Kasten Chase Applied Research Limited
TSX : KCA

Kasten Chase Applied Research Limited

July 21, 2005 16:13 ET

Kasten Chase Reports Q2 2005 Financial Results

TORONTO, ONTARIO--(CCNMatthews - July 21, 2005) - Kasten Chase (TSX:KCA), a leader in data storage security solutions, today reported second quarter 2005 financial results for the period ending June 30, 2005.

Revenue for the quarter was $0.5 million compared to $0.7 million during the previous quarter and $0.8 million one year ago. The net loss from the quarter was $2.4 million, or $ 0.04 per share, as compared to $2.0 million or $.04 per share in the previous quarter, and $11.6 million, or $0.20 per share for the same period one year ago.

During the second quarter, the Company continued development of its Assurency® SecureData and Business Services offerings for the data storage security market. Highlights include:

- a prestigious North American industry Storage Security award;

- the release of the next-generation Assurency Crypto-Accelerator (ACA) 2400;

- a reseller agreement with Softchoice, one of North America's fastest growing technology resellers; and

- a Storage Security Compliance Auditing service, designed to help organizations enhance 'compliance-readiness' and storage resiliency.

Operating expenses for Q2 were $2.7 million compared to $12.1 million in the same period last year.

At June 30, 2005, the Company had cash and cash equivalents and short-term investments of $5.6 million compared to $7.2 million as at March 31, 2005. The current ratio remains strong at 4.2:1.

"We are pleased that the second quarter has brought industry recognition to Kasten Chase's Assurency SecureData," said Michael Milligan, Chief Executive Officer, Kasten Chase. "The fact that Assurency SecureData won the prestigious Network Computing Well-Connected Award in the Storage Security Category is a clear endorsement of our approach and the quality of the technology we have, and continue to develop. This endorsement has helped to highlight Kasten Chase to a growing number of prospects."

The increased awareness of the need for encryption and the demand for storage security solutions is motivating our team. We continue to invest in developing our sales team and our award-winning and market-leading solutions, and work to generate new revenues in this market.

Conference Call

The Company will host a conference call for analysts, shareholders and members of the media at 4:30 P.M. ET today. The call will include an update on activities, as well as an overview of the Company's financial performance during the quarter. Management's presentation will be followed by a brief question and answer period.

Those wishing to participate are invited to dial in using the following numbers:

416-682-1063 (in Toronto)

1-866-384-0144 (North America)

The call will also be Web cast live at www.kastenchase.com.

About Kasten Chase

Kasten Chase (TSX: KCA) delivers innovative data storage security solutions to mitigate information security risks, meet compliance obligations and reduce the cost and complexity of data storage operations. The Company's award-winning, enterprise-class, storage security solution, utilizes a distributed, scalable architecture to encrypt networked, archive and backup storage. Kasten Chase complements its award-winning technology with business services that assess information risk and audit compliance practices for enterprise storage. Kasten Chase is headquartered in Mississauga, Ontario with offices in Ottawa, Ontario and Sterling, Virginia. Kasten Chase is a certified ISO 9001:2000 company.

For further information, please visit http://www.kastenchase.com

Dear Fellow Shareholders,

The second quarter of 2005 brought industry recognition of the need for encryption of sensitive data stored on tape and disk, an award for our Assurency® SecureData solution and the expansion of Assurency® Business Services.

During the last 90 days, there continued to be an increasing number of publicly reported security breaches. While many of these breaches were due to malicious online hacking, an increasing number of these announcements related to the accidental loss of computer backup tapes. The consequences of the public disclosure associated with such losses have caused the market for our products and services to become viable, competitive and quickly growing, particularly in the U.S.

In April, Iron Mountain, the leader in records storage and offsite data protection, publicly recommended companies encrypt backup tapes containing personal information. This endorsement of encryption is a critical market affirmation of Kasten Chase's storage security technology, since many companies are now actively seeking tape and disk encryption solutions. As a result, Kasten Chase has seen an increase in the number of requests for product briefings and is aggressively pursuing these opportunities.

In the second quarter, Kasten Chase's Assurency SecureData Solution was awarded "Best Storage Security Solution" in the prestigious Network Computing 2005 Well-Connected Award. Winning this award has further highlighted Kasten Chase's solution with prospects, media and analysts.

During the quarter, Kasten Chase released the Assurency® Crypto-Accelerator (ACA) 2400. The ACA 2400 is the next-generation of crypto-accelerators providing high-performance encryption and on-board compression along with centralized key management and support for the broadest range of storage environments. The ACA 2400 is available as part of the Assurency SecureData solution or on an OEM basis.

Assurency CipherShare™ received pre-qualification status, under the Information Technology Security (ITS) Pre-Qualification Program, by the Canadian Government's Communication Security Establishment (CSE). This successful evaluation pre-qualifies Assurency CipherShare for procurement by Government of Canada departments as a solution that is approved and recommended for protection of Government of Canada Protected B and below information. This approval makes it easier for our internal sales team and external resellers to sell into this market and we are actively following up on opportunities.

