given to employees in exchange for services and recognize that cost over the period that such services are performed. We adopted SFAS 123R on January 1, 2006 using the modified prospective transition method.

Prior to adopting SFAS 123R, we accounted for stock-based compensation under APB 25, as permitted by SFAS 123. No stock-based compensation cost was recognized in the Statement of Operations for the three months ended March 31, 2005, as all options granted had an exercise price equal to the fair market value of the underlying common stock on the date of grant. We have applied the modified prospective method in adopting SFAS 123R. Accordingly, periods prior to adoption have not been restated and are not directly comparable to periods after adoption. Under the modified prospective method, compensation cost recognized in the periods after adoption includes (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, less estimated forfeitures, and (b) compensation cost for all share-based payments granted and vested subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.

Prior to the adoption of SFAS 123R, we presented all tax benefits related to stock compensation as cash flows from operating activities in the Statement of Cash Flows. SFAS 123R requires the cash flows resulting from these excess tax benefits to be classified as cash flows from financing activities. In the three months ended March 31, 2006, the excess tax benefit from the exercise of stock options was $4,447 and was classified as cash flows from financing activities.

Had we used the fair value method prescribed by SFAS 123R to measure compensation related to stock options and awards to employees in prior periods, pro forma net income and pro forma earnings per share would have been as follows:


	Three Months
	Ended
	March 31, 2005
Net income as reported	$	7,222
Add: stock based compensation expense included in reported net income, net of tax		—
Less: stock based compensation expense determined under fair value method for all awards, net of related tax effects		(4,385	)

Pro forma net income	$	2,837

Net income per share:
Basic earnings per share — as reported	$	0.10

Basic earnings per share — pro forma	$	0.04

Diluted earnings per share — as reported	$	0.10

Diluted earnings per share — pro forma	$	0.04

Total stock-based compensation expense recorded for the three months ended March 31, 2006 was $2,784 of which $373 was included in research and development expenses, $800 was included in marketing and selling expenses, $1,337 was included in general and administrative expenses and $274 was included in cost of revenue. The total income tax benefit recognized in the Statement of Operations for the three months ended March 31, 2006 for share-based payments was $554.

Our 2005 Stock Incentive Plan (the “2005 Plan”) allows us to grant stock options, stock appreciation rights, restricted stock awards and other stock-based awards to our employees, officers, directors, consultants and advisors. Some of the stock options that we grant vest over time, generally four years, and some vest based on the achievement of performance metrics. Stock options generally expire seven years after the grant date. In 2005, the Compensation Committee of our Board of Directors granted 50,000 shares of restricted stock to one of the Company’s officers, which vest over three years. At March 31, 2006, there were 6,900,000 shares authorized and 5,262,537 shares available for grant under the 2005 Plan.

Our Amended and Restated 1998 Non-Officer Employee Stock Incentive Plan, as amended (the “1998 Plan”), allows us to grant non-statutory stock options and stock appreciation rights awards to our employees, consultants and advisors, other than those who are also officers within the meaning of Section 16 of the Securities Exchange Act of 1934, as amended. In general, stock options granted under the 1998 Plan become exercisable as to 25% of the shares subject to each option on the first anniversary of the grant date and in equal quarterly installments thereafter for three years. In general, no installment is exercisable after the fourth anniversary of the date on which such installment first becomes exercisable, and options generally expire eight years from the grant date. At March 31, 2006, there were 10,608,263 shares authorized and 2,112,464 shares available for grant under the 1998 Plan.

During the three months ended March 31, 2006, we issued under the 2005 Plan performance stock options to purchase a total of 100,000 shares of our common stock. During the fourth quarter of 2005, we issued under the 2005 Plan performance stock options to purchase 250,000 shares of our common stock. These performance stock options vest over three years upon the achievement of specified performance metrics. No shares were vested as of March 31, 2006.

A summary of stock option activity under all plans is as follows:


			Weighted
			Average Exercise
			Price Per
	Number of Shares		Share
Options outstanding, January 1, 2006	14,747,549		$	13.27
Granted	110,000			14.39
Exercised	(1,595,143	)		5.24
Canceled	(859,513	)		22.34

Options outstanding, March 31, 2006	12,402,893		$	13.72

Options exercisable, March 31, 2006	7,835,245		$	15.50

The weighted average remaining contractual term for options outstanding at March 31, 2006 was 4.1 years. The weighted average remaining contractual term for options exercisable at March 31, 2006 was 3.6 years.

A summary of the status of our restricted stock awards as of March 31, 2006 is as follows:


		Weighted
		Average Price
	Number of Shares	Per Share
Restricted stock awards nonvested, January 1, 2006	50,000	$	12.15
Granted	—		—
Vested	—		—
Forfeited	—		—

Restricted stock awards nonvested, March 31, 2006	50,000	$	12.15

We estimate the fair value of each option award issued under our stock option plans on the date of grant using a Black-Scholes based option-pricing model that uses the assumptions noted in the following table. Expected volatilities are based on implied volatility of our common stock. We base the expected term of the options on our historical option exercise data taking into consideration the exercise patterns of the option holder during the option’s life. We base the risk-free interest rate on the U.S. Treasury yield curve in effect at the time of the grant for a term equivalent to the expected life of the options. We value restricted stock at market value on the date of grant.


	Three Months Ended
	March 31,
	2006			2005
Stock Option Plan:
Expected volatility		58.1	%		84.9	%
Risk-free interest rate		4.5	%		3.6	%
Expected life in years		3.8			4.0
Expected dividend yield		0.0	%		0.0	%

Stock Purchase Plan:
Expected volatility		49.8	%		40.0	%
Risk-free interest rate		3.7	%		1.8	%
Expected life in years		0.5			0.5
Expected dividend yield		0.0	%		0.0	%

Based on the above assumptions, the weighted average estimated fair value of options granted in the three months ended March 31, 2006 and 2005 was $6.82 and $11.07 per share, respectively. The total intrinsic value of options exercised in the three months ended March 31, 2006 and 2005 was $15,745 and $4,928, respectively. We estimate forfeitures related to executive and non-executive option grants at an annual rate for 2006 of 1.7% and 7.4% per year, respectively. The weighted average estimated fair value for shares issued under our 1994 Employee Stock Purchase Plan in the three months ended March 31, 2006 and 2005 was $3.82 and $4.67 per share, respectively.

Other reasonable assumptions about these factors could provide different estimates of fair value. Future changes in stock price volatility, life of options, interest rates, forfeitures and dividend practices, if any, may require changes in our assumptions, which could materially affect the calculation of fair value.

Total unrecognized stock-based compensation expense related to unvested stock options and unvested restricted stock awards, expected to be recognized over a weighted average period of 1.3 years, amounted to $22,874 at March 31, 2006.

We repurchase shares on the open market which are used in part to satisfy share option exercises.

3. Acquisition

On December 30, 2005, we completed our acquisition of Cyota, Inc. for total costs of $137,024. We deposited $13,600 of the cash consideration into an escrow fund to secure certain indemnification obligations of the former stockholders of Cyota and to satisfy certain other obligations of the former stockholders of Cyota. On the 12-month anniversary of the closing, the balance of the escrow fund in excess of any amounts held for unresolved claims will be distributed to the former stockholders of Cyota. In addition, we have agreed to pay $5,500 for retention bonuses for the Cyota employees. These retention bonuses are being accrued over the required service period. As of March 31, 2006 we have accrued $663 for the retention bonuses.

Cyota delivers online security and anti-fraud solutions to thousands of financial institutions worldwide. The acquisition enabled us to introduce a risk-based layered authentication approach that will allow customers to choose from a range of authentication techniques – from life questions, watermarking and anomaly detection to digital certificates, tokens and smart cards – depending on the risks posed and desired convenience.

We accounted for the Cyota acquisition as a purchase, and accordingly, included the assets purchased and liabilities assumed in the consolidated balance sheet at the purchase date based upon their estimated fair values. The results of operations of Cyota are included in the condensed consolidated financial statements beginning January 1, 2006.

The preliminary purchase price is shown below:


Cash paid for capital stock	$	128,835
Fair value of outstanding stock options assumed		10,283
Direct acquisition costs		1,437
Intrinsic value of unvested options		(3,531	)

Total purchase price	$	137,024

The purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed, based on their estimated fair values, and deferred stock compensation was recorded based on intrinsic value. The excess purchase price over those assigned values was recorded as goodwill. The fair values assigned to tangible and intangible assets acquired and liabilities assumed are based on management’s estimates and assumptions, and other information compiled by management, including independent valuations that utilized established valuation techniques. Goodwill recorded as a result of this acquisition is not deductible for tax purposes.

The total preliminary purchase price has been allocated as follows:


Cash and equivalents	$	5,600
Restricted cash		291
Accounts receivable, net		2,928
Prepaid expenses and other current assets		1,012
Property and equipment		1,234
Other assets		459
Accounts payable		(1,229	)
Other payable & accrued expenses		(2,877	)
Deferred revenue		(522	)
Deferred tax liabilities		(8,418	)
Accrued severance liability		(594	)
Amortizable intangible assets:
Existing technology		16,400
Customer relationships		6,860
Other		790

Total amortizable intangible assets		24,050
Goodwill		115,090

Total purchase price allocation	$	137,024

The purchase price and related allocation are preliminary and may be revised as a result of adjustments made to the purchase price, additional information regarding liabilities assumed, including contingent liabilities, and revisions of preliminary estimates of fair values made at the date of purchase, based upon final appraisals. During the three months ended March 31, 2006, we recorded adjustments to goodwill of $1,408 related to revisions of estimates of liabilities and contingent liabilities, as well as the tax effects of options acquired.

