Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Form 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO

Commission File Number 0-22689

SCM Microsystems, Inc.

Registrant’s telephone number, including area code: (510) 360-2300

Securities Registered Pursuant to Section 12(b) of the Act:

Securities Registered Pursuant to Section 12(g) of the Act:

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements or any amendment to this Form 10-K.    o

     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.

     The aggregate market value of voting stock held by non-affiliates of the registrant as of March 19, 2001 was approximately $168,235,000 based upon the last sales price reported for such date on the Nasdaq National Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 5% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant, have been excluded in that such persons may be deemed to be affiliates. This determination is not necessarily conclusive.

     At March 19, 2001, registrant had outstanding 15,543,040 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

     The Company’s Proxy Statement and Notice of Annual Meeting is incorporated herein by reference.

Table of Contents

SCM MICROSYSTEMS, INC.

TABLE OF CONTENTS

SCM, CIMax, SmartReady, SmartSecure, St@rKey, SwapBox and SwapSmart are registered trademarks and Dazzle, Dazzle Digital Video Creator, POD Tool, SmartOS and SwapFTL are trademarks of SCM Microsystems. Other product and brand names may be trademarks or registered trademarks of their respective owners.

1

Table of Contents

PART I

      This Annual Report on Form 10-K contains forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control. All statements, other than statements of historical facts included in this Annual Report on Form 10-K regarding our strategy, future operations, financial position, estimated revenues or losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this Annual Report on Form 10-K, the words “will”, “believe”, “anticipate”, “intend”, “estimate”, “expect”, “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Annual Report on Form 10-K. You should not place undue reliance on these forward-looking statements. Although we believe that our plans, intentions and expectations reflected in or suggested by the forward-looking statements that we make in this Annual Report on Form 10-K are reasonable, we can give no assurance these plans, intentions or expectations will be achieved. We disclose important factors that could cause our actual results to differ materially from our expectations under “Risk Factors” and elsewhere in this Annual Report on Form 10-K. These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.

Item 1.     Business

      SCM Microsystems designs, develops and sells hardware, software and silicon that enables people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We sell our products primarily into two broad markets: Security and Digital Media.

      In the Security market, we provide reader technology for access control systems deployed on the digital television and PC platforms:

	•	our conditional access modules and interface technology are used by digital television broadcasters to restrict access to encrypted digital television broadcasts to paying subscribers; and
	•	our smart card readers and interface technology are used to control access to PCs, computer networks and the Internet to facilitate computer and network security and secure online transactions.

      In the Digital Media market, we provide hardware and software products that help consumers capture, edit and share digital media content. Our Digital Media and Video products:

	•	allow users to easily capture on a personal computer media content such as analog or digital video, digital photos or digital music from multiple sources, such as VCRs, digital camcorders, digital cameras and MP3 music players;
	•	help users to edit and personalize their digital media content on a PC; and
	•	help users to convert their digital media content to a format where the content can be shared with family and friends, such as an electronic file for email or web posting, a compact disk, or CD, or digital versatile disk, or DVD.

      Our target customers vary by market. For the Security market, our target customers are primarily manufacturers in the consumer electronics, computer and conditional access system industries. For the Digital Media market, our target customers are end user consumers as well as manufacturers in the computer and consumer electronics industries. We sell and license our products through a direct sales and marketing organization, both to the retail channel and to original equipment manufacturers, or OEMs. We also sell through distributors, value added resellers and systems integrators worldwide.

      Operationally, we have organized our business around three divisions:

	•	Digital Television and Video, which focuses on products, development, customers and relationships in the global markets for digital TV and digital video solutions;

2

Table of Contents

	•	PC Security, which focuses on products, development, customers and relationships in the global markets for solutions that enable smart card-based enterprise, financial and government PC Security applications; and
	•	Digital Media, which focuses on products, development, customers and relationships in the global market for solutions that enable data transfer between various digital devices and platforms.

      While throughout 2001, we organized our business around these three divisions, beginning in fiscal 2002 we will structure our operations around two businesses:

	•	Security, which comprises our digital TV and PC security products, markets and activities and focuses on the global market for securing encrypted digital TV broadcasts and for enabling smart card based security solutions for the PC platform; and
	•	Digital Media and Video, which comprises our digital media and digital video products, markets and activities and focuses on the global market for capturing, editing and sharing digital media content, including digital video.

      In addition, on February 28, 2002, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. We expect that the various activities relating to the separation of the Digital Media and Video business will not be completed for several months from the date hereof. We are evaluating various strategies to separate the Digital Media and Video business, including a spin-off or sale.

      See Note 13 to the consolidated financial statements for financial information regarding revenue and gross margin for our reported business segments through 2001. See Management’s Discussion and Analysis for historical financial information, including revenue and gross margin, for our Security and Digital Media and Video businesses as they are defined under our new business structure.

Market Overview — Security

      Individuals, businesses, governments and educational institutions increasingly rely upon computer networks, the Internet, intranets and direct broadcast systems for information, entertainment and services. The proliferation of and reliance upon digital data and digital transactions has created an increasing need to protect and control access to these networks and the devices that connect to them. For the enterprise, there is a need to control access to corporate networks and intranets to prevent loss of proprietary data. For consumers and for online merchants or banks, there is a need to authenticate credit cardholders or bank clients for Internet transactions without jeopardizing sensitive personal account information. For digital television broadcasters and Internet service providers, there is a need to limit access to broadcast content to paying subscribers. In all of these areas, standards-based connectivity devices that provide secure, controlled access are an easily deployed and effective solution.

      The research firm Datamonitor estimates that by 2003, 85 million households will subscribe to digital television in North America, Europe and the Asia-Pacific region, compared with 15 million households in 1999. This rapid transition from analog to digital television is being driven by consumer demand for the very high resolution, high quality video images that digital broadcasting affords, as well as by the medium’s ability to enable delivery of a broad range of customized, private content and interactive services. Digital TV may take the form of direct satellite broadcast services, digital cable services or direct terrestrial broadcasts.

      A primary challenge for broadcasters is to limit access to their content to the intended users such as those who have purchased appropriate subscriptions or event specific pay-per-view privileges. Traditionally, security software that restricts access to encrypted content has been embedded in set-top boxes that are connected to a viewer’s television set. To take advantage of the digital broadcasting environment

3

Table of Contents

      To address the need for greater competition in the market for advanced set-top receivers, many industry leaders have endorsed the use of removable security modules that enable the same set-top box to be used with multiple security systems. Various standards for removable security have been developed and adopted around the world. In Europe, the Digital Video Broadcasting-Common Interface, or DVB-CI standard was developed by the DVB Project, an international consortium of over 200 enterprises involved in varying aspects of digital television including France Telecom, Deutsche Telekom, Nokia, Sony and Philips. Legislation has been enacted in Spain, Switzerland and the United Kingdom mandating that set-top boxes comply with the DVB-CI standard in order to assure broad access to digital content without requiring consumers to purchase multiple set-top boxes. In addition, in the United Kingdom, the British Digital Broadcasting Consortium has defined a reference design for set-top boxes for the British digital television market that is compliant with the DVB-CI standard. In the United States, the Federal Communications Commission has mandated the conversion of the proprietary cable infrastructure to an open environment that supports greater competition by 2005. To support this move, CableLabs, a research and development consortium of U.S. cable television multi-system operators, or MSOs, has developed specifications for removable security as part of its OpenCable initiative. We believe that similar standards may be adopted in certain Asian countries in the future.

      The proliferation of personal computers in both the home and office combined with widespread access to computer networks and the Internet have created significant opportunities for electronic transactions of all sorts: business-to-business, e-commerce, home banking, etc. For example, Forrester Research is predicting business-to-consumer transactions to generate $108 billion by 2003, with business-to-business transactions reaching $1.3 trillion. In the area of e-commerce, International Data Corporation, or IDC, reports that the total value of goods and services purchased over the Web will grow from $350 billion in 2000 to $3 trillion in 2004. However, network and Internet-based transactions pose a significant threat of fraud, eavesdropping and data theft for both companies and individuals. As a result of the anonymity of the Internet, merchants and consumers need assurances that customers are correctly identified and that the authenticity and confidentiality of information such as credit card numbers is established and maintained. We believe that successful expansion of electronic transactions, particularly outside the U.S., will require the implementation of improved security measures that accurately identify and authenticate users and reliably encrypt data transmissions over networks and the Internet.

      Authentication of a user’s identification is generally accomplished by one of two approaches: passwords, which are codes known only by specific users; and tokens, which are user-specific physical devices that only authorized users possess. Passwords, while easier to use, are also the least secure because they tend to be short and static, and are often transmitted without encryption. As a result, passwords are vulnerable to decoding or observation and subsequent use by unauthorized persons. Tokens range from simple credit card-size objects to more complex devices capable of generating time-synchronized or challenge-response access codes. Certain token-based systems require both possession of the token itself and a personal identification number, or PIN, to indicate that the token is being used by an authorized user. Such an approach, referred to as two-factor authentication, provides much greater security than single factor systems such as passwords or the simple possession of a token.

      One example of a token used in two-factor authentication is the smart card, a credit card-sized plastic card that contains an embedded microprocessor, memory and a secure operating system. In addition to their security capabilities, smart cards are able to store data such as account information,

4

Table of Contents

      The benefits of smart cards are beginning to influence industry leaders to incorporate smart card technology into their product development. Microsoft Corporation, Hewlett-Packard and Sun Microsystems have endorsed smart cards as key components of their respective data security architectures. Computer industry leaders such as Microsoft and Apple Computer have incorporated support for smart cards into their latest operating systems, including Windows^TM 2000, Windows XP and Mac OS X, and the Linux operating system also includes support for smart cards. In addition, Sun Microsystems has released a popular Java application program interface for smart cards. Beginning in 2001, Visa and Mastercard have distributed smart cards to their subscribers, following American Express’s lead in the first wide scale commercial deployment of smart cards in the U.S. during 2000. Also in 2001, the U.S. Department of Defense began initial deployments of smart cards and readers to the first of 4 million armed force personnel under the government’s Common Access Card personal identity program. However, consumer demand for smart cards still lags industry support for these tokens, as applications such as discount and reward programs designed to create customer loyalty are not widely in place despite broad smart card deployment. We believe that new applications that appeal to consumers will drive the adoption of smart card technology for e-commerce and electronic business transactions, particularly in the United States.

Our Security Products

      Our Security products allow people to conveniently access secure digital content and services, enabling a wide range of consumer, business and government applications. Our Security products include a range of solutions from silicon and software components to fully integrated hardware solutions that enable secure exchange of electronic information for applications such as e-commerce, broadband content delivery and secure content transfer by providing controlled access points to PCs and to digital television set-top boxes. We believe that our Security solutions provide a necessary component to the market for these applications and others to enable their continued market acceptance and growth.

      We have developed our Security products using our core competencies in smart card and PC interoperability, digital television conditional access and PC Card expertise. We provide high quality, standards compliant solutions in the following product categories:

      Conditional Access Modules. Our conditional access modules combine our smart card interface technology with the proprietary descrambling code of a digital television content provider, providing a cost-effective and highly secure means of controlling access to digital broadcasts. Our conditional access modules utilize a smart card to determine if a viewer has access to a given content provider’s service. If the viewer is authorized, the conditional access module descrambles the signal for viewing.

      Our conditional access modules comply with the European DVB-CI standard for removable security for digital television systems. This allows them to be used with any open standards television receiver, and enable the receiver to accept content from multiple service providers. Subscribers wishing to change service providers can do so just by removing one conditional access module and inserting another. Service providers also benefit from seamless security upgrades and reductions in fraud. Our conditional access modules enable content providers to deliver a variety of services including video-on-demand, pay-per-view, interactive video, home shopping, home banking and interactive games.

5

Table of Contents

      We sell our conditional access module platforms to security encryption system providers in Europe including Mindport, Nagra-Kudelski, Philips, NDS, France Telecom and Telenor (Norway Telecom). These encryption companies in turn provide their security systems, including our conditional access modules, to major European content providers such as France Telecom and Telenor; consumer electronics companies such as Nokia, Panasonic, Philips and Toshiba; and broadcasters such as BBC, ITV (UK), Channel 4 (UK), Telefonica (Spain) and SVT (Sweden).

      We are actively involved in the development and adoption of removable conditional access modules to support open digital receivers worldwide. We are currently key contributors to the European DVB and U.S. OpenCable standards-setting organizations for removable conditional access. By our own estimation, we have supplied more than 90% of the open standards-based security modules for European digital TV, and based on that experience, co-authored the specifications for the U.S. Point of Deployment (POD) modules, which are scheduled to be deployed throughout the U.S. cable system by 2005. We continue to support the development of the worldwide digital TV market by working with industry standards organizations such as CableLabs, DVB and Free Universe Network, or FUN, a consortium of companies supporting open digital television platforms in Germany; leading consumer electronics companies; and security system providers to achieve interoperability between multiple conditional access systems, head end transmitters and set tops, all of which depend on our conditional access modules for encryption and de-encryption.