Kasten Chase extended its Assurency Business Services with the launch of the Storage Security Compliance Auditing Service. Recent market research indicates storage security is a priority for over 43% of storage professionals. The Storage Security Compliance Auditing service, designed to assist storage professionals in preparing for an external audit or struggling with compliance obligations, will provide a framework for assessing data management and security practices against compliance obligations.

Kasten Chase further extended its sales force by signing a reseller agreement with Softchoice, one of North America's fastest growing technology resellers. Softchoice will now be an authorized reseller of both Assurency SecureData and Assurency CipherShare solutions. The agreement will increase our sales force through Softchoice's four call centres and 33 branches across North America.

We are pursuing all sales and marketing opportunities with our partners and resellers. We are actively following up with prospects in the financial services, healthcare and government markets.

We are carefully balancing cash management with the need to invest in market opportunities. We are continuing to pursue financing and other corporate alternatives. Successful execution is critical to Kasten Chase being able to continue operations in the normal course.

The increased awareness of the need for encryption and the demand for storage security solutions is motivating our team. As we continue to invest in developing our sales team and our award-winning and market-leading solutions, and work to generate new revenues in this market, we thank you for your support and patience.

Sincerely,

Michael J. Milligan

Chief Executive Officer

Management's Discussion and Analysis

The following comments and analysis are intended to provide an overview of the results of operations and financial position of Kasten Chase Applied Research Limited (Kasten Chase or the Company) for the quarters ended June 30, 2005 and 2004. The financial data has been prepared in accordance with Canadian generally accepted accounting principles. Except as otherwise stated, the information contained herein is given as of July 21, 2005. Unless otherwise indicated, all amounts are in millions of Canadian dollars.

Forward-Looking Information

This Management's Discussion and Analysis may include forward-looking statements with respect to business plans, activities, prospects, opportunities and events anticipated or being pursued by the Company and the Company's future results.

Although the Company believes the assumptions underlying such statements to be reasonable, any of the assumptions may prove to be incorrect. The anticipated results or events upon which current expectations are based may differ materially from actual results or events. Therefore, undue reliance should not be placed on such forward-looking information.

The realization of outcomes referred to in such statements is subject to a number of risks and uncertainties, including but not limited to:

- the timing and course of development of market demand for data storage security solutions like the ones offered by the Company;

- the level of interest of potential customers, partners and investors in the Company and its products, services and technology;

- the availability of financing for the Company;

- the availability of funding for customer and partner purchases;

- the process and timing of decisions affecting the Company to be made by third parties over which the Company has little or no control or influence;

- the introduction of new technology or the development of data storage security solutions by companies with more resources and established market presence;

- the timing, cost and commercial development of new products and services;

- the potential loss of existing customers, partners, contractors, suppliers and key employees;

- developments in the data storage industry, including mergers and acquisitions, affecting the relative importance of data storage security initiatives;

- changes in economic, market (information technology, storage and capital markets) and competitive conditions, industry standards, and government laws and regulations; and,

- other risk factors (see Risks and Uncertainties).

The forward-looking information contained in this Management's Discussion and Analysis is current as of July 21, 2005. There should not be an expectation such information will be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.

Overview

Kasten Chase develops and applies technology to provide information security.

Kasten Chase has developed and offers secure information management solutions for secure storage of data, secure workgroup collaboration, and secure remote access to enterprise networks.

The Company has two product portfolios:

1. Assurency® Secure Information Management Solutions

a. Assurency SecureData

b. Assurency Business Services

c. CipherShare™

2. RASP Data Security™

a. RASP Secure Access®

b. Enterprise RASP™

c. Workplace RASP™ and

d. RASP Secure Media™ and RASP Secure Media Plus™.

Assurency SecureData is a secure information management solution which provides true data protection throughout the information lifecycle. It is based on a secure, scalable architecture and uses strong, fast encryption and enhanced key management to enable the secure storage of data, optimization of the use of storage resources, compliance and risk management.

Assurency Business Services is a collaborative, standards based suite of 'best practices' services for compliance management, risk assessment and business case analysis for the enterprise storage security market.

Assurency SecureData and Business Services address the emerging market for storage security and recognize the implementation of such technology must be complemented by the development and on-going assessment of security policies and procedures. SecureData and Business Services are delivered to end users with and through storage vendors.

CipherShare addresses the need within organizations for secure communication and file sharing. CipherShare establishes a secure, self-managed and collaborative work environment which can span the enterprise network and beyond to secure information and enhance workgroup productivity. CipherShare is delivered to the market through resellers.

The markets for Assurency® SecureData and Business Services and CipherShare are in the early stages of development. The Company has not yet generated significant new revenues from these products and services.