Intangible assets include amounts recognized for the fair value of existing technology, customer relationships, trade name and trademarks, and non-competition/non-solicitation agreements. These intangible assets have the following estimated useful lives:


							Useful life
							(Years)
Existing technology							6.5
Customer relationships							7
Other							6.5

4. Comprehensive Income

Comprehensive income was as follows:


	Three Months Ended
	March 31,
	2006			2005
Net income	$	5,330		$	7,222
Unrealized loss on marketable securities, net of tax		(524	)		(307	)
Foreign currency translation adjustments		(717	)		(1,071	)

Comprehensive income	$	4,089		$	5,844

The tax benefit of unrealized holding losses on marketable securities was $282 and $162 for the three months ended March 31, 2006 and 2005, respectively.

5. Restructurings

During 2002 and 2001, we evaluated and initiated restructuring actions in order to consolidate some of our operations, enhance operational efficiency and reduce expenses. These actions resulted in total restructuring charges of $56,036 and $19,956 in the years ended December 31, 2002 and 2001, respectively.

Restructuring charges recorded during 2002 and 2001 consisted of facility exit costs, costs associated with the sale and liquidation of our Swedish development operations, and severance and other costs associated with the reduction of employee headcount.

During 2004 we recorded a net charge of $1,032 related to revised estimates of facility exit costs. We revised this estimate of facility exit costs based upon the terms of finalized subleases and associated costs obtained during the second quarter of 2004. We also reduced our restructuring reserve by $250 at December 31, 2004 when we determined our remaining severance costs were lower than originally estimated.

On December 1, 2005, our management committed to a plan to restructure the company’s engineering resources into four core locations around the world. Under the plan, which we expect to bring greater cost efficiencies to the engineering group and closer coordination to engineering projects, approximately 120 positions will be relocated. All engineering personnel currently based in our offices in Vancouver, B.C. , San Mateo, California and New York City will be relocated to Bedford, Massachusetts or to expanded operations in India and Brisbane, Australia. These transitions will be conducted in phases, with an expected completion date of December 2006. The program is projected to result in total charges in the range of $10,000 to $14,000 primarily related to facility closings and headcount reductions associated with relocating engineering resources. The restructuring charges related to facility closings will be recorded in the periods in which the facilities cease to be used.

During the three months ended March 31, 2006, we recorded restructuring charges of $2,624 related to a facility closing and headcount reductions. Restructuring charges accrued and unpaid at March 31, 2006 were as follows:


	Facility
	Exit Costs
Balance at January 1, 2006	$	15,755
Restructuring charges		2,624
Payments		(2,436	)

Balance at March 31, 2006	$	15,943

We expect to pay the remaining restructuring costs accrued at March 31, 2006 as follows:


Nine months ending December 31, 2006	$	6,110
Year ending December 31, 2007		4,272
Year ending December 31, 2008		3,333
Year ending December 31, 2009		2,228

Total	$	15,943

6. Segments

We have one reportable segment, e-Security Solutions. The operations of the e-Security Solutions segment consist of the sale of software licenses, hardware, maintenance, professional and managed services through three product groups: Enterprise solutions, Developer solutions and Consumer solutions. Enterprise solutions include sales of RSA SecurID^® authenticators, RSA^® Authentication Manager software, RSA Certificate Manager software, RSA ClearTrust^® software, and maintenance and professional services associated with these products. Developer solutions include sales of RSA BSAFE^® encryption software and protocol products, RSA Certificate Manager components, and maintenance and professional services associated with these products. Consumer solutions include RSA SecurID^® authentication for consumers, RSA FraudAction(SM) software, RSA Adaptive Authentication, RSA Transaction Monitoring and RSA SecureSuite™ software. The segment was determined primarily based on how management views and evaluates our operations.

Our operations are conducted throughout the world. Operations in the United States represent approximately 54% of total revenue. Our operations in other countries have been grouped by regional area below. The following tables present information about our e-Security Solutions revenue:


	Three Months Ended
	March 31,
	2006		2005
Product and service groups
Enterprise solutions	$	76,016	$	70,185
Developer solutions		6,117		5,433
Consumer solutions (1)		5,374		—

Total	$	87,507	$	75,618


	Three Months Ended
	March 31,
	2006		2005
Geographic areas
United States	$	46,845	$	41,117
Europe and other		30,684		25,842
Asia Pacific		9,978		8,659

Total	$	87,507	$	75,618


(1)		Consumer solutions were previously reported as part of enterprise solutions as we considered the amount immaterial.

Except for Tech Data Corporation, one of our distributors, no single customer accounted for more than 10% of our total revenue for the three months ended March 31, 2006 or 2005. Revenue from Tech Data Corporation accounted for 10% and 11% of our total revenue for the three months ended March 31, 2006 and 2005, respectively.

The tables below present information about our long lived assets by regional area:


	At March 31, 2006
					Europe and
	Total		United States		Other		Asia Pacific

Property and equipment, net	$	71,064	$	40,697	$	28,792	$	1,575
Goodwill		274,456		274,456		—		—
Other assets		40,327		37,639		761		1,927


	At December 31, 2005
					Europe and
	Total		United States		Other		Asia Pacific

Property and equipment, net	$	69,764	$	40,127	$	27,958	$	1,679
Goodwill		275,864		275,864		—		—
Other assets		41,534		40,444		68		1,022

7. Litigation

On or about April 11, 2005, Prism Technologies LLC filed a complaint for patent infringement in U.S. District Court for the District of Delaware against RSA Security, VeriSign, Inc., Netegrity, Inc., Computer Associates International, Inc. and Johnson & Johnson – Case Number 05-214. In its complaint, Prism Technologies alleges that some of our products, including our RSA ClearTrust product, and certain products of each of the other defendants infringe a patent that Prism Technologies owns, and Prism Technologies seeks unspecified damages as well as a permanent injunction enjoining the defendants from infringing its patent. The parties are conducting discovery. We believe Prism Technologies’ claims are without merit. We cannot predict the outcome of this matter, but we believe that the disposition of the matter will not have a material adverse effect on our continuing operations and consolidated financial position.

From time to time, we have been named as a defendant in other legal actions arising from our normal business activities, which we believe will not have a material adverse effect on us or our business.

8. Subsequent Event

On April 24, 2006 we acquired PassMark Security, Inc., a privately held company based in Menlo Park, California. PassMark delivers software-based authentication to millions of users worldwide, through some of the largest consumer-facing financial institutions. We expect the acquisition of PassMark to extend and broaden our channels-to-market in the financial sector.

We purchased PassMark for approximately $9,000 in cash and the issuance of 2,005,977 shares of RSA Security common stock. This transaction will be accounted for as a purchase, and the securities issued will be valued based on the average of the closing stock price on or around the closing date. The total merger consideration is estimated to be approximately $48,200.

In addition, we have set aside $2,700 to fund employee retention plans and termination costs. We have also reserved approximately 75,000 shares of our common stock related to the assumption of outstanding PassMark stock options.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We make statements in this Report that are forward looking, that is, statements that are not historical facts but that convey projections about the future. For example, statements containing the words “believes,” “anticipates,” “plans,” “expects,” “estimates,” “intends,” “may,” “projects,” “will,” “would,” and similar expressions may be forward-looking statements. We caution investors not to place undue reliance on any forward-looking statements in this Report because these statements speak only as of the date when made. Furthermore, we are not obligated to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. There are a number of factors that could cause our actual results to differ materially from those indicated by these forward-looking statements, including without limitation the factors described below under “Part II, Item 1A Risk Factors.”

Overview

RSA Security Inc. and its consolidated subsidiaries are an expert in protecting online identities and digital assets. The inventor of core security technologies for the Internet, the company leads the way in strong authentication and encryption, bringing trust to millions of user identities and the transactions that they perform. RSA Security’s portfolio of award-winning identity and access management solutions helps businesses to establish who’s who online – and what they can do.

In December 2005, we acquired Cyota, Inc., a privately-held company that delivers online security and anti-fraud solutions to thousands of financial institutions worldwide. In April 2006, we acquired PassMark Security, Inc., a privately-held company that delivers software-based authentication with a focus on financial institutions. With the purchases of Cyota and PassMark, we have introduced a risk-based layered authentication approach that allows customers to choose from a range of authentication techniques – from life questions, watermarking and anomaly detection to digital certificates, tokens and smart cards – depending on the risks posed and desired convenience. Additionally, we believe that these acquisitions will enable us to establish our company as a strategic hub for the consumer marketplace, providing the ability to authenticate and protect all aspects of online banking and e-commerce: end-users, merchants and transactions.