      CIMaX®. Our CIMaX is a controller chip that enables digital TV receiver manufacturers to quickly create equipment that can accept common interface modules, including DVB-CI compliant conditional access modules. The CIMaX controller interfaces with major digital TV receiver microprocessors and includes support for other systems critical to implementing removable conditional access.

      Smart Card Readers. We develop and sell smart card readers, software and application specific integrated circuits, or ASICs, used to control access to computers or networks. These smart cards readers act as a “lock” on the computer or network that can only be opened by a user with a legitimate smart card “key,” supporting security in enterprise or government networks and enabling rapidly emerging Internet applications such as electronic loyalty programs, online cash downloading, home banking and on-line credit card transactions.

      Our products employ an open-systems architecture that provides compatibility across a range of hardware platforms and software environments and accommodates remote upgrades so that compatibility can be maintained as the security infrastructure evolves. We have made significant investments in software that enable our smart card readers and components to read any of the billions of smart cards in the world, regardless of manufacturer or application. Our smart card readers are also available with a variety of interfaces, including USB, PCMCIA or serial port.

      To ensure compatibility with multiple platforms and applications, we offer a range of smart card readers for use with both desktop and notebook computers, from simple PC Card reader devices to more complex PIN entry systems. Our readers include the SmartReady®, SmartSecure®, SmartTrust and SmartRetail lines. Our readers are compatible with digital identification means, such as a password typed on a keyboard, as well as biometric identification means, such as a thumbprint placed on the reader. Our newest family of SCRx31 readers, which are part of the SmartReady line, address both Europay, MasterCard and Visa (EMV) standards for financial transactions and PC/ SC specifications for network security applications based on PKI through the use of flexible software drivers. We sell our readers to end user organizations, such as large enterprises and the U.S. government, and also to original equipment manufacturers who incorporate our readers into their devices, such as PCs or set top boxes. We typically customize our smart card readers with unique customer casing designs and configurations.

      SmartOS Smart Card Interface Architecture. SmartOS is SCM’s own standards-based operating system for smart card readers that utilizes our various ASICs along with a unique firmware technology

6

Table of Contents

      STC II Controller Chip; STC and STC+. SCM’s STC II controller chip an embedded, single chip solution for smart card and biometric readers that supports multiple interfaces, multiple reader devices and all relevant security standards. In addition, the STC II chip is the industry’s first to offer on-board flash upgrades, allowing future firmware and application enhancements. With the STC II, all connectivity and security platforms are based on the same controller, offering high performance as well as cost-efficient economies of scale to OEMs and customers. The STC II chip forms the basis of SCM’s newest line of SCRx31 smart card readers and joins SCM’s portfolio of ASICs for smart card readers including the Smart Transporter, or STC, and STC+ chip.

      We distribute our industry standards-compliant hardware, software and silicon Security solutions to original equipment manufacturer, or OEM, customers in the consumer electronics, computer and conditional access system industries.

Market Overview — Digital Media

      Devices that create, play and store digital media, such as digital still and video cameras and CD and DVD players and recorders, are among the fastest growing consumer electronics devices in history. The proliferation of these devices is resulting in the creation of new digital media content that people typically want to share with their friends, family and colleagues. In order to view, edit or electronically distribute this digital content, it must be transferred to, or captured on, a PC.

      At the same time, analog technology is still very important for consumers who are reluctant to invest in or learn new technologies or who have a significant amount of existing media content in an analog format, such as VHS video. We believe that many consumers would like to use both analog and digital technologies. For example, consumers may wish to:

	•	convert analog video, such as a VHS tape, to a digital format so it can be transferred to a PC for editing, emailing, webcasting or recording to a CD or DVD; or
	•	convert digital video, such as a DVD, into an analog format so it can be played on a VCR and viewed on a television set.

      We believe that our market opportunity lies in the increasing demand for products that allow users to capture their analog and digital media content on a PC and then use the PC to edit and share this content.

      There are two categories of media content that can be captured on the PC. The first category consists of analog and digital video and the second category consists of digital still images, music and other data.

7

Table of Contents

      Capturing analog or digital video content on a PC requires compatibility between the video format, the PC platform and interface connection of the camcorder or video cassette player. Due to the wide range of video recording and playback devices in the market, a variety of video formats and interface connections are in use. Different PC platforms support various interface connections, which may not be compatible with every video device. For example, the newer Apple computers use a device interface connection known as 1394, which is ideal for connecting to state-of-the-art digital video camcorders, but not compatible with most of the analog camcorders and VCRs on the market. We believe that consumers need solutions that allow them to easily transfer analog or digital video to both Windows and Apple-based PCs using various types of interfaces.

      We believe that capturing digital still images, music or data on the PC is, in many cases, either more complex or less convenient than many consumers would like. First, while many digital appliances use removable media cards with quick loading flash memory to store content such as photographs, music and data, there are multiple, competing standards of media in use. These include CompactFlash^TM, IBM MicroDrive, MultiMediaCard^TM, Secure Digital^TM, SmartMedia^TM and Sony Memory Stick flash media cards. Because there are multiple types of flash media, there are no standard reader ports on most PCs for these media. Second, consumers who choose to directly connect their digital cameras or MP3 players to their PCs must use cables to transfer content. Often this involves plugging the cable into the back of the PC, which is inconvenient. Third, the speed of transfer of data using a cable connection is often very slow when large amounts of data, such as digital photographs, are being transferred. Higher image resolution of digital cameras and increases in flash media capacity, such as the rise from 16 MgB to 128 MgB, further extend the time required to transfer content. In addition to being inconvenient for the user, who must wait several minutes for the transfer of content such as photographs or music, the long transfer time also depletes the batteries of the digital appliance, which already have a limited period of effective operation. We believe that consumers need a fast and convenient way to transfer digital content from all types of flash media onto the PC.

      Historically, professional video producers such as entertainment and news organizations have used video editing products to enhance the overall quality and impact of their video programs. These products allow professional video producers to add elements such as titles, narration, music, special effects and transitions between video segments. These products are typically priced at $1,000 or more and are complex to use.

      The popularity of video recording devices, PCs and video playback devices such as VCRs and DVD players has fueled the growth of an emerging consumer market for low cost video editing solutions that enable consumers to create and edit home videos with the same elements as professional videos. Consumers who create video footage of family, community or business events want to be able to edit their videos using the same techniques as professional videographers. They may want to remove sections of video to capture only the highlights of the footage and reduce the amount of memory and processing power needed to store and play the video. Or, they may want to include music or voice narration, insert transitions between segments or add titles to their videos. To be successful in the consumer market, we believe that video editing products must include features that can produce professional looking results, must be easy to use and must be priced affordably.

      For many consumers, a significant reason for using a digital camera or camcorder, instead of an analog version, is that these devices allow consumers to record images that can be shared with others in a

8

Table of Contents

      E-mail and web posting have been used to distribute digital media content since consumers first began to create digital photographs and video. However, we believe that consumers increasingly want to share their digital media content by recording it to CDs or DVDs. CDs offer significant benefits for the sharing of digital music, photographs and short videos because they are durable, inexpensive, provide a high quality resolution and can be played on millions of CD players. DVDs offer significant benefits for the sharing of digital video content because they are high capacity, durable for video archiving, able to store video in very high resolution and, most importantly, can be played on a DVD player connected to a television, allowing the digital video to be viewed by a number of people at one time in a setting that is comfortable and familiar.

      We believe that the growing prevalence of CD and DVD players will increase demand for products that allow people to share digital and analog content by capturing that content to a CD or a DVD. CD recordable drives, which now come as standard accessories on most new PCs, enable people to record their own CDs in a format that is compatible with the majority of existing CD players. Industry research firm Santa Clara Consulting Group estimates that the installed base of CD recorders will grow to over 90 million by the end of 2001. Although introduced after CDs, DVDs have quickly become popular due to their high capacity and very high quality playback capabilities for video. At 4.7 GB per disk, DVDs have storage capacity equivalent to 7 CDs. DVD players have become one of the fastest growing consumer appliances ever. According to DVD Entertainment Group, DVD sales in the United States rose to $4.6 billion in 2001, more than 2.4 times 2000 sales; and sales of DVD units rose from 708,000 units in 1998 to 16.7 million units in 2001; and are expected to increase to 20 million units in 2002.

      As the number of DVD players grows, we expect a strong market opportunity for DVD recordable drives, or DVD writers, to emerge. Although introduced in 2001, market research firm Dataquest estimates that 2.1 million DVD rewritable drives will ship by the end of 2002 and 14.3 million drives by 2005. Many high-end PCs are beginning to include an integrated DVD recordable drive, and several standalone DVD writers were introduced to the market in 2001. Recording videos to DVDs allows high resolution, movie-length videos to be stored on one disk and for these disks to be viewed on the family television via playback on a DVD player. We believe that consumer demand for these features will increase demand for DVD recorders. As demand for DVD recorders increases, we believe that demand will also increase for software that allows consumers to edit and format their videos for DVD playback.

      As with digital video, digital photographs have typically been shared with family and friends via email and web posting. While this is convenient for long distance distribution of photographs, it does not provide an ideal environment for viewing the snapshots, as it involves viewing them on a computer screen that typically accommodates only one viewer at a time. This is very different from the way that people usually look at pictures in a hard cover photo album. When pictures are emailed, the experience is even more different from looking at a photo album, as the photos are stored in individual computer files that must be opened one by one. This is inconvenient and can detract from the viewer’s enjoyment of the photographs.

      Consumers can address these concerns by using a CD recorder to capture digital photographs on a CD. CDs provide an ideal media for storing digital photographs for playback on a DVD player or for simply archiving them. DVD players that can play CDs offer an opportunity for family and friends to view digital photographs in a shared environment as they are projected onto a television screen. To provide a viewing experience that is even more like the traditional photo album, photographs can be arranged in a digital slide show or photo album. Because of the value consumers associate with viewing

9

Table of Contents

Our Digital Media Products

      Our Digital Media and Video products offer a wide range of features to address a broad spectrum of consumer needs relating to the creation, editing and sharing of digital media.

      Our digital media readers allow consumers to read or write digital content directly from and to the flash memory card included in various digital devices such as digital cameras, camcorders, MP3 music players and PDAs. This feature provides a fast and convenient way for consumers to transfer their digital still images, music and data between the computer and various digital appliances.

      We offer a range of digital media readers, which are sold primarily under the Dazzle^TM brand in the retail channel and as non-branded solutions to our digital appliance, consumer electronics and computer OEM customers. Some of our products are designed and marketed to complement specific digital appliances, such as digital still cameras and Internet music players. Also, we offer digital media combo readers that read and write digital content from multiple storage media, including PC Cards and all six major flash media formats. This versatility alleviates consumer need for a special reader for each digital appliance that uses a different flash memory card or other storage media. Our digital media readers include various commonly used platform interfaces such as USB and SCSI, which allows consumers to use our digital media readers with most of the digital flash media on the market, including CompactFlash^TM, IBM MicroDrive, MultiMediaCard^TM, Secure Digital^TM, SmartMedia^TM and Sony Memory Stick.

      Under our Dazzle^TM brand, we offer a number of digital video products that help consumers capture, edit and share their analog or digital videos. Dazzle products are designed to be easy to install and use while offering a rich feature set for novice to advanced users. These products help consumers create personalized, TV-quality digital video from analog or digital sources and then share their finished product with colleagues, family and friends via email, websites, VHS tape, CD or DVD.

      Our digital video hardware products capture video on the PC by providing interface ports for external devices such as video cameras or VCRs, converting the video if necessary to a digital format and then inputting it to the PC via an interface connection such as serial, USB or 1394 port. Our digital video software products allow consumers to edit video on the PC by trimming, adding or moving sections, adding titles, transitions and audio, and, in the case of DVD authoring software, adding chapters, menus and themes. When the video is complete, our software and hardware products perform the necessary conversion of the video into the appropriate analog or digital format for output to tape, CD or DVD or posting to email or a website so consumers can share their video with others.

      Recognizing that consumers in the market today may need solutions for both analog and digital video, we offer a range of products to accommodate various combinations of video source and desired playback technology. Our hardware product range includes the following:

      Analog Input — Digital Output. Our Digital Video Creator series of capture and editing devices allows consumers to capture video from analog inputs, such as an analog camcorder, a TV or a VCR, transfer that content to a digital format, and edit and share that content in a digital format suitable for emailing, web posting or recording to a CD or, in some cases a DVD. This class of products includes our Digital Video Creator, DVC 50, DVC 80, DVC II and Mohave devices.