The RASP Data Security products enable secure remote access to U.S. Government classified Secret information. The RASP products were developed under the National Security Agency's (NSA) Remote Access Security Program (RASP). RASP Secure Access® provides secure dial-up remote access using the public switch telephone network. Enterprise RASP provides secure remote local area network access for a larger number of users. Workplace RASP provides secure remote access for users from fixed locations. RASP Secure Media and RASP Secure Media Plus encrypt the operating system, system files, applications and data on a remote user's personal computer. RASP Data Security products are sold directly to end users, primarily U.S. Government departments and agencies.

The NSA's sunset date for RASP is December 31, 2005 which means after that date RASP Data Security products will not be authorized by the NSA for use in accessing classified information. In the past, the NSA has extended the RASP sunset date and provided waivers to authorize the use of RASP Data Security products. It is not known if the NSA will extend the sunset date. The proximity of the sunset date and uncertainty with respect to any extension have caused and continue to cause a significant and continuing decline in RASP Data Security revenues. The Company has been a sub-contractor to L-3 Communications Systems (L-3) on the PETRA Project which is part of the NSA's High Assurance Remote Access (HARA) Program. The HARA Program is intended to be a successor to RASP.

The Company has established its credentials as an information security company as a result of its work with the NSA. The Company has developed and sees value in continuing to develop its Assurency® Secure Information Management Solutions portfolio to address the need in the marketplace created by compliance requirements which set expectations for appropriate information security policies and procedures and the implementation of information assurance technologies to protect stored data from misappropriation, manipulations or misuse and enable the management of that data over longer retention periods while making efficient use of storage resources. The significant decline in RASP Data Security revenues as a result of the impact of the NSA's sunset date for RASP and the time it is taking for the data storage security market to emerge are causing the Company to generate significant losses and use cash in operations. To address this issue, the Company is exploring the full range of its strategic alternatives.

Recent Developments

The Company's recent experience suggests the market for storage security is beginning to emerge in the area of securing backup and archive data stored on tape or disk. Privacy, compliance, a secure architecture, scalability and cost efficiency appear to be key market drivers. Interest is being shown in the healthcare, financial services and government sectors. The recent announcement of the Ontario Government's Smart Systems for Health Agency selecting Kasten Chase through a competitive bid process to provide its Assurency SecureData solution to secure the backup of sensitive health information is an example of such interest.

Kasten Chase has been awarded the "Best Storage Security Solution" in the 2005 Well-Connected Awards competition by Network Computing magazine receiving top recognition for its Assurency SecureData solution. The competition included some of the direct competitors of Kasten Chase.

Interest is developing among professional services firms and government for Assurency CipherShare. During the quarter, the Canadian Government's Communication Security Establishment under the Information Technology Security Pre-Qualification Program has successfully evaluated CipherShare. The successful evaluation pre-qualifies Assurency CipherShare for procurement by the Government of Canada.

Also in Q2, Kasten Chase signed a reseller agreement with Softchoice whereby Softchoice will sell both Assurency SecureData and Assurency CipherShare through its four call centers and 33 branches across North America. The Company will continue to develop new channels for the distribution and sale of this product.

Overall Performance

Revenues for Q2 2005 were $ 0.5 million compared to revenues of $0.8 million in Q2 of 2004. This represents a decrease of 41%. Kasten Chase continues to experience decreasing revenues from its RASP Data Security products due to the impact of the NSA's sunset date for RASP of December 31, 2005.

The market for storage security is in the early stages of development and therefore revenues will continue to be difficult to predict. The Company believes this market will emerge through 2005 and 2006.

Operating expenses for Q2 were $2.7 million compared to $2.5 million last quarter. In the second quarter of 2004 operating expenses were $12.1 million however that included a goodwill impairment of $9.7 million.

At June 30 2005, the Company had cash and cash equivalents and short-term investments of $5.5 million. The Company used $1.7 million in operations compared to Q2 2004 when the Company used $1.4 million. The current ratio remains strong at 4.2 : 1.

RESULTS OF OPERATIONS

Revenues

Revenues continue to be derived primarily from RASP Data Security products. Revenues remain very difficult to predict and significant fluctuations can occur from quarter to quarter as a result of many factors. (See Risks and Uncertainties below).



Product Portfolio Q2 2005 Q2 2004
RASP Data Security $ 0.38 83 % $ 0.78 100 %
Assurency Secure Information Management
Systems 0.08 17 % - - %
-------------------------
Total $ 0.46 100 % $ 0.78 100 %


Revenues for Q2 2005 were $0.5 million compared to revenues of $0.8 million in Q2 of 2004. This represents a decrease of 41% largely related to a decrease in the number of RASP systems sold.

In Q2 2005, 29% of revenues were from products, 46% from development services, and 25% from maintenance and support services, including training. In Q2 2004, 33% of revenues were from products, 34% from development services, and 33% from maintenance and support services, including training.

Expenses

Cost of Sales

The manufacture of Kasten Chase's products and the fulfillment of orders are outsourced to third parties.