We believe sales of our products are and will be driven by several major market trends:

	•		We are seeing increased sales to enterprises that are buying and licensing our products to help them comply with industry and governmental regulations and standards, such as the Sarbanes-Oxley Act of 2002, the Health Insurance Portability and Accountability Act of 1996 (HIPAA), the Federal Financial Institutions Examination Council (FFIEC) guidelines and the Payment Card Industry (PCI) standard, among others.

	•		We have observed that more enterprises are using single sockets layer virtual private networks (VPNs) to enable access to internal resources and are seeking to license technology to make their VPNs more secure and efficient.

	•		Demand for our Consumer solutions depends on market adoption of consumer-oriented authentication technologies. We believe that the primary drivers for this adoption are regulatory compliance efforts by enterprises that do business electronically with consumer customers, such as banks and financial institutions, and recent increases in digital identity and asset theft.

	•		We believe that enterprises are turning to identity and access management solutions in order to increase their efficiency, reduce their costs and mitigate their risks.

We see a number of major trends and drivers in our business:

	•		Our authentication product line contributes approximately 80% of our revenue, while our less mature Enterprise software products continue to build revenue.

	•		Our Developer solutions continue to contribute between 7% and 12% of our total revenue despite the availability of free, “open source” products that compete with our RSA BSAFE product line. Our Developer solutions revenue tends to fluctuate from quarter to quarter, depending on the number of large transactions in any given quarter.

	•		We have traditionally licensed our Developer solutions primarily to companies that incorporate our software into their own software products and sublicense the combined products to their customers. However, we are increasingly licensing our Developer solutions to enterprises for use within their internal applications to increase security and meet regulatory compliance needs.

	•		Although the majority of our customers utilize our products to secure and manage network and application access for their employees and partners, our sales of authentication credentials for use by consumers are increasing. We sell most of our consumer authentication credentials on a subscription basis, with revenue being recognized over the course of several years. Accordingly, our deferred revenue balance will likely increase as we build consumer revenue.

	•		Our product line synergies and the strength of our customer base create opportunities for us to sell additional products to existing customers and broader, multi-product solutions to new customers.

	•		We are selling to more small and medium-sized enterprises, which is providing increased growth for us.

	•		Information technology budgets remain constrained, which has had and could continue to have a direct effect on the sale of our products.

	•		Some of our products, especially our single sign-on solutions and Web access management products, have long and unpredictable sales cycles, in part because our customers may need to invest potentially substantial resources and modify their network infrastructures to take full advantage of the benefits offered by the products.

	•		Increased competitive activity is putting pressure on our product prices and lengthening our sales cycles.

Our Enterprise solutions customers typically place an initial order for a limited number of users, for either our RSA SecurID authenticators or any of our software products, and deploy additional authenticators or software licenses as their need for our products within their enterprise increases. Authenticators generally have a programmed life of two to five years, and as they expire, our customers typically place additional orders for replacement authenticators. We typically base our RSA Authentication Manager, RSA Certificate Manager and RSA ClearTrust software license fees on the number of users authorized under each customer’s license. In most cases, customers also enter into an annual customer support agreement for their software license at the time of their initial purchase and renew this support agreement annually. Our support agreement entitles our customers to software upgrades and telephone support.

Our Developer solutions software licensing terms vary by product and customer. Typical licensing terms may include an initial prepaid license fee and ongoing royalties paid as a percentage of the developer’s product or service revenue, or payment of annual license fees, or a single fully paid-up license fee. Often, our existing developer customers go on to license new software or technology from us or wish to increase the field of use rights for the technology they have already licensed. In such a case, we amend our license agreement with the customer and charge additional licensing fees, thus deriving additional revenue.

Our Consumer solutions group delivers online security and anti-fraud solutions to financial institutions worldwide. Some of our consumer solutions are available as a centrally hosted service. In most cases, these arrangements include initial set-up fees coupled with a continuing payment stream. We defer revenue from up-front fees billed during the setup phase and recognize this revenue on a straight line basis over the service term of the contract. The continuing payment stream may be fixed, variable based on contract defined activity, or a combination of fixed and variable amounts. Generally, we recognize these fees monthly in arrears. Customers also place orders for our RSA SecurID authenticators for consumers.

Our professional services group provides customers with project management, architecture and design, physical deployment, custom development, education and practitioner certification services. Customers typically pay for professional services either at a fixed price or at hourly or daily rates for the time it takes us to complete the project.

We have contracted with outside manufacturing organizations to produce our RSA SecurID hardware authenticators, and many of our products contain technology that is licensed from third parties. Our cost of revenue consists primarily of costs associated with the manufacture and delivery of RSA SecurID authenticators and royalty fees that we pay for the licensed technology. Cost of revenue also includes warranty obligation expense and labor and overhead costs associated with professional services, customer support, and production activities. Production costs include the programming labor, shipping, inspection and quality control functions associated with the RSA SecurID authenticators. We continue to work to establish new supplier relationships in order to increase the number of vendors from which we buy our authenticators and authenticator components, and reduce our vulnerability to potential supply problems.

We distribute our products through direct sales to end user customers and through indirect sales, including (i) sales through distributors and resellers that we ship directly to the end user customer and (ii) sales to distributors for stocking purposes. For the three months ended March 31, 2006, approximately 61% of our revenue was from sales through distributors and resellers shipped directly to the end user customers, approximately 33% of our revenue was from direct sales to end user customers, and approximately 6% of our revenue was from sales to stocking distributors. Our stocking distributors provide us with inventory level and point of sale reports on a monthly basis. A typical stocking distributor holds approximately four to six weeks of inventory on hand in the distribution channel. Generally, our arrangements with our distributors and resellers are non-exclusive, and we currently have arrangements with more than 2,000 distributors and resellers worldwide under the RSA SecurWorld ™Partner Program. The RSA SecurWorld Partner Program provides partners with a range of sales tools and educational resources and is designed to reward those partners that devote resources to our products and programs and to sell to new customers. Over time, we believe this program will increase our rate of customer acquisition and generate increased indirect sales for us.

Our direct sales to our customers in countries outside of the United States are denominated in either U.S. dollars or local currency, with the majority of our sales denominated in U.S. dollars. Where we do invoice customers in local currency, we are exposed to foreign exchange rate fluctuations from the time of invoicing until collection occurs. We are also exposed to foreign currency fluctuations between the time we collect in U.S. dollars and the time we pay our operating expenses in local currency. Fluctuations in currency exchange rates could affect the profitability and cash flows in U.S. dollars of our products sold in international markets.

Adoption of SFAS 123R

Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment” (SFAS 123R). SFAS 123R requires us to measure the grant date fair value of equity awards given to employees in exchange for services and recognize that cost over the period that such services are performed. Prior to adopting SFAS 123R, we accounted for stock-based compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Under APB 25, we generally did not recognize compensation expense in connection with the grant of stock options because all options granted had an exercise price equal to the fair market value of the underlying common stock on the date of grant.

In transitioning from APB 25 to SFAS 123R, we have applied the modified prospective method. Accordingly, periods prior to adoption have not been restated and are not directly comparable to periods after adoption. Under the modified prospective method, compensation cost recognized in periods after adoption includes (a) compensation cost for all share-based payments granted prior to but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, less estimated forfeitures, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, less estimated forfeitures.

The stock-based employee compensation cost that is reflected in the Statement of Operations for the three months ended March 31, 2006 was $2.8 million. The total income tax benefit recognized in our statement of operations for the three months ended March 31, 2006 for share-based payments was $0.6 million. At March 31, 2006, total unrecognized stock-based compensation expense related to unvested stock options, unvested performance stock options, and unvested restricted stock awards, expected to be recognized over a weighted average period of 1.3 years, amounted to $22.9 million. Total unrecognized stock-based compensation expense will be adjusted for future changes in estimated forfeitures, if any. For the year ended 2006, we estimate total stock-based compensation expense, including amounts from the issuance of restricted shares and amounts from stock options using the fair value provisions of SFAS 123R, to be between approximately $13.0 and $15.0 million.

Application of Critical Accounting Policies and Estimates

There are no material changes to the application of critical accounting policies and estimates described in Part I, Item 7 of our Annual Report on Form 10-K (as amended by Amendment No. 1 on Form 10-K/A) for the year ended December 31, 2005 other than our adoption of SFAS 123R, as described below. In addition, we have clarified below, in the paragraphs entitled “Revenue Recognition,” how our revenue recognition policies apply to our newly acquired Cyota business, which includes a centrally hosted service. The explanation relating to our hosted service does not reflect a change in our revenue recognition policies; it is merely a clarification of how our existing policies apply to a new aspect of our business.

The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated 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 at the date of the condensed consolidated financial statements and the reported amounts of revenue and expense during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, sales returns, doubtful accounts, intangible assets, income taxes, warranty obligations, restructurings, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, our actual results could differ from those estimates.

We believe the following critical accounting policies affect our significant estimates and assumptions used in the preparation of our condensed consolidated financial statements.

Revenue Recognition – Revenue is recognized when earned. We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We recognize revenue from licensing other intellectual property when evidence of an arrangement exists, the fee is fixed or determinable and collection is considered probable. We reduce revenue for provisions of estimated returns. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. For arrangements containing multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until vendor specific objective evidence of fair value exists or all elements have been delivered. We recognize revenue upon shipment of product to our stocking distributors, net of estimated returns. We defer maintenance services revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, which is generally twelve months.

