SCM MICROSYSTEMS INC - 10-Q Quarterly Report

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 accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the consolidated financial statements and footnotes thereto included in the SCM Microsystems’ (“SCM”) Annual Report on Form 10-K for the fiscal year ended December 31, 2001.

Reclassifications — Certain reclassifications have been made to the 2001 financial statement presentation to conform to the 2002 financial statement presentation.

During each quarter, the Company evaluates our investments for possible asset impairment by examining a number of factors including the current economic conditions and markets for each investment, as well as their cash position and anticipated cash needs for the short and long term. 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, SCM determined that our investments in SmartDisk Corporation, Spyrus Inc. and Satup Databroadcasting AG 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 of 2001. In the fourth quarter of 2001, we wrote off our remaining balances for Spyrus, Satup Databroadcasting AG 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. As of June 30, 2002, SCM’s ownership of all outstanding shares of Spyrus was approximately 13.4%. SCM’s ownership in Satup as of June 30, 2002, was approximately 10%.

SCM adopted Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), Goodwill and Other Intangible Assets, as of January 1, 2002. As defined by SFAS No. 142, the Company identified two reporting units which constitute components of SCM’s business that included goodwill. As of January 1, 2002, the fair value of these two reporting units was assessed and compared to the respective carrying amounts. Upon completion of the transitional impairment test, the fair value for each of the Company’s reporting units approximated or exceeded the reporting unit’s carrying amount and no impairment was indicated.

In accordance with SFAS No. 142, only SCM’s intangible assets relating to core technology, customer relations and non-compete agreements are subject to amortization. Assembled workforce was recorded as goodwill as of January 1, 2002.

The changes in the carrying amount of goodwill for the six months ended June 30, 2002 are as follows:

Amortization of goodwill and intangibles in the first six months of fiscal 2002 was $0.6 million compared with $7.4 million for the same period of 2001.

Had the provisions of SFAS No. 142 been applied for the three months ended and six months ended June 30, 2002 and 2001, the Company’s net income (loss) and net income (loss) per share would have been as follows (in thousands, except per share amounts):

During 2001, SCM incurred restructuring charges of approximately $5.2 million primarily relating to legal settlement costs and expenses resulting from the consolidation of operations in various facilities. In the first and second quarter of 2002, SCM incurred separation and restructuring charges of approximately $0.8 million and $1.5 million, respectively, primarily due to costs incurred in preparation of the anticipated separation of our Digital Media and Video division and employee severance costs. The following summarizes the expenses related to these activities during 2001 and the first six months of 2002 (in thousands):

The severance and other costs for the year ended December 31, 2001 primarily related to the reduction in force of approximately 81 employees. Approximately 20 of these employees were from Operations, 40 were from Sales and Marketing, 13 were from Research and Development and 8 were from General and Administrative functions. Approximately 44 were in the U.S., 19 were in Asia and 18 were in Europe.

The severance and other costs for the quarter ended March 31, 2002 primarily related to legal and consulting costs of $0.4 million for the anticipated separation of our Digital Media and Video division, $0.3 million for severance and related costs and $0.1 million for an asset impairment. The severance and other costs for the quarter ended June 30, 2002 primarily related to legal and consulting costs of $1.4 million for the anticipated separation of our Digital Media and Video division and $0.1 million for severance and related costs. The severance costs for both periods related to the termination of 29 employees, of which 15 were in the United States, 9 were in Europe and 5 were in Asia. Approximately 19 employees were from Sales and Marketing, 5 were from Operations, 3 were from Research and Development and 2 were from General and Administrative functions.

In June 2002, the Financial Accounting Standard Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities and supercedes Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. This statement also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002 and the adoption will not have an impact on the historical results of operations or cashflows.

In August 2001, the FASB 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. The Company early adopted SFAS No. 144 in the fourth quarter of 2001. The adoption of SFAS No. 144 did not have a material effect on the Company’s financial position, results of operations or cash flows.

In June 2001, the FASB issued SFAS No. 141, “Business Combinations,” and SFAS No. 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 for 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. SCM adopted SFAS No. 142 on January 1, 2002 and stopped amortizing goodwill and certain other intangibles that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles in fiscal 2002 for acquisitions made before June 30, 2001 is expected to be

approximately $1.6 million. Intangible assets of approximately $0.9 million were reclassed to goodwill and amortization ceased effective January 1, 2002.