Cost of sales includes third party costs to produce and manufacture products and fulfill orders, the bought-in costs of hardware components and products, the costs of software products, manuals, packaging, shipping costs, and facilities, together with compensation costs for the Company's production and order fulfillment personnel who work with the manufacturers and other suppliers.

Gross margin for Q2 2005 and Q2 2004 was 61%. Gross margins for both quarters are in line with management's expectations. Gross margin for the six months ended June 30 2005 and 2004 were 62% and 61% respectively.

Sales, Marketing and Customer Support

Kasten Chase has sales offices in Mississauga, Ontario and Sterling, Virginia. Marketing and customer support is based from the Company's Mississauga office. Sales, marketing and customer support expenses include compensation for personnel, travel, marketing programs and materials, advertising, public relations, trade shows, sales and customer support facilities and related tools.

Sales, marketing and customer support expenses for Q2 were $0.9 million compared to $0.8 million in Q2 of 2004. Sales, marketing and customer support expenses for the six months ended June 30 2005 and 2004 respectively were $1.7 million and $1.5 million. As expected, 2005 sales, marketing and customer support expenses will increase over 2004 due to the development of the market of Assurency SecureData and Business Services.

Product Development

All of the Company's research and development is undertaken in Canada. These expenses include compensation for personnel, the costs of third party contractors, training, tools and travel.

Research and development expenses were $1.2 million in Q2 2005 compared to $0.9 million in the same quarter last year. On a year to date basis, research and development expenses were $2.3 million in 2005 and $1.9 million in 2004. This increase is the result of efforts to further develop the Assurency SecureData product and to obtain various security certifications, such as Common Criteria.

General and Administrative

General and administrative expenses include compensation for senior executives and staff, travel costs, the costs of personnel, facilities and training for the finance, human resources and management information systems groups, costs associated with the Board of Directors and administrative expenses including insurance, auditing, legal and regulatory compliance.

General and administrative expenses were $0.4 million in Q2 of 2005 compared to $0.3 million in Q2 of 2004. General and administrative expenses for the six months ending June 30 2005 were $0.8 million compared to $0.7 million for the same period last year. These expenses are expected to remain steady notwithstanding any large foreign exchange gains or losses. (See Foreign Exchange below).

Amortization

In Q2 2005, amortization was $0.2 million compared to $0.4 million in Q2 last year. The acquired technology related to the Palladium Secure Modem used in RASP Data Security products is now fully amortized and therefore amortization has decreased.

Interest Income

Interest income was $0.05 million in Q2 compared to $0.07 million in the same quarter last year. Interest income for the six months ending June 30, 2005 was $0.09 million compared to $0.13 million in the same period last year. This decrease represents the decrease in cash and cash equivalents and short-term investments.

Net Loss

Net loss for the current quarter was $2.4 million or $0.04 per share. In Q2 2004, Kasten Chase reported a net loss of $11.6 million or $0.20 per share, which included a goodwill impairment charge of $9.7 million. Without the goodwill impairment charge, net loss in Q2 of 2004 would have been only $1.9 million. Net loss increased over the same period last year due to the decrease in sales and slight increase in operating expenses.

Employees

At June 30, 2005, Kasten Chase had 49 employees with 47 in Canada and 2 in the United States. The number of employees has remained relatively stable over the last eight quarters.

Liquidity and Capital Resources

The working capital ratios at June 30, 2005 and December 31, 2004 were 4.2:1 and 7.9:1, respectively. Current assets decreased by $3.8 million from $10.1 million to $6.3 million. Current liabilities increased slightly to $1.5 million at June 30, 2005 from December 31, 2004.

Cash and cash equivalents and short-term investments at the end of June 2005 totaled $5.5 million compared to $9.1 million at the end of last year. The resulting decrease in cash of $3.6 million was used in operations.

Inventory decreased from $0.3 million at the end of 2004 to $0.2 million at the end of the current quarter. The balance of the inventory consists of a small portion relating to RASP Data Security products and the remaining relates to Assurency Secure Information Management Solutions.

The Company has no debt other than trade payables incurred in the ordinary course of business.

The Company's current estimate is that a financing will be required to provide sufficient cash and short-term investments to continue operations for the foreseeable future. In addition to managing operating expenses and the use of cash, the Company is pursuing specific opportunities to generate revenues from its SecureData, Business Services, and CipherShare offerings. The Company is also pursing alternatives ranging from raising additional financing and seeking strategic investments to merger and acquisition activity. Successful execution is critical to the Company being able to continue in the normal course.

The consolidated financial statements have been prepared using generally accepted accounting principles on the going concern assumption the Company will continue in operation for the foreseeable future and will be able to realize its assets and satisfy its liabilities in the normal course of business. The Company's financial position is such that if the market for its Assurency Secure Information Management solutions, including SecureData, Business Services and CipherShare, does not develop in a manner resulting in significant new revenues in 2005 or if the alternatives being pursued do not result in additional cash being provided or a sale of the Company, operations will not continue in the normal course.