Some of our arrangements contain bundled products that include a term software license, an RSA SecurID(R) authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

For arrangements that contain an initial prepaid license fee with the payment of ongoing royalties, we recognize revenue on the initial prepaid license fee when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable. We recognize the ongoing royalties at the time a reliable estimate can be made of the actual usage that has occurred, provided that collection is probable. Annual license fees or one-time license fee arrangements typically contain non-refundable terms; therefore we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable.

We recognize revenue allocated to professional service elements as the services are performed. When customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns – We record allowances for estimated sales returns and allowances in the same period as the related revenue is recorded. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry data and other known factors. Our historical experience with sales returns varies by product line depending on the customer, industry and market. We must make judgments and estimates in connection with establishing the allowances for estimated sales returns in any reporting period. The amount and timing of our revenue and our cash flows for any reporting period may materially differ if actual sales returns and allowances differ from our estimates.

Allowance for Doubtful Accounts – We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, concentration risk trends, current economic trends, regional factors and other known factors when evaluating the adequacy of the allowance for doubtful accounts. Based upon our analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on our financial position and results of operations. We record recoveries of accounts previously written off as uncollectible as increases to the allowance for doubtful accounts.

Allowance for Warranty Obligations – Our standard practice is to provide a warranty on all RSA SecurID hardware authenticators for the customer selected programmed life of the authenticator (generally two to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a limited warranty for product defects for a specified period, generally ninety days. We provide reserves for warranty obligations based on historical failure and defective return rates, and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

Income Taxes – The preparation of our condensed consolidated financial statements requires us to estimate our income taxes in each of the jurisdictions in which we operate, including those outside the United States, which may be subject to certain risks that ordinarily would not be expected in the United States. A change in our estimate of income by jurisdiction could cause a change in our annual effective tax rate. The income tax accounting process involves our estimating our actual current exposure together with assessing temporary differences resulting from differing treatment of certain items for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.

Management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We base the valuation allowance on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. If actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust our valuation allowance, which could materially impact our consolidated financial position and results of operations.

Valuation of Goodwill and Other Intangible Assets – In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and earnings and other factors used to determine the fair value of the respective assets. We will record an impairment charge in the amount by which the carrying value of the assets exceeds their fair value. We generally determine fair value based on estimated discounted future cash flows. If these estimates or their related assumptions change in the future, we may be required to record impairment charges against these assets in the reporting period in which the impairment is determined. Any such impairment charge could be significant and could have a material adverse effect on our consolidated financial position and results of operations. We perform an annual test for impairment of our goodwill as of November 30 of each year and, if events or circumstances occur that would more likely than not reduce the fair value of the goodwill below its carrying amount, will perform an interim impairment test. We completed the required annual goodwill impairment test as of November 30, 2005, by comparing the carrying amount of the enterprise to the estimated fair value of the enterprise. Estimated fair value of the enterprise was determined based upon the market multiple valuation method, which requires that we utilize estimates of future cash flows, revenue and earnings. As of November 30, 2005, the fair value of the enterprise was greater than the carrying amount of the enterprise.

Therefore, our annual goodwill impairment test performed as of November 30, 2005 did not result in an impairment of our goodwill. At March 31, 2006, we had $274.5 million of goodwill, which accounted for approximately 41% of our total assets. Any goodwill impairment test could result in a decrease to the carrying value of goodwill and could have a material effect on our results of operations and consolidated financial position.

Restructurings – We periodically review our cost structure in terms of geographic footprint, product mix and human capital to ensure that we are in the best position to meet the demands of our shareholders, customers and other stakeholders. Our management may propose restructuring plans from time to time to more appropriately align our operations with external needs. A restructuring plan must be approved by our Board of Directors and our Chief Executive Officer or his designate.

The policy is consistent with the guidance under Statement of Financial Accounting Standards (SFAS) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”. These costs include, but are not limited to, the following: (a) termination benefits provided to current employees that are involuntarily terminated under the terms of a benefit arrangement that, in substance, is not an ongoing benefit arrangement or an individual deferred compensation contract (hereinafter referred to as one-time termination benefits); (b) costs to terminate a contract that is not a capital lease and (c) costs to consolidate facilities or relocate employees.

We continue to monitor and assess our facility obligations, real estate markets and our operating expenses. If the assumptions for the estimates used in our restructuring reserve change due to changes in the real estate and sublease markets, or due to the terms of sublease agreements that we have obtained, the ultimate restructuring expenses for these facilities could vary by material amounts, and could cause us to record additional or revise previously recorded restructuring charges in future reporting periods which could have a material effect on our results of operations and consolidated position.

Stock-Based Compensation – Effective January 1, 2006, we account for stock-based compensation expense in accordance with SFAS 123R. Prior to that date, we accounted for stock-based compensation using the intrinsic value method. Under SFAS 123R, stock-based compensation expense reflects the fair value of stock-based awards measured at the grant date, is recognized over the relevant service period, and is adjusted each period for anticipated forfeitures. We estimate the fair value of each stock-based award on the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model incorporates assumptions as to stock price volatility, the expected life of options, a risk-free interest rate and dividend yield. Many of these assumptions are highly subjective and require the exercise of management judgment. Our management must also apply judgment in developing an estimate of awards that may be forfeited. If our actual experience differs significantly from our estimates and we choose to employ different assumptions in the future, the stock-based compensation expense that we record in future periods may differ materially from that recorded in the current period.

Summary of Financial Performance for the three months ended March 31, 2006

	•		Our revenue for the three months ended March 31, 2006 was $87.5 million, an increase of $11.9 million, or 15.7%, compared to revenue of $75.6 million for the three months ended March 31, 2005.

	•		Our gross profit for the three months ended March 31, 2006 was $66.4 million, an increase of $5.6 million, or 9.1%, compared to gross profit of $60.8 million for the three months ended March 31, 2005.

	•		Our net income for the three months ended March 31, 2006 was $5.3 million, a decrease of $1.9 million, or 26.2%, compared to net income of $7.2 million for the three months ended March 31, 2005.

	•		Our cash, cash equivalents, and marketable securities were $208.2 million at March 31, 2006, compared to $187.8 million at December 31, 2005 and $282.3 million of cash, cash equivalents, and marketable securities at March 31, 2005. We repurchased 82,300 shares of our common stock for $1.2 million during the three months ended March 31, 2006.

Revenue

The following tables set forth the amount, percentage of total revenue and percentage increase of our revenue by product group, product type and product line:


	Three Months Ended					Three Months Ended
	March 31, 2006					March 31, 2005					Percentage

($ in millions)	Revenue		Percentage			Revenue		Percentage			Increase

Product group:
Enterprise solutions	$	76.0		86.9	%	$	70.2		92.8	%		8.3	%
Developer solutions		6.1		7.0	%		5.4		7.2	%		12.6	%
Consumer solutions (1)		5.4		6.1	%		—		—			NA

Total	$	87.5		100.0	%	$	75.6		100.0	%		15.7	%


Product type:
Authenticators	$	42.2		48.2	%	$	38.2		50.5	%		10.6	%
Software products		19.3		22.1	%		16.4		21.7	%		17.2	%
Maintenance, professional and managed services		26.0		29.7	%		21.0		27.8	%		23.9	%

Total	$	87.5		100.0	%	$	75.6		100.0	%		15.7	%


Product line:
Authentication products	$	69.3		79.2	%	$	65.4		86.5	%		6.0	%
Encryption products		6.2		7.1	%		5.4		7.1	%		14.9	%
Web access management products		6.6		7.5	%		4.8		6.4	%		37.2	%
Consumer products (2)		5.4		6.2	%		—		—			NA

Total	$	87.5		100.0	%	$	75.6		100.0	%		15.7	%


(1)		Consumer solutions were previously reported as part of enterprise solutions as we consider the amount immaterial.The increase in Consumer solutions revenue in 2006 is a direct result of the acquisition of Cyota in December 2005.

(2)		Consumer products were previously reported as part of authentication products as we consider the amount immaterial. The increase in Consumer products revenue in 2006 is a direct result of the acquisition of Cyota in December 2005.

We break our revenue into three geographic regions consisting of the United States, Europe and other, and Asia Pacific. The following table sets forth the amount of revenue, percentage of total revenue and percentage increase of revenue by region for the three months ended March 31, 2006 and 2005:


	Three Months Ended					Three Months Ended
	March 31, 2006					March 31, 2005					Percentage
($ in millions)	Revenue		Percentage			Revenue		Percentage			Increase

United States	$	46.8		53.5	%	$	41.1		54.4	%		13.9	%
Europe and other		30.7		35.1	%		25.8		34.1	%		18.7	%
Asia Pacific		10.0		11.4	%		8.7		11.5	%		15.2	%

Total	$	87.5		100.0	%	$	75.6		100.0	%		15.7	%

Total revenue increased $11.9 million or 15.7% in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005 which reflected revenue increases across all product types.