      Analog or Digital Input — Analog or Digital Output. Our Hollywood DV-Bridge product allows consumers to capture video from digital devices, such as a digital DV/ D8 camcorder, as well as analog devices, such as an analog camcorder, a TV or a VCR. The product converts that content to DV video,

10

Table of Contents

      Digital Input — Digital Output. Our DV-Editor series of products provide tailored solutions for users of DV camcorders who want to use their PCs to edit video content before recording that content to a CD or DV tape, emailing the content or posting it to a website. This series includes the DV-Editor, DV Editor SE and DV-Editor for Notebooks products.

      Almost all of our Dazzle hardware devices include software for editing video, and in some cases, also include software for creating photo slides shows and/or for creating videos in the DVD format. Our software products are discussed below.

      Our OnDVD software allows users to select digital photographs and organize them into digital photo albums, which can then be recorded to a CD, played on a DVD player and viewed by family and friends on a television set.

      Our MovieStar software is a complete digital video editing package for consumers that can be used to produce professional looking results. The software allows users to easily trim, add or move video footage, add titles, transitions and special effects and convert video to publishable formats.

      Our DVD Complete Deluxe software allows consumers to transform already edited video into the DVD format by adding themes, chapters, menus and special features such as director’s cuts and outtakes. DVD Complete Deluxe also converts video into a digital format that can be readily recorded to a DVD disk.

Distribution of Our Digital Media Products

      We sell our digital media readers and digital video capture and editing products via the retail channel and to original equipment manufacturers who either bundle our readers with their own products, such as digital cameras or computers, or offer the readers in the aftermarket for their products under their own brands.

      We sell our digital media readers in the U.S., Japan and U.K., primarily to digital camera and MP3 player OEMs. Sales through the retail channel are an increasing area of focus for us. Historically, we have sold our CameraMate and ZiO! readers under the Microtech^TM brand into the specialty retail channel for photographic equipment. Distribution partners here include various electronic and photography stores such as B&H Photo, CompUSA, The Good Guys, MicroCenter, CameraWorld.com and Sams. Increasingly, we are directing retail sales efforts of our digital media readers through the mass merchant retail market, where the products are sold under the Dazzle brand.

      We sell our digital video products in the U.S., Germany, Japan and U.K. primarily to the retail channel under the Dazzle brand. We distribute our Dazzle branded products through large specialized distributors such as Ingram Micro and Tech Data and various retail outlets such as Best Buy, Circuit City, CompUSA, Dixons/ PC World, Fry’s Electronics, Office Depot, Staples and Sears. We also sell select products through PC OEMs such as Dell.

Technology

      Most of the markets in which we participate are new, and their needs will evolve as they mature. For example, early markets such as ours typically require complete hardware solutions, but over time requirements shift to critical components such as silicon or software as OEM customers increase their

11

Table of Contents

      Chip-Level Integration. We have implemented a number of our core technologies into silicon chips. For our Security products, these include the STC, STC+ and STC II chips, the CIMaX DVB-CI chip and a custom PCMCIA controller based on technology licensed from Intel and optimized by us. For our Digital Media products, these include the EUSB-DM, DM Flux, PCDM and EUSB02 chips for digital media reader/writer applications. Additionally, our silicon designs for parallel port and USB connectivity are implemented within our digital media transfer products, as well as licensed to other peripheral manufacturers.

      Silicon and Firmware. For our Security products, we have developed physical interface technology that provides interoperability between PCs and smart cards from many different smart card manufacturers. Our interoperable architecture includes an International Standards Organization, or ISO, compliant layer as well as an additional layer for supporting non-ISO compliant smart cards. Through our proprietary integrated circuits and firmware, our smart card readers can be updated electronically to accommodate new types of smart cards without the need to change the reader’s hardware. For our Digital Media products, we have developed physical interface technology that provides interoperability and compatibility between various digital appliances, computer platforms and flash media storage cards.

      Proprietary Software. For our Security products, we have developed a flexible proprietary software architecture for real-time downloading of firmware for new smart card protocol handling requirements into a flash memory chip that resides on the smart card reader. This software, combined with our proprietary integrated circuits and firmware described above, allows the reader to accommodate new types of smart cards without the need to change the reader’s hardware. We have filed patent applications for this software application. For our Digital Media products, we have a range of value added software applications, which allow our customers to perform specialized functions such as create digital photo slide shows that can be burned to CD for viewing via a DVD player, edit digital videos and create videos in a DVD format that can be recorded to DVD disk.

      Complete Hardware Solutions. We provide complete hardware solutions for both our Security and Digital Media markets, and we can customize these solutions in terms of physical design and product feature set to accommodate the specific requirements of each customer. For example, we have designed and manufactured smart card readers that incorporate specific features, such as a transparent case and removable USB cable, to address the needs of specific OEM customers. We also have designed and manufactured digital media reader cases in multiple sizes, colors and shapes to meet customer specifications. Our digital media readers also address the wider needs of the market for differentiation between various digital media.

Customers and Applications

      Our Security products are targeted at original equipment manufacturers of computer, telecommunication and digital TV component and systems, and our Digital Media products are targeted primarily at the retail channel, as well as OEM computer and consumer electronics companies. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. Sales to our top 10 customers accounted for approximately 42% of our total net revenues in 2001. In 2001, Aston, a user of our digital television conditional access modules, accounted for 11% of net revenues. In 2000 and 1999, no customer exceeded 10% of our net revenues. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business, could harm our business and operating results.

12

Table of Contents

Sales and Marketing

      We market, sell and license our products worldwide to original equipment manufacturers and to the retail channel. We utilize a direct sales and marketing organization, supplemented by distributors, value added resellers, system integrators and resellers. As of December 31, 2001, we had 138 full-time employees and consultants engaged in sales and marketing activities. Our direct sales staff solicits prospective customers, provides technical advice and support with respect to our products and works closely with customers, distributors and OEMs. In support of our sales efforts, we conduct sales training courses, comprehensive targeted marketing programs, advertising, seminars, trade shows and ongoing customer and third-party communications programs.

      At December 31, 2001, our backlog was approximately $26 million, as compared to approximately $30 million at December 31, 2000. Our backlog consists of all written purchase orders for products that have a scheduled shipment date within the next six months. Orders for our products are usually placed by customers on an as-needed basis and we have typically been able to ship products within 30 days after the customer submits a firm purchase order. Our customer contracts generally do not require fixed long-term purchase commitments. In view of our order and shipment patterns and because of the possibility of customer changes in delivery schedules or cancellation of orders, our backlog as of any particular date may not be indicative of sales in any future period.

Collaborative Industry Relationships

      We are party to collaborative arrangements with a number of corporations and are a member of key industry consortia. We evaluate, on an ongoing basis, potential strategic alliances and intend to continue to pursue such relationships. Our future success will depend significantly on the success of our current arrangements and our ability to establish additional arrangements. These arrangements may not result in commercially successful products.

      Digital Video Broadcasting (DVB). We are members of the DVB Project, an industry-led consortium of over 300 broadcasters, manufacturers, network operators, software developers, regulatory bodies and others in over 35 countries committed to designing global standards for the delivery of digital television and data services.

      OpenCable. We are a founding member of the OpenCable project, an initiative of the cable television industry with a goal of attaining interoperable digital set-top boxes manufactured by multiple vendors. OpenCable was launched in September 1997 by Cable Television Laboratories, Inc., or CableLabs, a research and development consortium of cable television system operators, including most of the largest multi-system operators in the United States. The OpenCable process is intended to foster competition among suppliers for key elements of digital cable networks, while ensuring interoperability of devices connected to cable networks. We have played a leading role in OpenCable, including co-authoring the OpenCable standards specifications for conditional access to digital TV in the U.S. We are also the primary source of CableLabs-certified qualification tools used by consumer electronics manufacturers around the world preparing to enter the retail digital TV market.

      Teletrust. We are a member of Teletrust, a German organization whose goal is to provide a legally accepted means to adopt digital signatures. Digital signatures are encrypted personal identifiers, typically stored on a secure smart card, which allow for a high level of security through internationally accepted authentication methods. We are actively working on the smart card terminal committee which defines the standards for connecting smart cards to computers for applications such as secure electronic commerce over the Internet.

      PCMCIA. We are an executive member of Personal Computer Memory Card International Association or PCMCIA, an international standards body and trade association with over 500 member companies. PCMCIA was founded in 1989 to establish standards for integrated circuit cards and to promote interchangeability among mobile PCs. Other executive members include Advanced Micro Devices, AMP, Centennial, Compaq, IBM, Intel, Texas Instruments, 3Com, Toshiba and Xircom.

13

Table of Contents

      FUN. We are a member of Free Universe Network, a media and technology alliance in Germany whose goal it is to open up German broadband cable networks to ensure competition, diversity and unimpeded access for all market participants. The centerpiece of FUN is the definition of a universal platform which forms the basis for the distribution and use of all digital programs, through the integration of DVB common interface technology.

      FINREAD. We are a member of FINREAD, a consortium of European banks whose goal it is to create a secure online payment system based on smart cards that is affordable and easy to use, deploy and upgrade. Members of the FINREAD Consortium include Groupement des Cartes Bancaires “CB” (France), Visa EU (United Kingdom), Europay International (Belgium), Banksys (Belgium), Interpay Nederland (the Netherlands), SIZ (German Savings Banks Financial Group, Germany) and Ingenico (France). In addition to our participation with the standards setting activities of FINREAD, we have been selected by FINREAD to provide secure smart card readers for various financial application deployments in Europe.

      Smart Card Alliance. We are a member of the Smart Card Alliance, a U.S.-based, multi-industry association of member firms working to accelerate the widespread acceptance of multiple applications for smart card technology. We are also members of the Smart Card Alliance’s Secure Personal ID Task Force, which was formed to discuss issues relating to the implementation of privacy-sensitive identification systems. In 2001, we contributed to a white paper issued by the task force that describes key policy, process and technology considerations for a secure smart card-based personal ID system.

      Multimedia Card Association (MMCA); Secure Digital Association (SDA); and Compact Flash Association (CFA). We are a member of several associations relating to the development and use of various types of flash memory storage cards, including Multimedia, Secure Digital and Compact Flash.

Research and Development

      To date, we have made substantial investments in research and development, particularly in the areas of physical, token-based access devices, connectivity interface devices and digital video compression and editing technologies. Our engineering design teams work cross-functionally with marketing managers, applications engineers and customers to develop products and product enhancements to meet customer and market requirements. We also strive to develop and maintain close relationships with key suppliers of components and technologies in order to be able to quickly introduce new products that incorporate the latest technological advances. Our future success will depend upon our ability to develop and to introduce new products that keep pace with technological developments and emerging industry standards while addressing the increasingly sophisticated needs of our customers.

      Our research and development expenses were approximately $13.2 million, $13.5 million and $8.9 million for the years ended December 31, 2001, 2000 and 1999, respectively. As of December 31, 2001, we had approximately 169 full-time employees engaged in research and development activities, including software and hardware engineering, testing and quality assurance and technical documentation. All of our research and development activities occur in India, France, Germany and the U.S. We fund a portion of our research and development activities with technology development revenues received from OEM customers in connection with design and development of specific products. We recognized approximately $0.9 million, $1.4 million and $3.0 million in technology development revenues in 2001, 2000 and 1999, respectively.

Manufacturing and Sources of Supply

      We supplement our internal manufacturing capabilities with contract manufacturers in both Europe and Asia. We have implemented a global sourcing strategy that we believe enables us to achieve greater

14

Table of Contents

      We believe that our success will depend in large part on our ability to provide quality products and services. As of December 31, 2001, we had 142 full-time employees engaged in manufacturing and logistics activities. We have a formal quality control program to satisfy our customers’ requirements for high quality and reliable products. To ensure that products manufactured by others are consistent with our standards, we manage all key aspects of the production process, including establishing product specifications, selecting the components to be used to produce our products, selecting the suppliers of these components and negotiating the prices for these components. In addition, we work with our suppliers to improve process control and product design. Our quality control specialists conduct on-site inspections of our suppliers, and our products are tested by our contract manufacturers prior to shipment.

      We rely upon a limited number of suppliers of several key components of our products. For example, we currently utilize the foundry services of TEMIC, Philips and Atmel to produce our ASICs for our digital TV modules, we utilize the foundry services of Atmel and Samsung to produce our ASICS for our smart cards readers, and we purchase digital video compression chips from Zoran and LSI Logic and digital video editing software from Main Concept and DVD Cre8. Our reliance on only one supplier could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of these components could delay shipments of our products, which could have a material adverse effect on our business and operating results. These delays could also damage relationships with current and prospective customers.