Long-term Assets

Capital assets decreased by $0.1 million from the end of December of 2004 as capital assets additions of $0.06 million was offset by the depreciation for the first six months of the year. Acquired technology decreased solely from amortization.

Capital Stock

The authorized capital consists of an unlimited number of common shares. At June 30, 2005 and 2004, as well as December 31, 2004, the common shares issued and outstanding were 57,481,068.

Critical Accounting Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates are used in determining the allowance for doubtful accounts, inventory valuation, the useful lives of intangible assets, including acquired technology, and goodwill impairment. In making such estimates and assumptions, management: consults with employees knowledgeable in the area; gathers relevant information; where appropriate, seeks advice from qualified third parties; and, makes judgments, which in its opinion at that time, represent fair, balanced and appropriately conservative estimates and assumptions. Actual results could differ from these estimates.

Inventory Provision

The Company maintains an inventory provision to account for obsolescence or having to sell inventory at net realizable values less than cost. The Company makes estimates based on technological developments, revenue trends and forecasting.

Goodwill Impairment

The Company evaluates goodwill annually or whenever circumstances indicate that the carrying amount may not be recoverable. When the fair value of the Company is less than the fair value of the net assets, it becomes necessary to allocate the estimated fair value of the Company among the net assets including the recognized and unrecognized tangible and intangible net assets. The Company uses market capitalization and valuation models such as discounted cash flows to determine fair value and must exercise judgment and make assumptions. During 2004, the Company recorded a goodwill impairment of $9.7 million.

Amortization

The Company invests in capital equipment and acquired technology. These assets are amortized over their estimated useful lives. The Company does not capitalize development costs.

Quarterly Results of Operations

The following table sets forth certain unaudited consolidated statements of operation information for the eight most recent quarters of operations ending March 31, 2005. This unaudited information has been prepared on the same basis as our annual consolidated financial statements contained elsewhere in this annual report and includes all adjustments, consisting of only of normal recurring adjustments, necessary to present fairly the unaudited quarterly results. This information should be read in conjunction with our consolidated financial statements and related notes. The operating results for any quarter are not necessarily indicative of results for any future period.



2003 2004
Quarter
Ending Sept. 30 Dec. 31 March 31 June 30 Sept. 30 Dec. 31
(in thousands
of dollars,
except per
share amounts)
Revenues $ 1,805 $ 1,170 $ 1,331 $ 782 $ 1,128 $ 492
Cost of Sales 652 704 509 306 433 779
--- --- --- --- --- ---
Gross Margin 1,153 466 822 476 695 (287)

Operating Expenses:
Sales, marketing
and customer
support 849 606 756 754 842 582
Product
development 944 707 946 919 784 670
General and
administrative 372 1,271 373 322 494 466
Amortization 419 400 404 412 408 407
Loss on
disposal
of capital
assets (26) 6 - - - -
Goodwill
impairment - - - 9,715 - -
Restructuring
costs - - - - - (73)
Interest
income (80) (64) (64) (65) (54) (52)
---- ---- ---- ---- ---- ----
2,478 2,926 2,415 12,057 2,474 2,000

Net loss $(1,325) $(2,460) $(1,593)$(11,581) $(1,779) $(2,287)

Net loss
per share $ (0.02) $ (0.04) $ (0.03)$ (0.20) $ (0.03) $ (0.04)




2005
Quarter Ending March 31 June 30
(in thousands of dollars, except per share amounts)

Revenues $ 741 $ 461
Cost of Sales 269 182
--- ---
Gross Margin 472 279

Operating Expenses:
Sales, marketing and customer support 829 892
Product development 1,078 1,235
General and administrative 393 364
Amortization 248 242
Loss on disposal of capital assets - 2
Goodwill impairment - -
Restructuring costs - -
(48) (46)
---- ----
2,500 2,689
----- -----

Net loss $ (2,028)$ (2,410)

Net loss per share $ (0.04)$ (0.04)


Revenues have decreased quarter over quarter due to the NSA's sunset date for RASP products. Lower foreign exchange rates have also contributed to the decrease in revenues.

After removing the goodwill impairment of $9.7 million in Q2 of 2004 and removing the inventory write-off of $0.6 million from Cost of Sales in Q4, net loss per quarter for 2004 is consistent at $0.03 per share. Without the inventory write-off in Q4 of 2004, gross margin in that quarter would be 63%, which is in line with expectations.

Total operating expenses per quarter in line with the Company's cash management objectives.

Foreign Exchange

A significant portion of revenues continues to be billed in U.S. dollars. Expenses are incurred in local currencies of the countries in which Kasten Chase operates - Canada and the United States. The purchase of inventories is largely transacted in U.S. dollars. Foreign exchange gains or losses are included in General and Administrative expense. The Company does not engage in foreign currency speculation and does not use foreign exchange hedging.

Risks and Uncertainties

Kasten Chase has a dependency on the sale of RASP Data Security products to the U.S. Government. In Q2 2005, 80% of revenues were from sales to the U.S. Government. In Q2 2004, 99% of revenues were from sales to the U.S. Government.