SCM acquired a majority of the shares of Dazzle Multimedia, Inc. (Dazzle) between June 1999 and December 2000. In the first quarter of 2001, SCM acquired an additional 2.8% of the outstanding share capital of Dazzle Multimedia, Inc., a consolidated subsidiary, for approximately $2.4 million. The $2.4 million increased intangible assets by $2.3 million, and $0.1 million was expensed in the first quarter of 2001 for Dazzle’s research and development efforts that had not reached technological feasibility and had no future uses.

On May 22, 2002, SCM paid $4.5 million in cash to the shareholders of Towitoko AG, a leading supplier of smart card-based security solutions for home banking and private PC access in the German-speaking market for 100% of the outstanding stock of Towitoko AG. In addition, SCM will pay up to an additional $0.5 million in cash if certain financial performance criteria are met by the end of fiscal 2002. Towitoko AG is a private company based in Munich. The acquisition has been accounted for under the purchase method of accounting and the results of operations were included in SCM’s results of operations since the date of the acquisition. In connection with the acquisition, SCM incurred acquisition costs of approximately $0.1 million.

A preliminary valuation of the intangible assets related to the acquisition was completed by management in July of 2002. Management expects to finalize the allocation based on current information during the third quarter of 2002. A summary of the allocation of the purchase price is as follows (in thousands):

Intangible assets and goodwill from the acquisition approximated $3.3 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The non-compete agreements are being amortized on a straight-line basis over the term of the agreements of two years. The trade name and goodwill are considered to have indefinite useful lives. All other intangible assets are being amortized on a straight-line basis over an estimated useful life of five years. The goodwill from this acquisition is not deductible for tax purposes.

Proforma results of operations, to reflect the acquisition as if it had occurred on the first date of all periods presented, would not be significantly different than SCM’s results of operations as stated.

SCM adopted the provisions of Statement of Financial Accounting Standards No. 131 (“SFAS No. 131”), “Disclosures about Segments of an Enterprise and Related Information,” in 1998. SFAS No. 131 establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The method for determining what information to report is based on the way that management organizes the operating segments within SCM for making operating decisions and assessing financial performance. Our chief operating decision maker is considered to be our executive staff, consisting of the Chief Executive Officer and Chief Financial Officer.

Prior to January 1, 2002, management had aligned our organization along three business segments: Digital TV and Video, Digital Media and PC Security. Beginning in 2002 and going forward, we have structured 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 executive staff reviewed financial information and business performance along these two product segments in the first two quarters of 2002. We evaluate the performance of our business segments at the revenue and gross margin level. We do not include intercompany transfers between segments for management purposes. Segment information for the first two quarters of 2001 has been restated to reflect the new business segments.

Summary information by segment for the three and six months ended June 30, 2002 and 2001, is as follows (in thousands):

Geographic revenues are based on the country where the customers are located. Information regarding revenues by geographic region for the three-and six-month periods ended June 30, 2002 and 2001 are as follows (in thousands):

One customer represented 12% and 14% of SCM’s total revenue for the second quarter of 2002 and the first six months of 2002, respectively. No customers exceeded 10% of total net revenue for the three- and six-months ended June 30, 2001.

This Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q, the words “will”, “believe”, “anticipate”, “estimate”, “expect” 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 Quarterly Report on Form 10-Q. 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 Quarterly Report on Form 10-Q 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 “Factors That May Affect Future Operating Results”. These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.

The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto set forth in Item 1 of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that could affect our business, including the disclosures under Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors and the audited financial statements and notes thereto contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 26, 2002.

SCM Microsystems designs, develops and sells hardware, software and silicon that enable 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 have structured 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. 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.

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 consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgements, including those related to product returns, customer incentives, allowance for doubtful accounts, inventories, asset impairment, realization of deferred tax assets, accrued warranty reserves, restructuring costs, and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form

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 revenues from product sales 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. Product sold to 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 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, SCM may make additional allowances as necessary.

	•	SCM writes down 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.

	•	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 assessing the recoverability of our 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. On January 1, 2002, SCM adopted SFAS No. 142, “Goodwill and Other Intangibles Assets,” and is required to analyze our goodwill and intangible assets for impairment on a periodic basis. As a result of our 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. 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.