Competition

      The market for digital data security, access control and digital media capture, editing and sharing products is intensely competitive and characterized by rapidly changing technology. We believe that competition in this market is likely to intensify as a result of increasing demand for security products. We currently experience competition from a number of sources, including:

	•	Advanced Card Systems, Gemplus, O2Micro and OmniKey in smart card readers, ASICs and universal smart card reader interfaces;
	•	Carry Computer Engineering, DataFab, Lexar, SanDisk, Simple Technology and SmartDisk for digital media readers; and
	•	ADS, Canopus, Pinnacle Systems, Roxio and ULead in digital video capture and editing products.

      We also experience indirect competition from certain of our customers who currently offer alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these and other parties that develop digital data security products based upon approaches similar to or different from those employed by us. In addition, the market for digital information security and access control products may ultimately be dominated by approaches other than the approach marketed by us.

      We believe that the principal competitive factors affecting the market for our products include:

	•	the extent to which products support industry standards and provide interoperability;
	•	the extent to which standards are widely adopted and product interoperability required within industry segments;
	•	technical features;
	•	ease of use;

15

Table of Contents

	•	quality/reliability;
	•	level of security;
	•	strength of distribution channels;
	•	cost of manufacture; and
	•	price.

      While we believe that we compete favorably with respect to these factors, we may not be able to successfully compete due to these or other factors and competitive pressures we face could materially and adversely affect our business and operating results.

Proprietary Technology and Intellectual Property

      Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. We generally enter into confidentiality and non-disclosure agreements with our employees and with key vendors and suppliers. We have many trademarks registered in the United States and/or in Europe. We continuously evaluate the registration of additional trademarks as appropriate. We currently have patents issued in both the United States and Europe and have other patent applications pending worldwide. In addition, we have licenses for various other United States and European patents associated with our products. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable, and that any issued patent will fail to provide us with any competitive advantages.

      There has been a great deal of litigation in the technology industry regarding intellectual property rights. Litigation may be necessary to protect our proprietary technology. We have from time to time received claims that we are infringing upon third parties’ intellectual property rights and future disputes with third parties may arise and these disputes may not be resolved on terms acceptable to us. As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, cause product shipment delays, or require us to redesign our products or require us to enter into royalty or licensing agreements. Any of these events could have a material adverse effect on our business and operating results. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights.

Employees

      As of December 31, 2001, we had a total of 521 full-time employees, of which 169 were engaged in engineering, research and development; 138 in sales and marketing; 142 in manufacturing and logistics; and 72 in general management and administration. None of our employees is represented by a labor union. We have experienced no work stoppages and believe that our employee relations are good.

Item 2.     Properties

      Our corporate headquarters are in Fremont, California where we lease approximately 38,400 square feet pursuant to a lease agreement that expires on March 31, 2003. Our European headquarters are located in Ismaning, Germany, where we lease approximately 35,000 square feet pursuant to a lease agreement that began November 15, 2001 and ends November 15, 2008. We lease approximately 69,000

16

Table of Contents

Item 3.     Legal Proceedings

      None.

Item 4.     Submission of Matters to a Vote of Security Holders

      No matters were submitted to SCM’s stockholders during the fourth quarter of 2001.

PART II

Item 5.     Market for Registrant’s Common Equity and Related Stockholder Matters

      (a) Price Range of common stock; Number of Holders; Dividends

      Our common stock is quoted on the Nasdaq National Market and on the Neuer Markt of the Frankfurt Stock Exchange under the symbol “SCMM.” The following table lists the high and low closing prices from the first quarter of 1999.

      On March 19, 2002, the closing prices of our common stock were $11.72 per share as reported by the Nasdaq National Market and €13.10 per share as reported by the Neuer Markt of the Frankfurt Stock Exchange. As of March 19, 2002, we had approximately 2,236 stockholders of record and beneficial stockholders.

      We have never declared or paid cash dividends on our common stock or other securities. Our U.S. line of credit requires us to obtain the bank’s prior written consent in order to declare or pay any cash dividends. We currently anticipate that we will retain all of our future earnings for use in the expansion and operation of our business and do not anticipate paying any cash dividends in the foreseeable future.

17

Table of Contents

Item 6.     Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

18

Table of Contents

      The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. SCM’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in this section as well as those discussed under the heading “Factors That May Affect Future Operating Results” and elsewhere in this document. This discussion should be read together with the financial statements and the related notes thereto set forth in “Item 8. Financial Statements and Supplementary Data.”

Overview

      SCM Microsystems designs, develops and sells hardware, software and silicon that enables people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We sell our products primarily into two broad markets: Security and Digital Media. Our target customers vary by market. For the Security market, our target customers are primarily manufacturers in the consumer electronics, computer and conditional access system industries. For the Digital Media market, our target customers are end user consumers as well as manufacturers in the computer and consumer electronics industries. We sell and license our products through a direct sales and marketing organization, both to the retail channel and to original equipment manufacturers, or OEMs. We also sell through distributors, value added resellers and systems integrators worldwide. Operationally, through 2001 we organized our business around three divisions: Digital TV and Video, PC Security and Digital Media. Going forward and beginning in fiscal 2002, we will structure our operations around two businesses: Security and Digital Media and Video. On February 28, 2002, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. We expect that the various activities relating to the separation of the Digital Media and Video business will not be completed for several months from the date hereof. We are evaluating various strategies to separate the Digital Media and Video business, including a spin-off or sale. We were organized in Delaware in 1996.

Critical Accounting Policies and Estimates

      Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses SCM’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, bad debts, inventories, asset impairment, deferred tax assets, accrued warranty reserves, restructuring costs, and contingencies and litigation. Management bases its estimates and judgements on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

      Management believes the following critical accounting policies, among others, affect our more significant judgements and estimates used in the preparation of our consolidated financial statements.

	•	SCM recognizes product revenue upon shipment, net of estimated returns, provided that collection is determined to be probable and no significant obligations remain. Product return from distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection when given, and rebates at the time the related revenue is recorded. The estimates for

19

Table of Contents

		returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. While management believes we can make reliable estimates for these matters, nevertheless unsold products in these distribution channels are exposed to rapid changes in consumer preferences or technological obsolescence, product updates or competing products. Accordingly, it is possible that these estimates will change in the near future or that the actual amounts could vary materially from our estimates and that the amounts of such changes could seriously harm our business.
	•	SCM maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of SCM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
	•	SCM writes down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. In 2001, SCM wrote down approximately $11.2 million of inventory based on such judgements.
	•	SCM holds minority interests in companies having operations or technologies in areas within or adjacent to our strategic focus, some of which are in publicly traded companies and some of which are in non-publicly traded companies whose value is difficult to determine. SCM records an investment impairment when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investment that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. In 2001, SCM realized impairment charges of approximately $8.5 million related to our investments.
	•	In assessing the recoverability of the Company’s goodwill and other intangibles, SCM must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded. On January 1, 2002, SCM adopted SFAS No. 142, “Goodwill and Other Intangibles Assets,” and will be required to analyze its goodwill and intangible assets for impairment issues on a periodic basis. As a result of the intended separation of our Digital Media and Video business, in the fourth quarter of 2001, we recorded an asset impairment of approximately $36.1 million based on our findings that the intangible assets from past acquisitions were impaired.
	•	The carrying value of the Company’s net deferred tax assets assumes that SCM will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, we may be required to record additional valuation allowances against our deferred tax assets resulting in additional tax expense in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets quarterly and assesses the need for additional valuation allowances quarterly.
	•	SCM accrues the estimated cost of product warranties at the time revenues are recognized. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by actual warranty costs including, material usage or service delivery costs incurred in correcting a product failure. If actual material usage or service delivery costs differ from our estimates, revisions to our estimated warranty liability would be required.

20

Table of Contents

Recent Accounting Pronouncements

      In August 2001, the Financial Accounting Standard Board issued SFAS No. 144, “Accounting for the Impairment of Long Lived Assets.” SFAS No. 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long Lived Assets to be Disposed Of ”, addressing financial accounting and reporting for the impairment or disposal of long lived assets. This statement is effective for our fiscal year beginning January 1, 2002. The Company early adopted SFAS No. 144 in the fourth quarter of 2001.

      In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations,” and SFAS 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142, addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting of goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will rather be tested at least annually for impairment. Under the provisions of SFAS No. 142, any impairment loss identified upon adoption of this standard is recognized as a cumulative effect of a change in accounting principle, which is charged directly to retained earnings. Any impairment loss incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge to current period earnings. As of January 1, 2002, SCM has adopted SFAS No. 142 and, as a consequence will stop amortizing goodwill that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles for fiscal 2002 for acquisitions made before June 30, 2001 is expected to be approximately $1.1 million. Intangible assets of approximately $2.1 million will be reclassed to goodwill and amortization will cease effective January 1, 2002. We do not expect to take any charges in 2002 associated with the adoption of SFAS No. 142.

Acquisitions

      We have made a number of acquisitions over the last two years which are accounted for as follows:

      On June 30, 1999, we acquired a 51% interest in Dazzle Multimedia, Inc., a privately held company based in Fremont, California, in a transaction that was accounted for under the purchase method of accounting. Prior to the acquisition, SCM had an investment in Dazzle totaling approximately $6.5 million consisting primarily of a $2.5 million convertible loan, a $0.2 million equity investment and accounts receivable of $3.8 million from Dazzle resulting from sales to Dazzle during 1998 and 1999 prior to the acquisition date.

      The 51% interest was acquired by SCM directly from Dazzle in exchange for the conversion of the convertible loan and $2.0 million of the receivables discussed above and upon the exercise by SCM of a common stock warrant of $ 0.1 million. The warrant was originally issued by Dazzle in connection with the convertible loan financing transaction. Based on an independent valuation of Dazzle at the time of closing the transaction, which included a weighting of projected future discounted cash flows and market comparables, the net investment of $6.6 million (initial investment of $6.5 million plus $0.1 million warrant exercise) for a 51% stake in Dazzle was reduced by an impairment charge of $0.6 million to reflect a fair value of $6.0 million. Included in one-time and restructuring charges is $0.3 million of headcount termination costs and $0.3 million of other costs.

      At the date of the transaction, Dazzle had outstanding convertible notes, convertible preferred stock and stock options that were potentially dilutive securities. To the extent Dazzle issued additional common shares related to these potentially dilutive securities, SCM would receive an equivalent number of shares at no additional costs, to retain our 51% ownership interest.

21

Table of Contents

      Effective January 1, 2000, SCM and Dazzle entered into an additional agreement related to Dazzle options granted and new stock issuances subsequent to the date SCM acquired its majority interest. Under this agreement, in connection with each Dazzle equity issuance, each time Dazzle issued additional capital stock SCM automatically purchased shares under similar terms to retain SCM’s 51% ownership interest in Dazzle.

      At the time of the acquisition, the estimated aggregate fair value of Dazzle’s research and development efforts that had not reached technological feasibility as of the acquisition date and had no alternative future uses was estimated by an independent valuation specialist to be approximately $0.9 million, and was expensed at the acquisition date. This allocation represented the estimated fair value based on risk-adjusted cash flows related to incomplete research and development projects. Dazzle had two projects considered to be in-process technology at the time of the acquisition. These projects were for Dazzle’s MPEG 1 and MPEG 2 products, both due for completion in the first quarter of 2000.

      The percentage completion of these projects at the time of acquisition were as follows:

      The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risk-adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time.

      The revenue projection used to value the in-process research and development was based on units sales forecasts for worldwide sales territories and was adjusted to consider only the revenue related to development achievements completed at the acquisition date. Projected annual revenues for the in-process development projects were assumed to increase from product release through 2003 and decline significantly in 2004. Gross profit was assumed to be 37% in 2000 and 40% from 2001 through 2004. The projected gross margins were based on estimated costs of revenues that primarily included printed circuit boards, integrated circuits and related electronic components, plastic molding and tooling costs, assembly and testing costs, and packaging. These projections were based on Dazzle’s experience with similar products. Estimated operating expenses, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income for the in-process development projects. Operating expenses were estimated as a percentage of revenue and included sales and marketing expenses, administrative expenses, and development costs to maintain the technology once it achieved technological feasibility. In addition, net cash flows estimates were adjusted to allow for fair return on working capital and fixed assets. A 40% discount rate was used to discount the net cash flows back to their present value. If these projects had not been successfully developed, we would not have been able to realize the value assigned to the in-process research and development projects. Total costs incurred and estimated to complete both projects as of the acquisition date were approximately $1.9 million. As of December 31, 2000, all of these estimated costs had been incurred.