Our RSA SecurID authentication product line generates a substantial portion of our revenue. RSA SecurID credentials (which includes hardware and software, smart cards and USB tokens) licensed, in thousands, were as follows:


	Three Months Ended
	March 31,
	2006		2005		Percentage Increase
Number of credentials licensed		1,724		1,039		65.9	%

The increase in credentials licensed in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, was attributable to an increase in users within our existing enterprise accounts, new customers and the growth of credentials licensed for consumer authentication. We believe our RSA SecurID authentication products generate and will continue to generate substantial revenue for us.

Professional, maintenance and managed service revenue increased 23.9% in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, The increase in professional, maintenance and managed service revenue was primarily attributable to a high rate of renewals of annual maintenance contracts related to the sale of products in prior periods and the inclusion of managed service revenue related to our acquisition of Cyota, Inc. in December 2005.

We believe the increase in our Web access management revenue in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, was due in part to an increase in the number of customers allowing access of their information and applications by internal and external users. We believe that our Web access management revenue will continue to grow due to increased deployments of Web-based applications that may be accessed by a company’s employees, partners and customers.

The increase in encryption revenue during the three months ended March 31, 2006 as compared to the three months ended March 31, 2005 was primarily due to increased sales of our developer solutions to enterprises for use within their internal applications and an increase in professional services revenue. We believe that our Developer solutions revenue may benefit from companies’ needs to secure their computing systems, databases and transactions due to various regulatory requirements.

We believe that our future total revenue will be influenced by a number of major factors:

	•		As new, lower cost remote access technologies become available and as employment rates increase, we believe that we will benefit with increased total product revenue.

	•		We believe the increased awareness of digital identity theft will drive organizations and consumers to adopt technologies such as strong authentication, and we believe we will benefit from this trend.

	•		We believe that governmental regulations regarding the access to and distribution of private information will drive demand for our products. For example, we believe our revenue from the healthcare and financial services markets will increase as companies work to bring their information technology systems into compliance with industry-specific privacy and security laws and standards.

	•		We believe that as the United States government proceeds with its agenda of increasing awareness and funding of cyber-security issues and focusing on homeland security, we may benefit with increased revenue.

	•		However, information technology budgets continue to be constrained, and the continued uncertainty in the economy and global affairs may affect revenue generated from the sales of our products in future quarters.

	•		In addition, we are seeing increased competitive activity, which is putting pressure on our product prices. We believe that increased competition is lengthening our sales cycles.

	•		Growth in our consumer authentication credentials will increase the mix of our subscription revenue recognized ratably over the life of the contracts.

	•		In 2005, we instituted a major new program for our resellers and distributors and reorganized our sales force. Our future revenue will depend on the rate at which our current resellers and distributors participate in the new program, our ability to attract new resellers and distributors to the program and the effectiveness of our reorganized sales force.

Gross Profit

The following table compares our gross profit and gross margin for products and maintenance, professional and managed services:


	Three Months Ended March 31,
	2006					2005
	Gross		Gross			Gross		Gross
($ in millions)	Profit		Margin			Profit		Margin

Products	$	48.5		78.7	%	$	45.9		84.0	%
Maintenance, professional and managed services		17.9		69.0	%		14.9		71.0	%

Total	$	66.4		75.9	%	$	60.8		80.4	%

The decrease in total gross margin for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, was primarily a result of the greater mix of services revenue as a percentage of our total revenue, the integration of Cyota, costs associated with the build-out of our RSA Consumer Authentication Service and increased licensed technology fees to third parties.

Research and Development

The following table compares our research and development expenses for the three months ended March 31, 2006 and 2005:


	Three Months Ended March 31,
($ in millions)	2006			2005			% Change

Research and development	$	17.3		$	16.0			8.2	%
Percentage of revenue		19.7	%		21.1	%

Research and development expenses increased $1.3 million in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, primarily due to an increase in payroll costs of approximately $1.3 million associated with employees who joined the Company as a result of our Cyota acquisition and our continued allocation of resources towards investing in our future product offerings and $0.4 million associated with the adoption of SFAS 123R, partially offset by a decrease in consulting expenses of $0.3 million.

Marketing and Selling

The following table compares our sales and marketing expenses for the three months ended March 31, 2006 and 2005:


	Three Months Ended March 31,
($ in millions)	2006			2005			% Change

Marketing and selling	$	29.3		$	29.1			0.6	%
Percentage of revenue		33.5	%		38.5	%

Marketing and selling expenses increased $0.2 million in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, primarily due to an increase of approximately $0.8 million associated with the adoption of SFAS 123R, and an increase of payroll costs of approximately $0.2 million, partially offset by a decrease in costs associated with marketing programs of approximately $0.6 million.

General and Administrative

The following table compares our general and administrative expenses for the three months ended March 31, 2006 and 2005:


	Three Months Ended March 31,
($ in millions)	2006			2005			% Change

General and administrative	$	11.5		$	8.3			38.0	%
Percentage of revenue		13.2	%		11.0	%

General and administrative expenses increased $3.2 million in the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, primarily due to an increase in payroll costs of approximately $1.4 million, approximately $1.3 million associated with the adoption of SFAS 123R, increased legal fees of approximately $0.2 million and an increase of approximately $0.2 million of consulting fees.

Restructurings

During the year ended December 31, 2002, we recorded restructuring charges of $56.0 million, consisting of facility exit costs, costs associated with the liquidation of our Swedish development operations and the sale of certain Swedish assets and the business related to the assets to TFS Technology AB (“TFS”), and severance and other costs associated with the reduction of employee headcount.

During 2004, we recorded a net charge of $1.0 million related to our revised estimates of facility exit costs. We revised this estimate of facility exit costs based upon the terms of finalized subleases and associated costs obtained during the second quarter of 2004. We also reduced our restructuring reserve by $0.2 million at December 31, 2004 when we determined our remaining severance and costs were lower than originally estimated.

On December 1, 2005, our management committed to a plan to restructure our engineering resources into four core locations around the world. Under the plan, which we expect to bring greater cost efficiencies to the engineering group and closer coordination to engineering projects, and we estimate that approximately 120 positions will be relocated. All engineering personnel currently based in our offices in Vancouver, B.C, San Mateo, California and New York City will be relocated to Bedford, Massachusetts or to expanded operations in India and Brisbane, Australia. These transitions will be conducted in phases, with an expected completion date of December 2006. The program is projected to result in total charges in the range of $10.0 million to $14.0 million primarily related to facility closings and headcount reductions associated with relocating engineering resources.

Restructuring charges accrued and unpaid at March 31, 2006 were as follows:


	Facility
($ in millions)	Exit Costs
Balance at January 1, 2006	$	15.7
Restructuring charges		2.6
Payments		(2.4	)

Balance at March 31, 2006	$	15.9

We expect to pay the remaining restructuring costs accrued at March 31, 2006 as follows:


($ in millions)
Nine months ending December 31, 2006	$	6.1
Year ending December 31, 2007		4.3
Year ending December 31, 2008		3.3
Year ending December 31, 2009		2.2

Total	$	15.9

Interest Income and Other, Net

Interest income and other, net includes the following:


	Three Months Ended
	March 31,
($ in millions)	2006			2005

Interest income and other	$	0.4		$	0.2
Investment income		1.4			1.5
Unrealized (loss) gain from foreign currency translations		(0.3	)		0.2

Total interest expense and other, net	$	1.5		$	1.9

The increase in interest income and other, net for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, was primarily due to increasing overnight investment yields. The decrease in investment income for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, was due to lower cash and marketable securities investment balances resulting from our acquisition of Cyota, Inc. in December 2005, partially offset by increasing investment yields. The unrealized loss from foreign currency translation was primarily due to the weakening of the US dollar during the three months ended March 31, 2006.

Provision for Income Taxes

The provision for income taxes was $1.5 million for the three months ended March 31, 2006, compared to a provision of $2.0 million for the three months ended March 31, 2005. Our effective tax rate was 22.4% for the three months ended March 31, 2006, compared to an effective tax rate of 22.0% for the three months ended March 31, 2005.

Liquidity and Capital Resources

Summary of Sources and Uses of Cash

The following table summarizes our sources and uses of cash over the periods indicated:


	Three Months Ended
	March 31,
($ in millions)	2006			2005
Net cash provided by operating activities	$	11.8		$	4.8
Net cash used for investing activities	$	(37.1	)	$	(9.9	)
Net cash provided by (used for) by financing activities	$	13.5		$	(8.8	)
Decrease in cash and cash equivalents	$	(11.8	)	$	(14.0	)

Our primary sources of liquidity are our cash, cash equivalents and marketable securities resulting from our cash flow from operations. We had $57.2 million in cash and cash equivalents at March 31, 2006, consisting primarily of operating cash and cash equivalents. This represents a decrease of $11.8 million in cash and cash equivalents from December 31, 2005. As of March 31, 2006, we had $151.0 million in marketable securities consisting primarily of auction rate securities, U.S. Government and agency securities and corporate debt securities.

Cash provided by operations of $11.8 million during the three months ended March 31, 2006 consisted primarily of net income of $5.3 million, non-cash depreciation charges of $4.1 million and stock-based compensation of $2.8 million.