The demand for RASP Data Security products has and continues to be uncertain and difficult to predict. The NSA's sunset date for RASP is December 31, 2005. This has adversely affect demand for RASP Data Security products sooner and more severely than anticipated. In the past, the NSA has extended the sunset date or provided waivers for RASP. There has been no indication the sunset date will be extended or waivers will be provided.

The Company has and continues to experience the risks and uncertainties typically experienced by a small information technology business developing new solutions for an emerging market. In particular, the Company's new commercial initiative, Assurency Secure Information Management Solutions, carries the risks generally associated with new technology ventures. These risks include:

- the nature, timing and extent of the development of the market for the Company's Solutions;

- the level of interest of potential end users, customers, partners and investors in the Company and its products, services and technology;

- the efforts to gain end user, customer, partner and market acceptance of the Company's Solutions may not be successful;

- the efforts to establish key partnerships and distribution channels, particularly with storage vendors, may not be successful;

- the availability of financing for the Company;

- the availability of funding for end user, customer and partner purchases;

- the process and timing of decisions affecting the Company to be made by third parties over which the Company has little or no control or influence such as delays in completing field trials, delays in processing proposals, bids, orders or contracts, delays in budget approvals and funding allocations, changes in planning, policy and priorities;

- the inability to attract and retain employees with key training, skills and experience;

- the potential loss of existing customers, partners, contractors and suppliers;

- the timing, cost and complexity of the commercial development of new products and services;

- Solutions development, validation, production and technology issues may cause delays in commercial releases, delays in certifications and/or cost overruns;

- the development of new and competitive technologies, products and services;

- the development and introduction of new technologies or storage security solutions by companies with more resources and established market presence;

- developments in the data storage industry, including mergers and acquisitions, affecting the relative importance of storage security initiatives; and,

- world events and changes in economic, market (information technology, storage and capital markets) and competitive conditions, industry standards, and government laws and regulations.

The development of the market for data storage security is occurring more slowly than expected. As a result, near term revenues are uncertain and difficult to predict.

There are at least three companies providing direct competition each private, focused only on secure networked storage, and well funded by venture capital. From a technical perspective, the Company is well positioned but may lack the financial resources to establish the market presence required for market leadership, especially in the U.S.

The Company may not, on a timely basis, be able to:

- generate revenues and/or reduce operating expenses to avoid depleting its cash;

- obtain additional cash financing to improve its financial position; or,

- complete strategic alliances to increase revenues, reduce operating losses, increase channels to market, add to core technology, or expand product and services offerings.

The Company must protect the proprietary technology underlying its products and services. There can be no assurance the steps historically taken by the Company in this regard will be adequate to deter misappropriation or independent third party development of its technology. Although the Company believes its products and services do not infringe proprietary rights of others, there can be no assurance third parties will not assert infringement claims or the Company will not be required to obtain licenses of third party technologies.

To the extent the Company makes sales denominated in currencies other than Canadian dollars, gains and losses on the conversion of such sales to Canadian dollars may, in the future, contribute to fluctuations in business and operating results. In addition, fluctuations in exchange rates could affect the demand for the Company's products.

Additional Information

Additional information about Kasten Chase, including the Annual Information Form and Information Circular, may be found on SEDAR at www.sedar.com.



KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Balance Sheets

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June 30 December 31,
2005 2004
(in thousands of dollars) (UNAUDITED) (AUDITED)
---------------------------------------------------------------------

Assets
Current assets:
Cash and cash equivalents $4,883 $3,597
Short-term investments 667 5,475
Accounts receivable, net 151 333
Unbilled work in progress 141 148
Inventory 181 298
Prepaid expenses 322 204
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6,345 10,055

Capital assets 658 794
Intangibles 665 961
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$7,668 $11,810
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Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable and accrued liabilities $1,151 $779
Deferred revenue 366 500
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1,517 1,279

Shareholders' equity
Capital stock 75,258 75,258
Contributed surplus 163 105
Deficit (69,270) (64,832)
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6,151 10,531

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$7,668 $11,810
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KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Operations and Deficit

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars,
except per share data) 2005 2004
For the six months ended June 30 (UNAUDITED) (UNAUDITED)
---------------------------------------------------------------------

Revenues $1,202 $2,113

Cost of sales 451 815
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Gross margin 751 1,298

Operating expenses:
Sales, marketing and customer support 1,721 1,510
Product development 2,313 1,865
General and administrative 757 695
Amortization 490 816
Loss on disposal of capital assets 2 -
Goodwill impairment - 9,715
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5,283 14,601

Loss before interest (4,532) (13,303)

Interest income 94 129
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Loss for the period (4,438) (13,174)

Deficit, beginning of period (64,832) (47,592)
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Deficit, end of period $(69,270) $(60,766)
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Loss per share:
Basic $(0.08) $(0.23)
Diluted $(0.08) $(0.23)