      In the third and fourth quarter of 2000, SCM acquired an additional 43.8% of Dazzle’s outstanding common stock for $14.6 million in cash and 533,000 of SCM common stock valued at approximately $19.8 million. SCM also assumed Dazzle’s stock option program resulting in an increase in goodwill of approximately $1.6 million. Legal costs were estimated at $0.1 million. In 2001, SCM acquired an additional 3.0% of Dazzle’s outstanding share capital for approximately $2.2 million in cash. The $2.2 million increased intangible assets by $2.1 million and $0.1 million was expensed for Dazzle’s research and development efforts that had not reached technological feasibility and had no future uses.

      At the time of the acquisition in 2000, the estimated aggregate fair value of Dazzle’s research and development efforts that had not reached technological feasibility as of the acquisition date and had no alternative future uses was estimated by SCM’s management to be approximately $2.1 million, and was

22

Table of Contents

      The percentage completion of these projects at the time of acquisition were as follows:

      The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risk-adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time.

      The revenue projection used to value the in-process research and development is based on units sales forecasts for worldwide sales territories and adjusted to consider only the revenue related to development achievements completed at the acquisition date. Projected annual revenues for the in-process development projects were assumed to increase from product release through 2003 and decline significantly in 2004 and, except for MovieStar and DVC II, generate no revenue in 2005. Gross profit was assumed to be 48% in 2001, 49% in 2002, 50% in 2003 and 51% in 2004 for the highest priced products. Gross profit was assumed to be 30% in 2001, 31% in 2002 and 32% thereafter for the mid-tier priced products. For the lower priced products, gross profit was assumed to be 25% for all years projected. The projected gross margins were based on estimated costs of revenues which primarily include printed circuitry, integrated circuits and related electronic components, plastic molding and tooling costs, assembly and testing costs, and packaging. These projections were based on Dazzle’s experience with similar products. Estimated operating expenses, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income for the in-process development projects. Operating expenses were estimated as a percentage of revenue and included sales and marketing expenses and administrative expenses. Development costs are assumed to be applicable for 2001 only once technological feasibility has been achieved. In addition, net cash flows estimates were adjusted to allow for fair return on working capital and fixed assets. A 24.5% to 31.5% discount rate was used to discount the net cash flows back to their present value based on the risks associated with each project. If these projects were not successfully developed, we could not realize the value assigned to the in-process research and development projects. Total costs incurred as of the acquisition date for the MovieStar, EmMe, Mojave and My TV projects were approximately $350,000, $100,000, $316,000 and $75,000, respectively. Expenses to be incurred of $280,000, $70,000, $243,000 and $200,000, respectively, were estimated to complete the projects at the date of acquisition. As of December 31, 2001, the MovieStar, EmMe, Mojave and My TV projects had been completed.

      On June 27, 2000, SCM paid $7.5 million in cash and issued approximately 98,700 shares of its common stock, valued at $91.19 per share, to the shareholders of Microtech International, a privately held company in North Branford, Connecticut, in exchange for all of the outstanding share capital of Microtech. Microtech is a provider of digital photography solutions for the consumer and business markets. The transaction has been accounted for under the purchase method of accounting and the results of operations of Microtech have been included in SCM’s results of operations since the date of acquisition. In connection with the acquisition, SCM incurred acquisition costs of $1.0 million.

23

Table of Contents

      Goodwill and intangible assets from the acquisition approximated $17.7 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. Finite intangible assets are considered to have a life of five years and are amortized on a straight-line basis. On January 1, 2002, SCM adopted Statement of Financial Accounting Standards (“SFAS”) No, 142, “Goodwill and Other Intangible Assets,” which provides that goodwill and certain intangible assets with indefinite useful lives not be amortized.

      Effective July 1, 2000, Dazzle acquired the Personal Video Division (“PVD”) of FAST Multimedia AG (“FAST”), a developer of digital video production hardware and software for professional markets, headquartered in Munich, Germany. The transaction was accounted for under the purchase method of accounting and the results of operations of this division were included in SCM’s results of operations since its acquisition. Under the terms of the agreement, Dazzle acquired FAST’s PVD division and all the assets of the PVD division, including its research and development, marketing, sales, distribution and administrative operations. Dazzle paid FAST approximately $4.0 million in cash for the division. In addition, SCM issued 159,101 shares of its common stock valued at approximately $2.4 million during fiscal 2001 when FAST met certain financial performance criteria. The additional consideration was recorded as goodwill.

      Goodwill and intangible assets from the acquisition approximated $4.6 million and represented the excess of the purchase price over the fair value of the tangible assets acquired. The in-process research and development costs of $0.9 million were expensed in the third quarter of 2000. Finite intangible assets are being amortized on a straight-line basis over their estimated useful lives ranging from three to five years. On January 1, 2002, SCM adopted SFAS No, 142, “Goodwill and Other Intangible Assets,” which provides that goodwill and certain intangible assets with indefinite useful lives will no longer be amortized.

      At the time of the acquisition, the estimated aggregate fair value of FAST PVD’s research and development efforts that had not reached technological feasibility and had no alternative future uses was estimated to be approximately $0.9 million. This amount was expensed in the third quarter of 2000 and represented the estimated fair value based on risk-adjusted cash flows related to incomplete research and development projects. FAST PVD had three projects considered to be in-process technology at the time of the acquisition. These projects were DV.now AV, DV.twin and TV-Master. As of the date of acquisition, these projects were estimated to be 80%, 90% and 50% complete, respectively, and were completed in the fourth quarter of 2000.

      The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risk-adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time.

      The revenue projection used to value the in-process technology was based on sales forecasts for worldwide sales territories and was adjusted to consider only the revenue related to development achievements completed at the acquisition date. Projected revenues for the in-process technology projects were assumed to increase from product release to 2002 and to decline significantly in 2003 and 2004. Gross margins were projected to range from 42% for the remainder of 2000 to 40% for 2001 through to 2004. Projected gross margins were based on estimated cost of revenues including component costs, tooling costs, assembly and testing costs and packaging based on FAST PVD’s experience with similar products. Estimated operating costs, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income for the in-process development projects. Operating expenses were estimated as a percentage of revenues and included sales and marketing expenses, administrative expenses and development costs to maintain the technology

24

Table of Contents

      On September 28, 2000, SCM paid $4.1 million in cash and issued approximately 106,229 shares of our common stock, valued at $36.56 per share, to the shareholders of 2-Tel BV, a privately held company in the Netherlands, in exchange for all of the outstanding share capital of 2-Tel. 2-Tel is a provider of hardware and software solutions for the chip and smart card-based electronic commerce applications. The transaction has been accounted for under the purchase method of accounting. In connection with the acquisition, SCM incurred acquisition costs of approximately $0.3 million.

      Goodwill and intangible assets from the acquisition approximated $8.5 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The in-process research and development costs of $1.9 million were expensed in the last half of 2000. Finite intangible assets are being amortized on a straight-line basis over an estimated useful life of five years. On January 1, 2002, SCM adopted SFAS No, 142, “Goodwill and Other Intangible Assets,” which provides that goodwill and certain intangible assets with indefinite useful lives will no longer be amortized.

      At the time of the acquisition, the estimated aggregate fair value of 2-Tel’s research and development efforts that had not reached technological feasibility and had no alternative future uses was approximately $1.9 million. This amount was expensed in the last half of 2000 and represented the estimated fair value based on risk-adjusted cash flows related to incomplete research and development projects. 2-Tel had three projects considered to be in-process technology at the time of the acquisition. These projects were E-Gate 2000, Retail Application Terminal and the Transmobile Wallet. The E-Gate 2000 and Retail Application Terminal projects were due to be completed in the fourth quarter of 2000 while the Transmobile Wallet was scheduled for completion in the second quarter of 2001. As of the date of the acquisition, the percentage completion of these projects were estimated to be 79% for the E-Gate 2000, 81% for the Retail Application project and 31% for the Transmobile Wallet. As of December 31, 2000, the E-Gate and Retail Application projects were complete and the Transmobile Wallet was estimated to be 60% complete. As of December 31, 2001, the Transmobile Wallet had been completed.

      The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risk-adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time.

      The revenue projection used to value the in-process technology was based on sales forecasts for worldwide sales territories and was adjusted to consider only the revenue related to development achievements completed at the acquisition date. Since the projected debt-free cash flow for the E-Gate 2000 product was considered to be slightly negative, no in-process technology value was ascribed to this product. Projected revenues for the two remaining in-process technology projects were assumed to increase from product release to 2003 and to decline significantly in 2004 and 2005. Gross margins were projected to range from 62% in the first few years to 54% in 2004 and 2005 for the Retail Application

25

Table of Contents

26

Table of Contents

Results of Operations

      The following table sets forth certain items from SCM’s consolidated statement of operations as a percentage of total revenue for the periods indicated:

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

      Net Revenue. Revenue from product sales is recognized upon product shipment, when a purchase order has been received, the sales price is fixed and determinable and collection of the resulting receivable is probable. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. Net revenue for the twelve months ended December 31, 2001 was $184.9 million compared to $157.8 million in 2000, an increase of 17%. The increase in revenue in 2001 over 2000 was due primarily to increased shipments of our products in our Digital TV and Video and PC Security divisions, partially offset by decreased sales of our products in our Digital Media division. Revenues from our Digital TV and Video products were $109.1 million in 2001 compared with sales of $78.9 million in 2000. Increases in revenues in our Digital TV and Video division primarily consisted of increased shipments of our conditional access modules for digital television broadcasts in Europe. Revenues from our PC Security division increased to $19.7 million in 2001 as compared to $16.0 million in the prior year primarily due to a significant increase in sales of smart card readers in the U.S. Revenues from our Digital Media division were $56.2 million in 2001 compared to $62.9 million in 2000. This decrease was primarily due to a decrease in sales of our digital media reader/writers to our OEM

27

Table of Contents

      For products in our Digital TV and Video and PC Security divisions, average unit prices remained relatively stable; however, in our Digital Media division, price declines were experienced that were partially offset by reductions in product costs.

      Gross Profit. Gross profit for 2001 was $48.6 million, or 26% of total net revenue, compared to $53.0 million, or 34% in 2000. The decrease in gross profit as a percentage of net revenue from the 2000 level was due primarily to inventory provisions of $11.2 million taken during 2001 related to products that were considered excess, obsolete or impaired due to technological advancements. In the first quarter of 2001, a $10.0 million provision was recorded which related to our StarKey PC Satellite receiver and to our digital media reader products and related components. During the fourth quarter of 2001, a further provision increase of $1.2 million was recorded for StarKey components and finished product because we determined this product was unable to address any identifiable market. Excluding these charges, SCM’s gross profit was $59.8 million, or 32% of total net revenue. SCM’s gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to continue to fluctuate from period to period.

      Research and Development. Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are related to hardware and chip development, as well as software development. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, SCM has not capitalized any software development costs. For 2001, research and development expenses were $13.2 million, compared with $13.5 million in 2000. As a percentage of total net revenue, research and development expenses were 7% in 2001 compared to 9% for 2000. The decrease in 2001 in absolute amounts was primarily due to the continued strategic movement of engineering activities from high cost regions such as Silicon Valley to lower cost locations such as India. Personnel related expenses decreased by $0.4 million.

      Selling and Marketing. Selling and marketing expenses consist primarily of employee compensation as well as advertising and other marketing costs. Selling and marketing expenses for 2001 were $29.6 million, or 16% of revenue, compared with $23.4 million in 2000, or 15% of revenue, an increase of 27%. The increase in absolute amounts in 2001 included an increase of $5.3 million in personnel and commission related costs associated with the increased sales headcount and sales personnel compensation expenses in SCM’s U.S. and European offices and an increase in marketing costs of $1.3 million.

      General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing SCM’s administrative functions, professional fees arising from legal, auditing and other consulting services and charges for allowances for doubtful accounts receivable. In 2001, general and administrative expenses were $20.4 million, an increase of 45% compared with $14.1 million in 2000, representing 11% and 9% of total net revenue for 2001 and 2000, respectively. These increases in absolute amounts were primarily due to an increase in personnel related expenses of $0.3 million to support higher levels of business activities; an increase of $0.7 million for depreciation expense; an increase in bad debt expense of $2.0 million recorded in the first quarter of 2001 after we experienced increased delays and non-payments from some customers, as well as some customers filing for bankruptcy; an increase in professional fees of $0.9 million; an increase in facilities costs and supplies of $1.9 million; and an increase in insurance costs of $0.4 million which were only partially offset by a decrease in general expenses of $0.2 million. We expect that our general and administrative costs will fluctuate as a percentage of total net revenue.