Any increase or decrease in our accounts receivable balance and accounts receivable days outstanding (calculated as net accounts receivable divided by revenue per day) may affect our cash flow from operations and liquidity. Our accounts receivable and accounts receivable days outstanding may increase due to changes in factors such as the amount of international sales and length of customer’s payment cycle. We also record deferred revenue billings as accounts receivable, and the timing of these billings affects the accounts receivable days outstanding. Historically, international and indirect customers pay at a slower rate than domestic and direct customers. An increase in revenue generated from international and indirect customers may increase our accounts receivable days outstanding and accounts receivable balance. If the economy deteriorates, we may observe an increase in the length of our customers’ payment cycle. To address increases in accounts receivable balance and to improve cash flow, we may from time to time take actions to encourage earlier payment of receivables. Discounts offered to customers to encourage payment are deducted from revenue. To the extent that our accounts receivable balance increases, we may incur increased bad debt expense and increased estimates for reserves against revenue and will be subject to greater general credit risks.

Cash used for investing activities of $37.1 million during the three months ended March 31, 2006 consisted primarily of $66.9 million used to purchase marketable securities and $3.9 million of cash used to purchase property and equipment, which was partially offset by $34.7 million of net sales and maturities of marketable securities.

Cash provided by financing activities of $13.5 million during the three months ended March 31, 2006 consisted primarily of $10.2 million of proceeds from employee exercises and purchases under our stock option and employee stock purchase plans, $4.4 million of excess tax benefit from the exercise of stock options, partially offset by $1.2 million of cash used to repurchase shares of our common stock.

The following are our contractual commitments associated with our lease obligations, restructurings, purchase obligations and royalty commitments as of March 31, 2006:


			Payments Due by Period
			Less
			Than		1 – 3		3 - 5		More Than
($ in millions)	Total		1 Year		Years		Years		5 Years

Operating leases	$	124.8	$	13.7	$	41.0	$	29.9	$	40.2
Restructurings		15.9		7.2		8.7		—		—
Purchase obligations		2.6		1.1		1.5		—		—
Royalty commitments		5.0		2.0		2.5		0.5		—

Total commitments	$	148.3	$	24.0	$	53.7	$	30.4	$	40.2

We have commitments for various operating leases worldwide that expire at various times through 2017 and that are shown above, net of existing sublease agreements, excluding facility exit costs included in restructuring charges. The lease commitments of $124.8 million shown also include lease commitments of $10.3 million related to certain exited facilities that have not been reserved for in restructuring charges, which represents our estimated sublease income from these facilities from the end of the period reserved to the end of the lease term. The restructuring commitments shown above are primarily for facility exit costs of up to 45 months of minimum lease payments due under certain excess facilities lease agreements, net of related sublease agreements. Our purchase obligations relate to inventory commitments. Our royalty commitments represent our minimum contractual royalty obligations for the use of licensed technology.

We currently have no debt nor have we found it necessary, given our success in generating cash from operations and our significant liquidity, to obtain a credit facility.

We provide e-security solutions to various customers in diverse industries. We perform ongoing credit evaluations of our customers and maintain allowances for potential credit losses. We had two significant customers who are distributors, whose aggregate balances accounted for approximately 21% and 14% of our total accounts receivable as of March 31, 2006 and December 31, 2005, respectively.

Our plans for future uses of cash may include additional acquisitions of other entities or technologies and additional purchases of property and equipment. In April 2006, we paid approximately $9.0 million in cash to acquire PassMark. We have agreed to pay up to $5.5 million for retention bonuses for certain employees as part of our acquisition of Cyota. We anticipate capital expenditures will be primarily for purchases of property and equipment and will be approximately $6.0 million to $8.0 million for the remainder of 2006.

We believe that cash generated from our operating activities will be sufficient to fund our working capital requirements, including our restructuring liabilities, through at least the next twelve months. We anticipate that current cash on hand, cash generated from operations, and cash generated from the exercise of employee options and employee stock purchase plans will be adequate to fund our planned capital and financing expenditures for at least the next twelve months.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to a variety of risks, including changes in the market value of our marketable securities, investments, our common stock and foreign exchange rates. Market fluctuations could impact our results of operations and financial condition. In the normal course of business, we employ established policies and procedures to manage these risks.

Our marketable securities and cash equivalents are generally high credit quality instruments, primarily U.S. Treasury and government agency obligations, taxable municipal obligations and money market investments with the average maturity of the total investment portfolio being two years or less. For securities where the interest rate is adjusted periodically, the reset or auction date will be used to determine the maximum maturity date. Accordingly, we believe that our potential interest rate exposure in investments is not material.

We also currently have no debt, and therefore, we have no direct exposure to movements in interest rates.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as our business practices evolve and could have a material adverse impact on our financial results. Our primary exposures to fluctuations in foreign currency exchange rates relate to sales and operating expenses denominated in currencies other than the US

dollar. The operations of our foreign subsidiary in Ireland are measured using the U.S. dollar as its functional currency, while all of our other foreign branches and subsidiaries operations are measured using the local currencies as the functional currencies. Our sales to our customers in countries outside of the United States are primarily billed through Ireland and are thus denominated in U.S. dollars. When we do invoice customers in a non U.S. dollar currency, we are exposed to foreign exchange fluctuations from the time of invoice until collection occurs. In Ireland, where we primarily invoice our customers in U.S. dollars, we pay our operating expenses in local currencies. Accordingly, fluctuations in the Euro relative to the U.S. dollar are reflected directly in our income statement. We are also exposed to foreign currency rate fluctuations between the time we collect in U.S. dollars and the time we pay our operating expenses in local currency. Fluctuations in foreign currency exchange rates could affect the profitability and cash flows in U.S. dollars of our products sold in international markets.

Item 4. Controls and Procedures

Our management, with the participation of our Chief Executive Officer, who is also our acting Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2006. Based on this evaluation, our Chief Executive Officer concluded that, as of March 31, 2006, our disclosure controls and procedures were effective, in that they (1) were designed to ensure that material information relating to RSA Security, including its consolidated subsidiaries, is made known to our Chief Executive Officer by others within RSA Security, particularly during the period in which this Report was being prepared, and (2) provide reasonable assurance that information that we are required to disclose in the reports we file under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

No change in our internal control over financial reporting (as defined in the SEC rules promulgated under the Securities Exchange Act) occurred during the quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

ITEM 1A. Risk Factors

There are no material changes to the risk factors described in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005 other than the addition of a new risk factor below, entitled “If our restructuring of our engineering resources is not successful, then our product development and enhancement efforts could be adversely impacted, which could hurt our business.”

Our operating results tend to fluctuate from quarter to quarter. Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. A variety of factors, many of which are outside of our control, can cause these fluctuations, including, among others:

	•		the size, timing and shipment of individual orders for our products;

	•		changes in our operating expenses;

	•		the timing of personnel departures and new hires and the rate at which new personnel become productive;

	•		the timing of the introduction or enhancement of our products and our competitors’ products;

	•		customers deferring their orders in anticipation of the introduction of new products by us or our competitors;

	•		market acceptance of new products;

	•		changes in the mix of products sold;

	•		changes in product pricing, including changes in our competitors’ pricing policies;

	•		development and performance of our direct and indirect distribution channels and changes in the mix of vertical markets to which we sell our products;

	•		the amount and timing of charges relating to restructurings and the impairment or loss of value of some of our assets, especially goodwill and intangible assets; and

	•		general economic conditions.

We may not be able to achieve, sustain or grow our profitability from quarter to quarter. Because our operating expenses are based on anticipated revenue levels and a high percentage of our expenses are fixed, a small variation in when revenue is recognized can cause significant variations in operating results from quarter to quarter. Our business has historically tended to be seasonal, with the last quarter of the year having the highest amount of revenue and the first quarter of the year having the lowest amount of revenue.

Our failure to successfully integrate Cyota and PassMark into our business and operations could hurt our business. The integration of the business and operations of Cyota, Inc., which we acquired in December 2005, and PassMark Security, Inc., which we acquired in April 2006, into our business and operations is a complex, time-consuming and expensive process. Before any acquisition, each company has its own business, culture, customers, employees and systems. After the acquisition, we must ensure that the companies operate as a combined organization using common communications systems, operating procedures, financial controls and human resources practices. In order to successfully integrate Cyota and PassMark, we must, among other things, successfully:

	•		retain key Cyota and PassMark personnel;

	•		integrate, both from an engineering and a sales and marketing perspective, Cyota’s and PassMark’s products and services into our suite of product and service offerings;

	•		coordinate research and development efforts;

	•		train and integrate our sales forces;

	•		integrate our business processes and systems; and

	•		eliminate redundant costs and consolidate redundant facilities.

To remain competitive we may need to acquire other companies or purchase or license technology from third parties in order to introduce new products and services or enhance our existing products and services. We may not be able to find businesses that have the technology we need and, if we find such businesses, may not be able to purchase or license the technology on commercially favorable terms or at all. Once we have completed an acquisition or technology license, the acquired business or our relationship with the licensor may not be successful. In addition, acquisitions and technology licenses are difficult to identify and complete for a number of reasons, including the cost of potential transactions, competition among prospective buyers and licensees and the need for regulatory approvals. In order to finance a potential transaction, we may need to raise additional funds by selling our stock or borrowing money. We may not be able to find financing on favorable terms, and the sale of our stock may result in the dilution of our existing stockholders.