Weighted average number of shares (in thousands):
Basic 57,481 57,481
Diluted 57,481 57,481


KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Cash Flows

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars) 2005 2004
For the six months ended June 30 (UNAUDITED) (UNAUDITED)
---------------------------------------------------------------------

Cash provided by (used for):
Operations:
Loss for the period $(4,438) $(13,174)
Add (deduct) items not affecting cash:
Amortization 490 816
Goodwill Impairment - 9,715
Loss on disposal of capital assets 2 -
Foreign exchange gain (58) (96)
Stock-based compensation 59 22
Net changes in non-cash working capital items:
Accounts receivable 192 449
Unbilled work in progress 6 (29)
Inventory 118 71
Prepaid expenses (116) (112)
Accounts payable and accrued liabilities 360 (708)
Deferred revenue (144) (227)
---------------------------------------------------------------------
(3,529) (3,274)

Financing:
Issuance of common shares - -

Investing:
Redemption of short-term investments 4,808 4,963
Proceeds on sale of capital assets 1 -
Additions to capital assets (62) (260)
---------------------------------------------------------------------
4,747 4,703

Foreign exchange gain on cash held in
foreign currency 68 73

Increase in cash equivalents 1,286 1,502

Cash and cash equivalents, beginning of period 3,597 3,054
---------------------------------------------------------------------
Cash and cash equivalents, end of period $4,883 $4,556
---------------------------------------------------------------------
---------------------------------------------------------------------

Short-term investments, end of period $667 $6,918
---------------------------------------------------------------------

Cash and cash equivalents and short-term
investments, end of period $5,550 $11,474

---------------------------------------------------------------------
Supplemental disclosure:
Interest received in cash $174 $233
---------------------------------------------------------------------


KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Operations and Deficit

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars,
except per share data) 2005 2004
For the quarter ended June 30 (UNAUDITED) (UNAUDITED)
---------------------------------------------------------------------

Revenues $461 $782

Cost of sales 182 306
---------------------------------------------------------------------
Gross margin 279 476

Operating expenses:
Sales, marketing and customer support 892 754
Product development 1,235 919
General and administrative 364 322
Amortization 242 412
Loss on disposal of capital assets 2 -
Goodwill impairment - 9,715
---------------------------------------------------------------------
2,735 12,122

Loss before interest (2,456) (11,646)

Interest income 46 65
---------------------------------------------------------------------

Loss for the quarter (2,410) (11,581)

Deficit, beginning of quarter (66,860) (49,185)
---------------------------------------------------------------------
Deficit, end of quarter $(69,270) $(60,766)
---------------------------------------------------------------------
---------------------------------------------------------------------

Loss per share:
Basic $(0.04) $(0.20)
Diluted $(0.04) $(0.20)

Weighted average number of shares (in thousands):
Basic 57,481 57,481
Diluted 57,481 57,481


KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Cash Flows
---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars) 2005 2004
For the quarter ended June 30 (UNAUDITED) (UNAUDITED)
---------------------------------------------------------------------

Cash provided by (used for):
Operations:
Loss for the quarter $(2,410) $(11,581)
Add (deduct) items not affecting cash:
Amortization 242 412
Goodwill Impairment - 9,715
Loss on disposal of capital assets 2 -
Foreign exchange gain (18) (28)
Stock-based compensation 30 11
Net changes in non-cash working capital items:
Accounts receivable 362 439
Unbilled work in progress - 11
Inventory (23) (19)
Prepaid expenses (117) (85)
Accounts payable and accrued liabilities 401 (203)
Deferred revenue (182) (24)
---------------------------------------------------------------------
(1,711) (1,353)
Financing:
Issuance of common shares - -

Investing:
Redemption of short-term investments 1,392 (73)
Proceeds on sale of capital assets 1 -
Additions to capital assets - (97)
---------------------------------------------------------------------
1,393 170

Foreign exchange gain on cash held in
foreign currency 25 19

Increase in cash equivalents (295) (1,504)

Cash and cash equivalents, beginning of quarter 5,178 6,060
---------------------------------------------------------------------
Cash and cash equivalents, end of quarter $4,883 $4,556
---------------------------------------------------------------------
---------------------------------------------------------------------

Short-term investments, end of quarter $667 $6,918
---------------------------------------------------------------------

Cash and cash equivalents and short-term
investments, end of quarter $5,550 $11,474

---------------------------------------------------------------------
Supplemental disclosure:
Interest received in cash $69 $126
---------------------------------------------------------------------


KASTEN CHASE APPLIED RESEARCH LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the quarter ended June 30, 2005 and 2004 (amounts in thousands of dollars, except shares and per share data)

Kasten Chase Applied Research Limited (Kasten Chase or the Company) is a high-assurance data security company. The Company has developed products that enable customers to communicate securely, protect stored data and access data securely. Kasten Chase's data security solutions address the needs of customers in the government and financial services sectors in North America.