In June 2002, the Financial Accounting Standard Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. This statement also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002, and the adoption will not have an impact on the historical results of operations, financial position or liquidity of the Company.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment of Long Lived Assets.” SFAS No. 144 supersedes 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 FASB issued SFAS No. 141, “Business Combinations,” and SFAS No. 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 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 is expected to be approximately $1.6 million. Intangible assets of approximately $0.9 million were reclassed to goodwill and amortization ceased effective January 1, 2002.

market for 100% of the outstanding stock of Towitoko AG. In addition, SCM could pay an additional $0.5 million in cash if certain financial performance criteria are met by the end of fiscal 2002. Towitoko AG is a private company based in Munich. The acquisition has been accounted for under the purchase method of accounting and the results of operations were included in SCM’s results of operations since the date of the acquisition. In connection with the acquisition, SCM incurred acquisition costs of approximately $0.1 million.

Based on SCM management’s preliminary assessment of value, intangible assets and goodwill from the acquisition approximated $3.3 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. Non-compete agreements, entered into in connection with the acquisition, are being amortized on a straight-line basis over the term of the agreements of two years. The trade name and goodwill are considered to have indefinite useful lives. All other intangible assets are being amortized on a straight-line basis over an estimated useful life of five years.

At the time of the acquisition, Towitoko had no significant research and development projects that were incomplete. Instead, Towitoko, was focused on maintaining its current products that were separated into three product groupings based on their similarities and the markets they targeted. Those groupings were Project Solutions, which consisted of several hardware products that utilized significantly the same software aimed at large customers and original equipment manufacturers; Retail Solutions using several hardware products with software aimed at the retail market; and Business Solutions, which included several related software solutions. The Retail Solutions and Business Solutions products will continue to be sold into Towitoko’s and now SCM’s distribution channels. The hardware in the Project Solutions grouping will be phased out over the next year and will be replaced with SCM’s existing hardware utilizing Towitoko’s software.

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 quarter ended June 30, 2002 was $45.0 million, down 3% compared to $46.6 million for the same quarter of 2001. The decrease in revenue in the second quarter of 2002 compared with the same quarter in 2001 was due primarily to lower revenue from our Security division of $2.1 million, partially offset by an increase in revenue from our Digital Media and Video division of $0.5 million. Revenue within our Security division was lower in the second quarter of 2002 versus the same quarter of the previous year due to a reduction in shipments of our conditional access modules for the European digital television market, partially offset by an increase in shipments of our smart card readers to the U.S. Government. The increase in Digital Media and Video revenue was due to increased sales of our digital media reader products. For the first six months of 2002, net revenue was $88.4 million, compared to $91.7 million for the same period of 2001, a decrease of 4%. The decrease in revenue in the first six months of 2002 compared with the same period in 2001 was due primarily to a decrease in sales of our Digital Media and Video products of $4.9 million, partially offset by an increase in sales of our Security products of $1.6 million. The decrease in sales of our Digital Media and Video products was primarily due to a slowdown in demand for these consumer related products beginning in the second quarter of 2001. The increase in sales of our Security products was primarily due to increased demand for our PC Security related products from our original equipment manufacturing (OEM) customers. Sales to SCM’s top 10 customers accounted for 52% and 39% of total net revenue in the first six months of 2002 and 2001, respectively.

Gross Profit. Gross profit for the second quarter of 2002 was $15.0 million, or 33.3% of total net revenue, compared to $15.2 million, or 32.6%, for the second quarter of 2001. Gross profit in the first six months of 2002 was $29.6 million, or 33.5% of revenue, compared to gross profit of $19.4 million, or 21.2% of revenue for the first six months of 2001. The increase in gross profit as a percentage of revenue for the second quarter of 2002 as compared to the same period in 2001 was primarily due to lower manufacturing costs and other costs of goods sold. In the six-month period, higher gross profit levels in 2002 compared with 2001 were primarily due to a $10.0 million increase in inventory reserves taken in the first quarter of 2001 for our St@rKey PC satellite receiver as well as for our digital media reader products and related components. Our St@rKey product was designed to receive MPEG 1 video over satellite, but changing market requirements