28

Table of Contents

      Amortization of Goodwill and Intangibles. Amortization of goodwill and intangibles in 2001 was $14.9 million, compared with $5.5 million in 2000. The increase of $9.4 million in intangible asset amortization resulted from a full year’s amortization charge related to our acquisitions of Microtech, 2-Tel and Dazzle and from Dazzle’s acquisition of FAST’s Personal Video Division, compared to less than one year recorded in 2000. On January 1, 2002, SCM adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” and as a consequence has stopped amortizing goodwill that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles for fiscal 2002 for acquisitions made before June 30, 2001 will be approximately $1.1 million.

      Impairment of Goodwill and Intangibles. In conjunction with the planned separation of our Digital Media and Video business, we early adopted SFAS 144 which superceded SFAS 121 and took a non-cash write-down of goodwill and other intangibles of $36.1 million in the fourth quarter of 2001. The entire amount of the goodwill and intangibles write down was related to the Digital Media and Video business. We would have been required to conduct a valuation of our goodwill and intangible assets in the first quarter of 2002 under the new SFAS No. 142, “Goodwill and Other Intangible Assets,” which became effective for the Company on January 1, 2002. This valuation would have resulted in a similar non-cash charge that we would have had to take in the first quarter, had we not already taken this charge in the fourth quarter. Consequently, we do not expect to take any charges in the first quarter of 2002 associated with the adoption of SFAS No. 142.

      In-Process Research and Development. In-process research and development costs of $0.1 million in 2001 were included in SCM’s results as one-time charges for the write-off of development efforts that had not yet reached technological feasibility related to the acquisition of additional shares of Dazzle common stock. In-process research and development costs of $4.9 million in 2000 were included in SCM’s results as one-time charges for the write-off of development efforts that had not yet reached technological feasibility within our recently acquired companies and had no alternative future uses as of the various acquisition dates. Of these expenses, $0.9 million related to the acquisition of FAST’s Personal Video Division, approximately $1.9 million related to the acquisition of 2-Tel, and approximately $2.1 million related to the acquisition of the minority interest of Dazzle. These amounts were determined by independent appraisals.

      One-Time and Restructuring Charges. SCM recorded one-time and restructuring charges of $5.2 million in 2001 related to legal settlement costs of $1.8 million, severance and other costs of $3.4 million related to the relocation and closure of certain SCM facilities and asset write-offs associated with those moves. SCM recorded one-time and restructuring charges of $5.7 million in 2000. Approximately $5.0 million of these charges related to contract termination, dispute resolution settlement and associated legal fees and $0.7 million for the relocation and closure of certain SCM facilities and asset write-offs associated with those moves.

      Loss from Investments. During the first and fourth quarters of 2001, because of the persistent deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties by these companies in obtaining additional funding, we determined that our investments in SmartDisk, Spyrus and Satup were permanently impaired. Accordingly, in the first quarter of 2001 we wrote down our investment in SmartDisk to its fair market value as of March 31, 2001 and wrote down our investment in Spyrus to its estimated value, which approximated 20% of the original cost. The result was a charge to the income statement of $5.7 million in the first quarter in 2001. In the fourth quarter of 2001, we wrote off our remaining balances for Spyrus, Satup and our investment in a Singapore subsidiary of PC Card. The result was a charge to the income statement of $2.8 million in the fourth quarter of 2001.

      Interest Income, Net. Interest income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt. In 2001, interest income, net was $1.9 million, compared to $5.9 million in 2000. Lower average investable cash balances as well as lower overall interest rates in 2001 resulted in the decrease in interest income, net in 2001 compared to 2000. We expect continued investment of cash balances to generate future net investment income in 2002.

29

Table of Contents

      Foreign Currency Transaction Gains and Other Income. Foreign currency transaction gains were $2.1 million in 2001 compared to $1.6 million in 2000. These foreign currency transactions gains were primarily from gains in Singapore ($2.5 million) being partially offset by losses in other subsidiaries. These gains and losses resulted primarily from the revaluation of receivables (especially U.S. dollar denominated receivables) to the functional currency of the subsidiary. Other income in 2000 included a gain on the sale of Impleo of approximately $0.4 million offset by other expenses of $0.1 million.

      Income Taxes. The benefit from income taxes was $6.7 million in 2001 or a 4% benefit compared to a tax provision with a federal statutory rate of 34%. This benefit resulted principally from net losses generated in the United States which were partially offset by taxable income generated in foreign jurisdictions. The effective tax benefit was further reduced by expenses not deductible for tax purposes primarily consisting of the amortization and impairment of intangibles and goodwill and in-process research and development. As of December 31, 2001, SCM had net operating loss carryforwards of approximately $49.3 million and $22.6 million for U.S. federal and California state income tax purposes, respectively.

      Minority Interest. The minority interest of $0.2 million in 2001 and $0.4 million in 2000 reflects the proportion of losses from Dazzle Multimedia that were attributable to the minority shareholders of Dazzle during those periods.

Year ended December 31, 2000 Compared to Year ended December 31, 1999

      Net Revenue. Revenue from product sales is recognized upon product shipment, when a purchase order has been received, the sales price is fixed and determinable and collection of the resulting receivable is probable. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. Net revenue for the twelve months ended December 31, 2000 was $157.8 million compared to $127.3 million in 1999, an increase of 24%. The increase in revenue in 2000 over 1999 was due primarily to increased shipments of products in our Digital TV and Video division, offset by decreased sales of products in our PC Security division. Revenues from our Digital TV and Video division were $78.9 million in 2000 compared with sales of $46.4 million in 1999. Increases in revenues in our Digital TV and Video division primarily consisted of increased shipments of our conditional access modules for digital television broadcasts in Europe, as well as, increased shipments of our Dazzle branded digital video products worldwide. Revenues from Dazzle branded digital video products have been consolidated in SCM’s results since we took a majority interest in Dazzle Multimedia on June 30, 1999. No Dazzle product sales were included in the first six months of 1999. Revenues from our PC Security division were $16.0 million in 2000 compared with $19.2 million in 1999. This decrease was primarily due to reduced demand from the U.S. government for our legacy SwapBox products in the last three quarters of 2000.

      For all product groups, average unit prices remained relatively stable, and increases in net revenue were due to increased volume shipments.

      Gross Profit. Gross profit for 2000 was $53.0 million, or 34% of total net revenue, compared to $44.7 million, or 35% in 1999. The increase in gross profit in absolute dollars for the year was due to our increase in net revenue. The decrease in gross profit as a percentage of net revenue from the 1999 level was due to lower unit gross margins in all SCM’s divisions, caused primarily by a shift in product mix within those divisions. In the fourth quarter, gross profit was impacted by higher than expected sales of some older Dazzle digital video products that carried lower margins, made lower still by a rebate program with higher than anticipated participation. Digital media product margins in 1999 also included a $1.1 million charge resulting from the write down of excess inventory in that division and costs associated with the ramp up of production of certain digital media products in the second quarter of 1999. The write down of inventory resulted from a review of SCM’s products in the Digital Media division, which was conducted following a slow down in sales of certain products. These declining sales were attributed to an overlap in SCM’s product lines. SCM’s gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter,

30

Table of Contents

      Research and Development. Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are primarily related to hardware and chip development, and to a lesser degree, software development. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, SCM has not capitalized any software development costs. For 2000, research and development expenses were $13.5 million, compared with $8.9 million in 1999, an increase of 52%. As a percentage of total net revenue, research and development expenses were 9% in 2000 compared to 7% for 1999. The increase in absolute amounts in 2000 was primarily due to increased engineering headcount and related product development costs at SCM’s development centers in France and India, and due to research and development expenses of Dazzle Multimedia, in which we acquired a majority stake in June of 1999. Personnel related expenses increased by $3.4 million and prototype expenses increased by $0.6 million in 2000 compared with 1999. Research and development expenses in 2000 also included $0.5 million in stock-based compensation expenses related to the assumption of Dazzle’s stock option program following our acquisition of the minority interest of Dazzle in the fourth quarter of 2000.

      Selling and Marketing. Selling and marketing expenses consist primarily of employee compensation as well as advertising and other marketing costs. Selling and marketing expenses for 2000 were $23.4 million, or 15% of revenue, compared with $13.3 million in 1999, or 11% of revenue, an increase of 75%. The increase in absolute amounts in 2000 included an increase of $4.6 million in marketing program costs associated with the retail sales strategy of Dazzle and Microtech and increases in personnel related expenses including sales headcount and sales personnel compensation expenses in SCM’s U.S. and European offices of $ 3.4 million. Also, sales commissions and travel increased by $0.7 million and $0.4 million, respectively, in 2000 compared to 1999 levels. Selling and marketing expenses in 2000 also included $0.4 million in stock-based compensation expenses related to the assumption of Dazzle’s stock option program following our acquisition of the minority interest of Dazzle in the fourth quarter of 2000.

      General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing SCM’s administrative functions, professional fees arising from legal, auditing and other consulting services and charges for allowances for doubtful accounts receivable. In 2000, general and administrative expenses were $14.1 million, an increase of 25% compared with $11.3 million in 1999, representing 9% of total net revenue for 2000 and 1999. This increase in absolute dollars was primarily due to an increase in personnel related expenses of $1.2 million to support higher levels of business activities; an increase in travel costs of $0.4 million; and an increase in rent expense of $0.4 million. General and administrative expenses in 2000 also included $0.8 million in stock-based compensation expenses related to the assumption of Dazzle’s stock option program following our acquisition of the minority interest of Dazzle in the fourth quarter of 2000. These increases in 2000 compared to 1999 were offset by a $2.0 million non-recurring allowance for doubtful accounts recorded in 1999 as a result of cash flow difficulties experienced by one of our customers. An initial provision of $2.3 million for bad debt from this customer was made in December 1998. The customer continued to trade during the first quarter of 1999. During the second quarter of 1999, the customer filed bankruptcy. As of December 31, 1999 all outstanding balances due from this customer had been written off.

      Amortization of Goodwill and Intangibles. Amortization of goodwill and intangibles in 2000 was $5.5 million, compared with $1.3 million in 1999. The increase of $4.2 million in intangible asset amortization resulted from our acquisitions of Microtech, 2-Tel and Dazzle and from Dazzle’s acquisition of FAST’s Personal Video Division.

31

Table of Contents

      Impairment of Goodwill and Intangibles. In 1999, in connection with the acquisition of a majority interest in Dazzle Multimedia, SCM incurred a non-recurring charge of $0.6 million resulting from the write down of the Dazzle investment at the date of the acquisition.

      In-Process Research and Development. In-process research and development costs of $4.9 million in 2000 were included in SCM’s results as one-time charges for the write-off of development efforts that had not yet reached technological feasibility within our recently acquired companies and had no alternative future uses as of the various acquisition dates. Of these expenses, $0.9 million related to the acquisition of FAST’s Personal Video Division, approximately $1.9 million related to the acquisition of 2-Tel, and approximately $2.1 million related to the acquisition of the minority interest of Dazzle. These amounts were determined by independent appraisals. The $0.9 million recorded in 1999 related to our purchase of 51% of Dazzle’s outstanding stock in the second quarter of 1999.

      One-time and Restructuring Charges. SCM recorded one-time and restructuring charges of $5.7 million in 2000. Approximately $5.0 million of these charges related to contract termination, dispute resolution settlement and associated legal fees and $0.7 million for the relocation and closure of certain SCM facilities and asset write-offs associated with those moves. In 1999, in connection with the acquisition of a majority interest in Dazzle Multimedia, SCM incurred headcount termination costs of $0.3 million and legal and other costs of $0.3 million.

      Interest Income, Net. Interest income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt. In 2000, interest income, net was $5.9 million, compared to $6.4 million in 1999. Lower average investable cash balances in 2000 resulted in the decrease in interest income, net in 2000 compared to 1999. We expect continued investment of cash balances to generate future net investment income in 2001.

      Foreign Currency Transaction Gains and Other Income. Foreign currency transaction gains were $1.6 million in 2000 compared to $0.3 million in 1999. These foreign currency transactions gains were primarily from gains in Germany/ France ($0.8 million) and Singapore ($0.8 million) being partially offset by losses in the U.S. ($0.5 million) and other subsidiaries. These gains and losses resulted primarily from the revaluation of receivables (especially U.S. dollar denominated receivables) to the functional currency of the subsidiary. Other income in 2000 included a gain on the sale of Impleo of approximately $0.4 million offset by other expenses of $0.1 million. There was no other income in 1999.