1. Significant accounting policies:

The disclosures contained in these unaudited interim financial statements do not include all requirements of generally accepted accounting principles (GAAP) for annual financial statements. The unaudited interim financial statements should be read in conjunction with the annual consolidated financial statements for the year ended December 31, 2004.

The unaudited interim financial statements reflect all adjustments, consisting of normal recurring accruals, which are, in the opinion of management, necessary to present fairly the financial position of the Company as of June 30, 2005 and the results of operations and cash flows for the three months and six months ended June 30, 2005 and 2004.

The unaudited interim financial statements are based upon accounting principles consistent with those used and described in the annual financial statements. The auditors did not perform a review (as defined by the CICA standards) on these unaudited interim financial statements.

(a) Future operations:

The Company's principal source of revenue from ongoing operations has been from the sale of RASP Data Security™ products which are sold pursuant to the U.S. National Security Agency's Remote Access Security Program (RASP). RASP has a sunset date of December 31, 2005. The sunset date has caused a significant decline in RASP Data Security product revenues.

The market for the Company's Assurency® SecureData and CipherShare products has taken longer to develop than anticipated. While the Company has taken steps to reduce operating expenses, it has continued to invest in the development of its Assurency Secure Information Management solutions in anticipation of the market for data storage security.

The Company used $1,713 in cash on operations during the second quarter of 2005. The Company's cash and short-term investments declined by $1,687 during the second quarter of 2005 from $7,237 at March 31, 2005 to $5,550 at June 30, 2005.

The Company's current estimate is that a financing will be required to provide sufficient cash and short-term investments to continue operations for the foreseeable future. In addition to managing operating expenses and the use of cash, the Company is pursuing specific opportunities to generate revenues from its SecureData, Business Services, and CipherShare offerings. The Company is also pursing alternatives ranging from raising additional financing and seeking strategic investments to merger and acquisition activity. Successful execution is critical to the Company being able to continue operations in the normal course.

The consolidated financial statements have been prepared using generally accepted accounting principles on the going concern assumption the Company will continue in operation for the foreseeable future and will be able to realize its assets and satisfy its liabilities in the normal course of business. The Company's financial position is such that if the market for its Assurency Secure Information Management solutions, including SecureData, Business Services and CipherShare, does not develop in a manner resulting in significant new revenues in 2005 or if the alternatives being pursued do not result in additional cash being provided or a sale of the Company, operations will not continue in the normal course.

If the Company's financial statements were prepared on the assumption the Company will not continue operations for the foreseeable future, adjustments might be made to the carrying value and classification of assets and liabilities, other liabilities could be recognized and as a result, expenses could be increased.

2. Segmented information:

The Company has reviewed its operations and determined that it operates in one business segment and only has one reporting unit. The Company designs, develops and manufactures data communications technology. The Company's products and services include secure communication software and devices, media encryptors, secure networked storage software and devices and secure workgroup software. Management reviews the Company's performance primarily by revenues.



a) Revenues from business sectors were as follows:

---------------------------------------------------------------------
---------------------------------------------------------------------
Three Months Six Months
ended ended
June 30 June 30
2005 2004 2005 2004
---------------------------------------------------------------------

RASP Data Security $376 $782 $1,085 $2,015
Assurency Secure Information
Management Systems 85 - 117 98
---------------------------------------------------------------------
Total $461 $782 $1,202 $2,113
---------------------------------------------------------------------
---------------------------------------------------------------------

b) Revenues by geographic location:

---------------------------------------------------------------------
---------------------------------------------------------------------
Three Months Six Months
ended ended
June 30 June 30
2005 2004 2005 2004
---------------------------------------------------------------------

Canada $297 $277 $744 $865
United States 164 505 458 1,248
---------------------------------------------------------------------
Total $461 $782 $1,202 $2,113
---------------------------------------------------------------------
---------------------------------------------------------------------

c) Capital assets by geographic location:

---------------------------------------------------------------------
---------------------------------------------------------------------
As at As at
June 30 December 31
2005 2004
---------------------------------------------------------------------

Canada $657 $780
United States 1 14

---------------------------------------------------------------------
Total $658 $794
---------------------------------------------------------------------
---------------------------------------------------------------------

All of the intangibles were located in Canada in 2005 and 2004.


(d) Revenues attributed to regions based on location of customer were as
follows:


---------------------------------------------------------------------
---------------------------------------------------------------------
Three Months Six Months
ended ended
June 30 June 30
2005 2004 2005 2004
---------------------------------------------------------------------

Canada $8 $7 $111 $282
United States 451 775 1,088 1,828
Europe 2 - 3 3
---------------------------------------------------------------------
Total $461 $3,209 $1,202 $2,113
---------------------------------------------------------------------
---------------------------------------------------------------------


The Company's largest customer, the U.S. Federal government, accounted for approximately 80% of revenues in the second quarter of 2005 (2004 - 99%) and approximately 97% of accounts receivable at June 30, 2005 (2004 - 97%).

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