Some of our products have long and unpredictable sales cycles, which may impact our quarterly operating results. Transactions for some of our products, especially our Web access management products, often involve large expenditures by our customers. The sales cycles for these transactions can be long and unpredictable due to a number of uncertainties such as:

	•		customers’ willingness to invest potentially substantial resources and modify their network infrastructures to take advantage of our products;

	•		customers’ budgetary constraints;

	•		the need to educate potential customers about our products’ capabilities;

	•		the timing of customers’ budget cycles;

	•		delays caused by customers’ internal review processes; and

	•		for sales to government customers, governmental regulatory, approval and purchasing requirements.

During times when the global economy experiences weakness or uncertainty, we may have difficulty selling our products and services. The global economy, especially the technology sector, can be volatile, and an economic slowdown can have serious negative consequences for our business and operating results. For example, during a period of economic weakness or uncertainty, current or potential customers may defer purchases, go out of business or have insufficient capital to buy or pay for our products and services. During the last several years, we have observed that many companies have reduced their budgets for information technology products and services, which may reduce or eliminate some potential sales of our products and services. In addition, if our resellers and distributors experience financial difficulties due to an uncertain economy, then we may have difficulty selling to and collecting money from those resellers and distributors.

If we fail to remain competitive, then we could lose market share for our established products or fail to gain market share for our less mature products and services. We have seen increased competition in our market in recent years, and we expect this trend to continue. A number of competitive factors could cause us to lose potential sales or to sell our products and services at lower prices or at reduced margins, including, among others:

	•		Some of our competitors offer e-security products with features and functionality that our products do not currently offer or at lower prices than we offer. In addition, our customers and potential customers may perceive some of our competitors’ products and services as being more convenient and easier to use than ours.

	•		Some computer and software companies that have not traditionally offered e-security products are now offering free or low-cost e-security products and functionality bundled with their own computer and software products.

	•		Some of our current and potential competitors have greater financial, marketing and technical resources than we do, allowing them to leverage an installed customer base and distribution network, adapt more quickly to new technologies and changes in customer requirements, or devote greater resources to the promotion and sale of their products and services than we can.

	•		Our industry is undergoing consolidation, with larger firms acquiring some of our competitors. A larger firm that acquires a competitor may be a greater threat to us than the original, smaller competitor was for the reasons described in the immediately preceding bullet point.

	•		Our issued U.S. patents expire at various dates ranging from 2006 to 2023. When each of our patents expires, competitors may develop and sell products based on the same or similar technologies as those covered by the expired patent.

	•		The expiration of some of our patents has also permitted the use and distribution of “freeware,” free versions of some of our technology, and we believe that some potential customers may be choosing to use freeware instead of buying our products.

	•		Many companies have reduced their information technology budgets due to the current economic conditions, which could make competition more intense because we are competing for fewer customer dollars.

If our restructuring of our engineering resources is not successful, then our product development and enhancement efforts could be adversely impacted, which could hurt our business. We are currently executing a plan to restructure our engineering resources into four core locations around the world, including relocating a number of engineering positions to our headquarters in Bedford, Massachusetts and to expanded operations in India and Australia. We may not be able to retain or attract the talented engineering personnel we need in order to realize the benefits of this restructuring. In addition, the restructuring is disruptive to our engineering organization, as projects are reassigned to new locations and personnel. This disruption could lead to delays or errors in the development and enhancement of our products. Further, if the costs of expanding our operations in India and Australia are greater than we anticipate, or if we are not successful in integrating those operations into our worldwide engineering organization, then we may not realize the cost or operational efficiencies that we expect from the restructuring.

We depend heavily on key, talented employees in a competitive labor market. Our success depends on our ability to attract, motivate and retain skilled personnel, especially in the areas of management, sales and engineering. We compete with other companies for a small pool of highly qualified employees. Although we believe that our compensation plans are competitive, we may not be able to hire and retain the employees we need.

Our stock price has been volatile and is likely to remain volatile. From April 1, 2005 through April 28, 2006, our stock price has ranged from a per share high of $21.04 to a low of $9.99. A number of factors may contribute to the volatility of our stock price, including:

	•		our ability to meet the expectations of brokerage firms, industry analysts and investors with respect to our operating and financial results;

	•		our public announcements and our competitors’ public announcements;

	•		the public’s perception of the strength of the e-security solutions market and technology companies generally;

	•		litigation developments;

	•		the volatility of the stock market in general and of the technology sector in particular; and

	•		general economic conditions.

If the market for e-security solutions does not continue to grow, then demand for our products and services may decrease. The market for some of our e-security solutions is continuing to develop, and demand for our products and services depends on, among other things:

	•		the perceived ability of our products and services to address real customer problems;

	•		the perceived quality, price, ease-of-use and interoperability of our products and services as compared to those of our competitors;

	•		the market’s perception of how easy or difficult it is to deploy our products, especially in complex, heterogeneous network environments;

	•		the continued evolution of electronic commerce as a viable means of conducting business;

	•		market acceptance and use of new technologies and standards;

	•		the ability of network infrastructures to support an increasing number of users and services;

	•		the public’s perception of the need for secure electronic commerce and communications over both wired and wireless computer networks;

	•		the U.S. government’s continued focus on e-security as a means to counteract terrorism and other hostile acts;

	•		the pace of technological change and our ability to keep up with these changes;

	•		the market’s perception of our products’ ability to address the e-security aspects of various laws; and

	•		general economic conditions, which, among other things, influence how much money our customers and potential customers are willing to allocate to their information technology budgets.

Unless we keep up with the ongoing changes in e-security technology and standards, our products and services could become obsolete. Our success depends in part upon our ability to enhance our existing products and to introduce new, competitively priced products and solutions with features that meet changing market requirements, all in a timely and cost-effective manner. A number of factors, including the following, could have a negative impact on the success of our products and services:

	•		quality, reliability or security failures, which could result in product returns, delays in collecting accounts receivable, unexpected service or warranty expenses, reduced orders and a decline in our competitive position;

	•		delays or difficulties in the development of our products and services;

	•		our competitors’ introduction of new products or services ahead of our new products or services, or their introduction of superior or cheaper products or services;

	•		the availability of free, unpatented implementations of encryption algorithms and security protocols;

	•		the market’s failure to accept new technologies, including consumer authentication, connected authentication devices, smart cards, enterprise strong authentication, Web access management and digital certificates;

	•		our failure to include features in our products, or obtain industry and governmental certifications, that our customers or U.S. or foreign government regulators may require;

	•		our failure to anticipate changes in customers’ requirements; and

	•		the implementation of industry or government standards that are inconsistent with the technology embodied in our products and services.

If any of our products are found to have, or suspected to have, security vulnerabilities, then we could incur significant costs and damage to our reputation. If any of our products are found to have significant security vulnerabilities, then we may need to dedicate engineering and other resources to eliminate the vulnerabilities and to repair or replace products already sold or licensed to our customers. In addition, our customers and potential customers could perceive our products as unreliable, making it more difficult for us to sell our products.

If we fail to obtain a sufficient supply of high-quality RSA SecurID authenticators or components, then we may be unable to fill customer orders or may need to replace defective authenticators shipped to our customers. Problems with the availability or quality of our products could cause our revenue to decrease and our costs to increase, damage our reputation in the marketplace and subject us to damage claims from our customers. Examples of quality and possible availability problems include:

	•		In 2002 and 2003, our quarterly analysis of historical failure and defective return rates indicated that certain RSA SecurID authenticators produced between 2000 and 2002 were subject to higher defect and failure rates.

	•		Many of our suppliers are located outside of the United States. If political, economic, health-related or natural events, such as the U.S. actions in Iraq or the 2004 earthquake and tsunami disasters in Asia, were to affect international trade, then we could experience difficulties in obtaining product components from our international suppliers.

	•		We depend on a limited number of suppliers for some of our product components. If our existing suppliers were unable to provide us with a sufficient supply of quality components, then we would have to expend significant resources to find new suppliers, and it is possible that we would be unable to find new suppliers in a timely manner.

International sales make up a significant portion of our business. International sales accounted for more than 40% of our total revenue in each of the years ended December 31, 2005, 2004 and 2003 and the three months ended March 31, 2006. There are certain risks inherent in doing business internationally, including:

	•		foreign regulatory requirements and the burdens of complying with a wide variety of foreign laws;

	•		legal uncertainty regarding liability and the costs of resolving or litigating a dispute internationally;

	•		difficulties in the enforcement of intellectual property rights;

	•		export and import restrictions on cryptographic technology and products incorporating that technology;

	•		difficulties and delays in establishing international distribution channels;

	•		the need to tailor or “localize” our products in order to compete in particular international markets and to comply with foreign laws;

	•		difficulties in collecting international accounts receivable;

	•		fluctuations in currency exchange rates;

	•		potentially adverse tax consequences, including restrictions on the repatriation of earnings;

	•		tariffs and other trade barriers; and

	•		political instability.