      Income Taxes. The benefit from income taxes was $1.0 million in 2000, or a 17% benefit compared to a tax provision with a federal statutory rate of 34%. This benefit resulted principally from net losses generated in the United States which were partially offset by taxable income generated in foreign jurisdictions. The effective tax benefit was further reduced by expenses not deductible for tax purposes primarily consisting of the amortization of intangibles and goodwill and in-process research and development. As of December 31, 2000, SCM had net operating loss carryforwards of approximately $38.4 million and $11.2 million for U.S. federal and California state income tax purposes, respectively, and approximately $0.6 million of net operating loss carryforwards available to offset taxable income in Japan.

      Minority Interest. The minority interest of $0.4 million in 2000 and $(0.6) million in 1999 reflects the proportion of losses and profits from Dazzle Multimedia that are attributable to the minority shareholders of Dazzle.

      Throughout 2001 we organized our business around Digital TV and Video, Digital Media, and PC Security. As we described herein, beginning with fiscal 2002 and going forward we will structure our operations around two businesses: Security, which comprises our digital TV and PC security products, and Digital Media and Video, which comprises our digital media and digital video products. The Net Revenue descriptions in the Management Discussion and Analysis section of this Annual Report on Form 10-K and Note 13 to the consolidated financial statement financial statements reflect the way we have organized our business in 2001 and prior thereto.

32

Table of Contents

      In light of the new structure of our business beginning with fiscal 2002 and going forward, we are providing summary financial information below to reflect how our newly reorganized business divisions would have performed financially from a revenue, gross profit, and gross margin perspectives for the years ended December 31, 2001, 2000, and 1999.

      Below is historic unaudited summary information for the years ended December 31, 2001, 2000, and 1999 for our new business structure (in thousands):

      Quarterly historical unaudited summary information by our new business structure for the year ended December 31, 2001 is as follows (in thousands):

Liquidity and Capital Resources

      As of December 31, 2001, SCM’s working capital was $101.4 million. Working capital decreased in 2001 by approximately $22.4 million, primarily because of the decrease in cash, cash equivalents and

33

Table of Contents

      In 2001, cash and cash equivalents increased by $25.7 million primarily due to the conversion of short term investments into cash and equivalents. Cash provided by operating activities of $1.1 million primarily resulted from a net loss of $68.3 million and an increase in deferred income taxes of $8.0 million being offset by the adding back of depreciation and amortization of $18.2 million, an asset impairment of $36.1 million and a loss on long-term investments of $8.5 million, a decrease in accounts receivable of $8.9 million, a decrease in inventory of $2.7 million, and an increase in accounts payable of $2.0 million and accrued expenses of $1.2 million. Cash from investing activities of $25.9 million consisted primarily of net proceeds of short-term investments of $33.2 million being partially offset by purchases of capital expenditures of $4.7 million, $2.2 million used to purchase additional Dazzle common stock and purchases of long-term investments of $1.0 million. Cash provided by financing activities was $0.9 million and consisted primarily of proceeds for the issuance of equity securities.

      SCM has a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million Euro (approximately $0.7 million as of December 31, 2001). The German line has no expiration date and bears interest at 7%. Borrowings under this line of credit are unsecured. We have an unsecured line of credit in France of 0.3 million Euro (approximately $0.3 million as of December 31, 2001) which bears interest at 4.48% and has no expiration date. In the United States, we have an unsecured $3.0 million line of credit which bears interest at 8.5% and expires in May 2002. In addition, we have a Singapore $1.2 million (approximately $0.6 million as of December 31, 2001) overdraft facility with a local bank due on demand. The Singapore line is secured by a U.S. $0.4 million fixed deposit and has a base interest rate of 7.5%. There were no amounts outstanding under any of these credit facilities as of December 31, 2001 and 2000.

      The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These lease agreements expire at various dates during the next fifteen years. Future minimum lease payments under noncancelable operating leases as of December 31, 2001 were $3.1 million for 2002, $2.2 million for 2003, $1.9 million for 2004, $1.6 million for 2005, $1.3 million for 2006 and $1.8 million for all years thereafter.

      We currently expect that our current capital resources and available borrowings should be sufficient to meet our operating and capital requirements through at least the end of 2002. We may, however, seek additional debt or equity financing prior to that time. There can be no assurance that additional capital will be available to SCM on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

      You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only risks we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.

      If any of the following risks actually occur, our business, financial condition, results of operations or product market share could be materially and adversely affected. In such case, the trading price of our common stock could decline.

We have incurred operating losses and may not achieve profitability.

      We have a history of losses with an accumulated deficit of $74.4 million as of December 31, 2001. Although we were profitable for each quarter during the year ended December 31, 2000 and for the second and third quarters of 2001 (before one-time items and the amortization and impairment of goodwill and intangibles), we may continue to incur losses in the future and may be unable to achieve profitability.

34

Table of Contents

Our quarterly operating results will likely fluctuate.

      Our quarterly operating results have varied greatly in the past and will likely vary greatly in the future depending upon a number of factors. Many of these factors are beyond our control. Our revenues, gross margins and operating results may fluctuate significantly from quarter to quarter due to, among other things:

	•	business and economic conditions overall and in our markets, and in particular, the demand in our retail channels;
	•	the timing and amount of orders we receive from our customers that, in the case of our consumer products and products sold to the government, may be tied to seasonal demand or budgetary cycles;
	•	cancellations or delays of customer product orders, or the loss of a significant customer;
	•	our backlog and inventory levels;
	•	our customer and distributor inventory levels and product returns;
	•	new product announcements or introductions by us or our competitors;
	•	our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all;
	•	the sales volume, product configuration and mix of products that we sell;
	•	our success in expanding our sales and marketing organization and programs;
	•	technological changes in the market for our products;
	•	increased competition or reductions in the average selling prices that we are able to charge;
	•	fluctuations in the value of foreign currencies against the U.S. dollar;
	•	the timing and amount of marketing and research and development expenditures;
	•	our investment experience related to our strategic minority equity investments; and
	•	costs related to events such as acquisitions, litigation and write-off of investments.

      Due to these and other factors, our revenues may not increase or remain at their current levels. Because a high percentage of our operating expenses are fixed, a small variation in our revenue can cause significant variations in our earnings from quarter to quarter and our operating results may vary significantly in future periods. Therefore, our historical results may not be a reliable indicator of our future performance.

A number of factors make it difficult to estimate operating results prior to the end of a quarter.

      We do not typically maintain a significant level of backlog. As a result, revenues in any quarter depend on contracts entered into or orders booked and shipped in that quarter. In recent periods, customers, including distributors of our consumer products, have tended to make a significant portion of their purchases towards the end of the quarter, in part because they are able, or believe that they are able, to negotiate lower prices and more favorable terms. This trend makes predicting revenues difficult. The timing of closing larger orders increases the risk of quarter-to-quarter fluctuation. If orders forecasted for a specific group of customers for a particular quarter are not realized or revenues are not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected.

35

Table of Contents

Weakness in the economy could decrease demand for our products or for our customers’ products, causing customers to decrease or cancel orders to us or to delay payment.

      Recently, economic conditions in the United States have resulted in decreased demand from end users for many companies’ products, including ours. Throughout 2001 and during 2002 through the date hereof, we have experienced decreased actual and anticipated demand for our retail digital video editing products and for our digital media reader/writers sold through the retail and OEM channels. Reductions in consumer spending impacts our OEM business as well as our retail business because our OEM customers may reduce or cancel orders for our products if their own visibility of future orders is compromised by decreased demand or if increased pricing pressures force them to reduce costs by ceasing to bundle our products along with their own. Decreased or lower than expected sales will most likely adversely affect our stock price. Also, reduced or canceled orders for our products could lead to decreased sales in a particular period and, because many of our products are custom made for particular customers, could also cause us to write off inventory. In some cases, customers could delay payment or be unable to pay for orders made to us, causing us to increase our allowance for doubtful accounts or to write off certain receivables. In addition, if we anticipate that demand for our products will not increase, we may decide to reduce our operating expense base in order to maintain or reach profitability. Decreased sales, expense base decreases or any write-offs, or any combination of these, could have a materially adverse affect on our operating results.

There are risks associated with our decision to separate our Digital Media and Video business and our Security business.

      On February 28, 2002, we announced our intention to create two distinct businesses within SCM, a Security business and a Digital Media and Video business. In addition, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. During the first quarter of 2002, we have initiated activities to create a separate legal entity around our Digital Media and Video business in preparation for its separation, which we expect will not be completed for several months. Our inability to properly implement the separation may adversely affect our revenues, results of operations and our stock price. Risks which could impact our ability to properly implement the separation include:

	•	the separation process and results thereof will occupy a significant portion of senior management time and effort and may distract management and employees from the operation of these businesses;
	•	the separation could be delayed or cancelled;
	•	our separation strategy could be perceived negatively by our customers or cause them to choose our competitors’ products instead of ours;
	•	implementation of the separation strategy could make it more difficult for us to retain employees and may otherwise adversely affect employee morale; and
	•	adverse market perception of the separation may cause our stock price to decline.

      Also, there is no assurance that we will effectively implement the separation in a timely manner or at all. This implementation requires management to make and effect several administrative and employment-related decisions efficiently. If we do not implement these decisions efficiently, our operating results could be adversely affected. Furthermore, there is no assurance that, if we do implement the separation efficiently and in a timely manner, we will realize the benefits we contemplate from the separation. If we do not realize these benefits, our operations could be adversely affected and our stock price could decline.

36

Table of Contents

Our listing on the Neuer Markt of the Frankfurt Stock Exchange exposes our stock price to additional risks of fluctuation.

      Our common stock experiences a significant volume of trading on the Neuer Markt of the Frankfurt Stock Exchange. Because of this, factors that would not otherwise affect a stock traded solely on Nasdaq may cause our stock price to fluctuate. Investors outside the United States may react differently and more negatively than investors in the United States to events such as acquisitions, one-time charges and lower than expected revenue or earnings announcements. Any negative reaction by investors in Europe to such events could cause our stock price to decrease. In addition, the European economy and market conditions in general, or downturns on the Neuer Markt specifically, regardless of the Nasdaq market conditions, could negatively impact our stock price.

Our stock price has been and is likely to remain volatile.

      The stock market has recently experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. During the 12-month period from March 19, 2001 to March 19, 2002, the reported sale prices for our common stock on the Nasdaq market ranged between $4.70 to $18.63 per share. Volatility in our stock price may result from a number of factors, including:

	•	variations in our or our competitors’ financial and/or operational results;
	•	the fluctuation in market value of comparable companies in any of our markets;
	•	comments and forecasts by securities analysts;
	•	expected or announced relationships with other companies;
	•	trading patterns of our stock on the Nasdaq Stock Market or the Neuer Markt of the Frankfurt Stock Exchange;
	•	any loss of key management;
	•	announcements of technological innovations or new products by us or our competition;
	•	developments related to our decision to organize our company around a Security business and a Digital Media and Video business and to separate our Digital Media and Video business and focus on our Security business as a core strategy;
	•	litigation developments; and
	•	general market downturns.

      In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

Sales of our products depend on the development of several emerging markets.

      We sell our products primarily to emerging markets that have not yet reached a stage of mass adoption or deployment. If demand for products in these markets does not develop and grow sufficiently, revenues and gross profit margins in either or both of our Security or our Digital Media and Video business could level off or decline. We cannot predict the future growth rate, if any, or size or composition of the market of our products in any of these markets. The demand and market acceptance for our products, as is common for new technologies, will be subject to high levels of uncertainty and risk and may be influenced by several factors, including general economic conditions.

      In our Security business, these factors also include the following:

	•	the slow pace and uncertainty of adoption in Europe of open systems platforms that require conditional access modules, such as ours, that use the DVB-CI standard;

37

Table of Contents

	•	the strength of entrenched security and set-top receiver suppliers in the United States who may resist the use of removable conditional access modules, such as ours, and prevent or delay opening the U.S. digital television market to greater competition; and
	•	the ability of financial institutions, corporate enterprises and the U.S. government to create and deploy smart card-based applications that will drive demand for smart card readers such as ours.

      In our Digital Media and Video business, demand for our products will also be influenced by the following:

	•	the ability of flash memory card manufacturers to develop higher capacity memory cards that will drive demand for digital media readers, such as ours, that enable rapid transfer of large amounts of data;
	•	the availability of low cost hardware and software OEM solutions to allow expansion in the PC OEM market; and
	•	increased consumer acceptance of DVDs, CDs and DVD players and readers.

If we are unable to develop and maintain the strategic relationships necessary to develop, sell and market products that are commercially viable and widely accepted, the growth and success of our business may be limited.

      If we are unable to anticipate market trends and the price, performance and functionality requirements for our products, we may not be able to develop and sell products that are commercially viable and widely accepted. We must collaborate closely with our customers, suppliers and other strategic partners to ensure that critical development, marketing and distribution projects proceed in a coordinated manner. Also, this collaboration is important because these relationships increase our exposure to information necessary to anticipate trends and plan product development. If any of our current relationships terminate or otherwise deteriorate, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, our product development and marketing efforts may be adversely affected.