If we fail to protect our rights in our proprietary technology, competitors may use our technology, which could weaken our competitive position, reduce our revenue and increase our costs. We rely on a combination of patent, trade secret, copyright and trademark laws, software licenses, nondisclosure agreements and technical measures to protect our proprietary technology. However, despite our efforts to protect our proprietary rights, unauthorized third parties may nonetheless succeed at:

	•		copying aspects of our products;

	•		obtaining and using information that we regard as proprietary; or

	•		infringing upon our patents and other proprietary rights.

We rely on patents to protect our proprietary rights in our technology, but patents may not provide complete protection:

	•		It is possible that any patent that we or our licensors hold might be invalidated, circumvented, challenged or terminated.

	•		It is possible that patent examiners might reject the claims described in our pending or future patent applications.

	•		The laws of some countries in which our products are now, or may in the future be, developed or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States.

	•		All patents expire after a period of years. When each of our patents expires, other companies may develop and sell products based on our previously patented technology.

	•		During the life of a patent, third parties may design and sell “work-around” solutions that accomplish the goals of our patented inventions but do not infringe the patents themselves.

Our industry is highly litigious. From time to time, we have been involved in disputes with third parties who allege that our products may infringe intellectual property rights held by the third parties. For example, in April 2005, Prism Technologies LLC filed

a lawsuit against us and several other companies claiming that some of our products infringe Prism’s patent (see Part I, Item 3 (Legal Proceedings) of this report for more details). Any litigation carries a number of significant risks, including:

	•		litigation is often very expensive, even if it is resolved in our favor; and

	•		litigation diverts the attention of management and other resources.

Moreover, if a court or other government agency rules against us in any intellectual property litigation, we might be required to:

	•		discontinue the use of certain processes;

	•		cease the manufacture, use and sale of infringing products;

	•		expend significant resources to develop non-infringing technology;

	•		obtain licenses to the infringing technology; or

	•		pay significant monetary damages.

Our excess facilities are costly. We currently lease a number of excess, unused or under-used facilities, and our lease commitments for some of these facilities will not expire for several years. Although we have entered into sublessees for most of these facilities, if any of our sublessees were to fail to pay their portion of the rent to our landlords due to financial difficulties or for any other reason, then we would be responsible for paying the full rental amount.

We must establish and maintain strategic relationships. We need to create relationships with third parties, including some of our competitors, to ensure that our products will interoperate with the third parties’ products. If our products do not work with third-party products used by our customers and potential customers, then our products could lose or fail to achieve market acceptance. We may not be able to find appropriate strategic partners or may not be able to enter into relationships on commercially favorable terms. Furthermore, the relationships we do enter into may not be successful. Because our strategic relationships are generally non-exclusive, our strategic partners may decide to pursue alternative technologies or to develop alternative products in addition to or instead of our products, either on their own or in collaboration with our competitors.

Security technologies are under constant attack. The strength of our cryptographic and other e-security technologies is constantly being tested by computer professionals, academics and “hackers.” Any significant advance in the techniques for attacking e-security solutions could make some or all of our products obsolete or unmarketable. From time to time, we have learned of attempts by third parties to reverse engineer our products to find vulnerabilities. If a third party successfully “hacks” any of our products and makes its findings public, then we may need to dedicate engineering and other resources to eliminate the published vulnerabilities. For example, if a third party were to hack our RSA SecurID solution, then some of our customers could require that we replace some or all of their RSA SecurID authenticators with authenticators that are more secure. If we are required to make these replacements or if we cannot address the vulnerabilities in our products in a timely fashion, then our business and operating results could be adversely impacted. In addition, our customers and potential customers could perceive our products as unreliable, making it more difficult for us to sell our products.

We may incur significant expenses and damages because of liability claims. An actual or perceived breach of network or data security at our facilities or at a customer’s facilities could result in a product liability claim against us. A substantial product liability claim against us could harm our operating results and financial condition. In addition, any actual or perceived breach of network or data security, whether or not caused by the failure of one of our products, could hurt our reputation and cause potential customers to turn to our competitors’ products.

Our stockholder rights plan and some provisions of our charter may inhibit potential acquisition bids. We have a classified board of directors and have also adopted a stockholders rights plan, both of which could make it more difficult for a potential acquirer to complete a merger, tender offer or proxy contest involving our company. While these provisions are intended to enable our board to maximize stockholder value, they may have the effect of discouraging takeovers that could be in the best interest of certain stockholders and may therefore have an adverse effect on the market price of our common stock.

In addition, as a Delaware corporation, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which regulates corporate acquisitions. These provisions could discourage potential acquisition proposals and could

delay or prevent a change in control transaction. They could also have the effect of discouraging others from making tender offers for our common stock and preventing changes in our management.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On September 3, 2004, we announced that our Board of Directors authorized us to repurchase up to 6,700,000 shares of our common stock through December 31, 2005. We use repurchased shares for stock option and employee stock purchase plans and for general corporate purposes. On July 21, 2005, we announced that our Board of Directors increased the number of shares of common stock that we are authorized to repurchase by an additional 2,000,000 shares, and extended the expiration date of the stock repurchase program to June 30, 2006. On April 19, 2006 our Board of Directors approved the extension of the stock repurchase program for an additional two years, until June 30, 2008, but made no change to the number of shares authorized to be repurchased under the plan.

The table below contains information about our activities under this common stock repurchase program during the quarter ended March 31, 2006.

ISSUER PURCHASES OF EQUITY SECURITIES


					Total Number of
					Shares Purchased		Maximum Number
	Total Number				as Part of Publicly		of Shares that May
	of Shares		Average Price		Announced		Yet Be Purchased
Period	Purchased (1)		Paid per Share		Program		Under the Program
January 1-31, 2006		0		0		0		6,495,271
February 1-28, 2006		50,000	$	14.67		50,000		6,445,271
March 1-31, 2006		32,300	$	14.82		32,300		6,412,971
Total		82,300	$	14.75		82,300		6,412,971


(1)		All shares were purchased in open market transactions.

Item 6. Exhibits

See the Exhibit Index attached to this Report.

EXHIBIT INDEX


ITEM		DESCRIPTION
2.1		Agreement and Plan of Merger, dated as of April 24, 2006, among RSA Security Inc., S&C Acquisition Corp., PassMark Security, Inc. and the Representative (as defined therein) is incorporated herein by reference to Exhibit 2.1 to our Current Report on Form 8-K dated April 24, 2006.

10.1		RSA Security’s 1994 Employee Stock Purchase Plan, as amended, is incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K dated January 16, 2006.

10.2		Summary of 2006 Executive Incentive Compensation Plan of RSA Security is incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K dated February 14, 2006.

10.3		Letter Agreement, dated as of April 24, 2006, between RSA Security and William H. Harris, Jr. is incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K dated April 24, 2006.

10.4		Non-Competition and Non-Solicitation Agreement, dated as of April 24, 2006, between RSA Security and William H. Harris, Jr. is incorporated herein by reference to Exhibit 10.2 to our Current Report on Form 8-K dated April 24, 2006.

10.5		Indemnification Agreement, dated as of July 16, 2004, PassMark Security, Inc. and William H. Harris, Jr. is incorporated herein by reference to Exhibit 10.3 to our Current Report on Form 8-K dated April 24, 2006.

31.1		Certification of our CEO pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of our CFO pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32.1		Certifications of our CEO and CFO pursuant to 18 U.S.C. §1350.


PART I. FINANCIAL INFORMATION			3

Item 1. Financial Statements			3

Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005			3

Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2006 and 2005			4

Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005			5

Notes to Condensed Consolidated Financial Statements			6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16

Item 3. Quantitative and Qualitative Disclosures About Market Risk			30

Item 4. Controls and Procedures			31

PART II. OTHER INFORMATION			31

Item 1. Legal Proceedings			31

Item 1A. Risk Factors			31

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			38

Item 6. Exhibits			38

Signature			39
EX-31.1 - Sec 302 Certification of CEO
EX-31.2 - Sec 302 Certification of CFO
EX-32.1 - Sec 906 Certification of CEO & CFO

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	Percentage of
	Total Revenue
	Three Months Ended
	March 31,
	2006			2005
Revenue
Products		70.3	%		72.2	%
Maintenance, professional and managed services		29.7			27.8

Total revenue		100.0			100.0

Cost of revenue
Products		14.6			11.3
Maintenance, professional and managed services		8.4			8.1
Amortization of technology related intangible assets		1.2			0.2

Total cost of revenue		24.2			19.6

Gross margin		75.8			80.4


Costs and expenses
Research and development		19.7			21.1
Marketing and selling		33.5			38.5
General and administrative		13.1			11.1
Amortization of intangible assets		0.3			—
Restructurings		3.0			—

Total		69.6			70.7

Income from operations		6.2			9.7

Interest income and other		1.7			2.5

Income before provision for income taxes		7.9			12.2

Provision for income taxes		1.8			2.6


Net income		6.1	%		9.6	%


	RSA SECURITY INC.
	/s/ ARTHUR W. COVIELLO, Jr.
	Arthur W. Coviello, Jr.
	Chief Executive Officer and President, Acting Chief Financial Officer (Principal Financial Officer)