      The markets for our Security and Digital Media and Video products are characterized by rapidly changing technology and the need to differentiate our products through technological enhancements. Our customers’ needs change and new products are introduced frequently. Product life cycles are short and industry standards are still evolving. These rapid changes in technology, or the adoption of new industry standards, could render our existing products obsolete and unmarketable. If one of our products is deemed to be obsolete or unmarketable, then we might have to reduce revenue expectations or write off inventories for that product. Our future success will depend upon our ability to enhance our current products and to develop and introduce new products on a timely basis that address the increasingly sophisticated needs of our customers and that keep pace with technological developments, new competitive product offerings and emerging industry standards. In addition, in cases where we are selected to supply products based on features or capabilities that are still under development, we must be able to complete our product design and delivery process in a timely basis, or risk losing current and any future business from our customers.

      For example, our SmartReady, SmartSecure, SmartTrust and SmartRetail product families are designed to provide smart card-based security for PCs. Smart cards are beginning to be widely deployed by financial institutions, the U.S. government, corporations and other large organizations, in some cases in advance of anticipated security-oriented applications. However, standards for smart card readers are still emerging. We may not be able to comply with emerging standards in a timely manner or at all. If we cannot meet the standards requirements of the market or our prospective customers, we would likely lose orders to competitors.

38

Table of Contents

      Because we operate in markets for which industry-wide standards have not yet been fully set, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines. If any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected.

Our markets are highly competitive, and our customers may purchase products from our competitors.

      The markets for our products are intensely competitive and characterized by rapidly changing technology. We believe that the principal competitive factors affecting the markets for our products include:

	•	the extent to which products support existing industry standards and provide interoperability;
	•	technical features;
	•	ease of use;
	•	quality and reliability;
	•	level of security;
	•	brand name, particularly in retail channels;
	•	strength of distribution channels; and
	•	price.

      We believe that competition in our markets is likely to intensify as a result of increasing demand for the type of products we offer. We currently experience competition from a number of companies. In our Security business, our competitors include:

	•	Advanced Card Systems, Gemplus, O2Micro and OmniKey in smart card readers, ASICs and universal smart card reader interfaces.

      In our Digital Media and Video business, our competitors include:

	•	Carry Computer Engineering, DataFab, Lexar, SanDisk, Simple Technology and SmartDisk for digital media readers; and
	•	ADS, Canopus, Pinnacle Systems, Roxio and ULead for digital video capture and editing products.

      We also experience indirect competition from some of our customers who sell alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these competitors and new competitors, such as Motorola, that develop digital content security products. In addition, the market for our products may ultimately include technological solutions other than ours and our competitors.

      Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products and may be able to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, new competitors, or alliances among competitors, may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share.

39

Table of Contents

Seasonal trends in sales of our products may affect our quarterly operating results.

      Our business and operating results normally reflect seasonal trends. We have typically experienced lower revenue and operating income in the first quarter and second quarter and higher revenue in the third quarter and fourth quarter of each calendar year. We believe that the seasonal trends in our business and operating results are primarily due to the retail selling cycles of our consumer-oriented products, including our Digital Media and Video products. Because the market for consumer products is stronger in the second half of the year, we generally expect that our sales to retail distributors and to consumer-oriented OEMs will increase during that period. However, because of the unpredictability of the U.S. economy, there is no assurance that this increase will occur in the second half of 2002. In addition, our sales are impacted by the buying patterns of the U.S. government, which is an important customer for our PC Security products. These patterns tend to be variable in terms of the timing and size of orders, which contributes to the variability of our results on a quarterly basis.

A significant portion of our sales comes from a small number of customers and the loss of one of more of these customers could negatively impact our operating results.

      Our products are generally targeted at OEM customers in the consumer electronics, computer, digital appliance, digital media and conditional access system industries, and to retail distributors. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. For example, sales to our top 10 customers accounted for approximately 42% of our total net revenue in 2001, with one customer, Aston, accounting for 11% of our net revenue. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant OEM or retail customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business or digital media and video business, could result in decreased revenues and/or inventory or receivables write-offs and otherwise harm our business and operating results.

We face risks related to our increased dependence on a retail distribution model for distribution of our Digital Media and Video products.

      Historically, we sold substantially all our products directly to OEM customers. Following our acquisitions of Dazzle Multimedia and Microtech, we now sell a significant percentage of our products through our retail channel. Direct retail distribution creates additional risks for us including:

	•	increased exposure to demand cycles caused as a result of seasonal or economic trends;
	•	generally lower margins for products due to, among other factors, greater price competition and increased promotional and distribution costs;
	•	the need to develop, and the related marketing expense of developing brand recognition for our Dazzle and Microtech branded products;
	•	the need to protect the reputation of our brands for quality and value; and
	•	the need to successfully and cost-effectively maintain current retail channels and develop new retail distribution channels for these products.

      We sell a substantial portion of our Digital Media and Video products through retailers, including Best Buy, CompUSA, Dixons/PC World, Fry’s Electronics, Office Depot, Staples, Sears, B&H Photo, The Good Guys, MicroCenter and CameraWorld.com. Our retail distributors may have limited capital to invest in inventory, and their decisions to purchase our products are partly a function of pricing, terms and special promotions offered by us and our competitors over which we have no control and which we cannot predict. We could lose market share if the retailers that carry our products do not grow as quickly as retailers that carry our competitors’ products. Also, the amount of our products that retailers purchase

40

Table of Contents

      We also sell our digital video products through distributors, including Ingram Micro, Northamber and Tech Data. Our distributor agreements are generally nonexclusive and may be terminated by either party without cause. If these agreements are terminated, we may not be able to find other distributors willing to purchase our digital video products. Certain distributors have experienced financial difficulties in the past. Distributors that account for significant sales of our consumer products may experience financial difficulties in the future, which could lead to reduced sales or write-offs.

      Because a large percentage of our Digital Media and Video sales are to a small number of customers that are primarily retailers or distributors, this can exert pressure on our revenues generated from these customers. As a result of this pricing pressure, we have reduced and may need to continue to reduce the prices of some of our Digital Media and Video products. Any reduction in prices will negatively impact our gross margins unless we are able to reduce our costs. Also, some customers are requesting that we sell our products to them on a consignment basis. If we agree to these arrangements, our inventory levels will increase, and this will increase our costs and the risk of inventory write-offs.

We have global operations, which require significant managerial and administrative resources.

      Operating in diverse geographic locations imposes significant burdens on our managerial resources. In particular, our management must:

	•	divert a significant amount of time and energy to manage employees and contractors from diverse cultural backgrounds and who speak different languages;
	•	manage different product lines for different markets;
	•	manage our supply and distribution channels across different countries and business practices; and
	•	coordinate these efforts to produce an integrated business effort, focus and vision.

      In addition, we are subject to the difficulties associated with operating in a number of time zones, which may subject us to additional unforeseen difficulties or logistical barriers. Operating in widespread geographic locations requires us to implement and operate complex information and operational systems. In the future we may have to exert managerial resources and implement new systems that may be costly. Any failure or delay in implementing needed systems, procedures and controls on a timely basis or in expanding current systems in an efficient manner could have a material adverse effect on our business and operating results.

Our key personnel are critical to our business, and such key personnel may not remain with us in the future.

      We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel leave and are not adequately replaced, our business would be adversely affected. We provide compensation incentives such as bonuses, benefits and option grants, which are typically subject to vesting over four years, to attract and retain qualified employees. In addition, certain of our executive officers are subject to one-year non-compete agreements. Non-compete agreements are, however, generally difficult to enforce. Employee retention may become more difficult because of the uncertainty associated with the separation of our Security and Digital Media and Video businesses. Even though we provide competitive compensation arrangements to our executive officers and other employees, we cannot be certain that we will be able to retain them, including those individuals that are subject to non-compete agreements.

41

Table of Contents

      We believe that our future success will depend in large part on our continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and we may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future.

Our OEM customers may develop technology similar to ours, resulting in a reduction in related customer purchases, canceled orders and direct competition from these customers.

      We sell our products to many OEMs who incorporate our products into their offerings or who resell our products in order to provide a more complete solution to their customers. If our OEM customers develop their own products to replace ours, this would result in a loss of sales to those customers as well as increased competition for our products in the marketplace. In addition, these OEM customers could cancel outstanding orders for our products, which could cause us to write down inventory already designated for those customers.

The rapid growth of our businesses may create significant burdens on our systems.

      Our business has grown substantially, with net revenue increasing from $23.6 million in 1995 to $184.9 million in 2001. We have expanded our Security business from solutions for the PC platform to include solutions for the digital television platform and have entered into the digital media and video markets. Managing businesses in each of these markets requires skilled management and substantial resources. To address our need for additional resources and because of various acquisitions, we have increased in size from 67 employees at December 31, 1995 to 521 as of December 31, 2001.

      Our business model contemplates continued revenue growth. If we do not manage this growth effectively, our stock price and financial condition could be materially and adversely affected. Our growth and our growth plans have placed and are likely to continue to place a significant burden on our operating and financial systems and increase responsibility for senior management and other personnel. Our existing management or any new members of management may not be able to improve our existing systems and controls or implement new systems and controls in response to our anticipated growth. In addition, our intention to reduce or re-deploy personnel to reduce expenses from time to time may limit our capacity to grow.

Any delays in our normally lengthy sales cycle could result in significant fluctuations in our quarterly operating results.

      Our initial sales cycle for a new OEM customer or retail distributor usually takes six to nine months. During this sales cycle, we may expend substantial financial resources and our management’s time and effort with no assurance that a sale will ultimately result. The length of a new customer’s sales cycle depends on a number of factors that we may not be able to control. These factors include the customer’s product and technical requirements and the level of competition we face for that customer’s business. Any delays in the sales cycle for new customers would limit our receipt of new revenue and might cause us to expend more resources to obtain new customer wins.

We face risks associated with our past and future acquisitions.

      A component of our business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. In 2000, we completed four acquisitions:

	•	Microtech in June 2000;
	•	2-Tel B.V. in September 2000;

42

Table of Contents

	•	Dazzle Multimedia in December 2000, by acquiring substantially all of the outstanding minority interest; and
	•	the Personal Video Division of FAST Multimedia in July 2000, an acquisition completed through Dazzle Multimedia.

      The integration of the business and operations of any past or future acquisition is a complex, time consuming and expensive process. In order to successfully integrate any acquisition, we must, among other things, successfully:

	•	attract and retain key management and other personnel;
	•	integrate, both from an engineering and a sales and marketing perspective, the acquired products into our product offerings;
	•	coordinate research and development efforts;
	•	integrate sales forces;
	•	consolidate duplicate facilities; and
	•	cost effectively manage our combined business.

      Past and future acquisitions may disrupt ongoing operations, divert management from day-to-day business and adversely impact our results of operations. In addition, these types of transactions often result in charges to earnings for such things as transaction expenses, amortization of goodwill, or expensing of in-process research and development. Our available cash and our securities may be used to buy or invest in companies or products, which could result in significant acquisition-related charges to earnings and dilution to our stockholders. Moreover, if we buy a company, we may have to incur or assume that company’s liabilities, including liabilities that are unknown at the time of acquisition. We may be unable to complete any given acquisitions, which may limit the growth of our future revenues.

      During the fourth quarter of 2001, the Company evaluated its intangible assets for possible impairment by examining a number of factors including the current economic conditions and markets of past acquisitions and their products, as well as the Company’s best estimates for future revenues, cost of goods sold and operating costs related to those products. An independent valuation firm was used to assess the current value of these intangible assets given the information available. Based on the independent valuation firm’s finding, the Company determined that the intangible assets from a number of past acquisitions were impaired. The Company recorded a $36.1 million impairment charge in 2001 in order to adjust intangible assets to their estimated fair value as of December 31, 2001.

Our business is subject to risks related to our international sales.

      We were originally a German corporation, and we continue to conduct a substantial portion of our business in Europe. Approximately 58%, 48% and 52% of our revenues for the years ended December 31, 2001, 2000 and 1999, respectively, were derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, including:

	•	foreign currency exchange rate change, especially since we do not currently engage in hedging activities with respect to our foreign currency exposure;
	•	tariffs and other trade barriers, including import and export restrictions;
	•	potential adverse tax consequences;
	•	political or economic instability;
	•	compliance with foreign laws;

43

Table of Contents

	•	difficulties in protecting intellectual property rights in foreign countries; and
	•	transportation delays and interruptions.

We could lose money and our stock price could decrease as a result of write downs of our strategic investments.