prompted us to attempt to rework the product to receive MPEG 2 video. During the first quarter of 2001, we determined that St@rKey was not technically feasible to manage MPEG 2 in its current form, and therefore took a related inventory charge. We also increased inventory reserves in the first quarter of 2001 for our digital media readers, many of which are custom built for individual customers, after experiencing cancellations of some orders and reducing our expectations for future sales of these products due to generally weaker economic conditions. Excluding the inventory reserve increase, gross profit for the first six months of 2001 would have been 32%. Our gross profit has been and will continue to be affected by a variety of factors, including additional future inventory charges, 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 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. 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 the second quarter of 2002, research and development expenses were $3.1 million, or 7% of revenues, a decrease of 10% compared with $3.4 million, or 7% of revenues, in the second quarter of 2001. For the first six months of 2002, research and development expenses were $5.9 million, or 7% of revenues, a decrease of 15% compared with $7.0 million, or 8% of revenues, in the first six months of 2001. The decrease in absolute amounts between the two six-month periods was primarily due to decreased prototype expenses of $0.2 million and decreased personnel costs of $0.9 million, reflecting our continued strategic movement of engineering activities from high-cost regions such as Silicon Valley and Munich to our lower cost locations, such as India. Research and development costs as a percentage of net revenue are expected to fluctuate from period to period.

Selling and Marketing. Selling and marketing expenses consist primarily of employee compensation and advertising and other marketing costs. Selling and marketing expenses for the second quarter of 2002 were $7.0 million, or 16% of net revenues, an increase of 2% compared with $6.9 million or 15% of net revenues, in the second quarter of 2001. For the first six months of 2002, selling and marketing expenses were $13.5 million, or 15% of revenues, down 14% compared with $15.7 million, or 17% of revenues, in the same period of 2001. For the six-month period, selling and marketing expenses were lower in 2002 than in 2001 because of decreases in the U.S. and Europe, primarily in the areas of marketing program costs of $1.4 million, personnel related expenses of $0.6 million, and office administrative costs of $0.2 million.

General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing SCM’s administrative functions, professional fees such as legal, audit, tax and consulting fees, and changes to allowances for doubtful accounts receivable. In the second quarter of 2002, general and administrative expenses were $3.1 million, or 7% of revenues, a decrease of 36% compared with $4.9 million, or 10% of revenues, in the second quarter of 2001. For the first six months of 2002, general and administrative expenses were $7.3 million, or 8% of revenues, down 33% compared with $10.8 million, or 12% of revenues for the first six months of 2001. This decrease in absolute amounts for the three- and six-month periods of 2002 compared with the same periods in 2001 was primarily due to overall savings from restructuring activities executed during the second half of 2001 and first half of 2002, as well as a decrease in expense for allowances of doubtful accounts receivable of $1.6 million. We expect that general and administrative costs will fluctuate as a percentage of total net revenue.

Amortization of Goodwill and Intangibles. Amortization of goodwill and intangibles in the second quarter of 2002 was $0.3 million compared with $3.7 million for the same period of 2001. For the first six months of 2002, amortization of goodwill and intangibles was $0.6 million compared with $7.4 million for the first six months of 2001. Amortization of goodwill and intangibles was lower in the first six months of 2002 because the previous year period included amortization of goodwill that has since been written down. As the Company implemented SFAS No. 142 as of January 1, 2002, goodwill is no longer amortized. During the second quarter of 2002 gross goodwill and intangibles increased by $3.3 million due to the acquisition of

In-Process Research and Development. In-process research and development costs of $0.1 million in the first quarter of 2001 were written off for development efforts that had not yet reached technological feasibility at the time of our residual 2.8% acquisition of Dazzle’s share capital. These development efforts had no alternative future uses as of this acquisition date.

Separation Costs and Restructuring Charges. During the second quarter of 2002, SCM incurred separation and restructuring charges of $1.5 million. These expenses were primarily related to legal and consulting costs of $0.6, investment banking fees of $0.8 million, severance and related costs of $0.2 million. During the second quarter of 2001, SCM incurred one-time and restructuring charges of $3.6 million primarily related to legal settlement costs and expenses related to the consolidation of operations at various facilities. For the first six months of 2002 separation and restructuring charges were $2.3 million. These expenses primarily related to legal and consulting costs of $1.0 million, investment banking fees of $0.8 million, severance and related costs of $0.4 million and an asset impairment of $0.1 million.

Loss from Investments. From time to time, we make strategic investments in both private and public companies. During each quarter, we evaluate our investments for possible asset impairment. We examine a number of factors, including the current economic conditions and markets for each investment, as well as its cash position and anticipated cash needs for the short and long term. During the first quarter of 2001, because of the persistent deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties involved in obtaining additional funding, SCM determined that our investments in SmartDisk and Spyrus had been permanently impaired. Accordingly, 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 of 2001.

Interest and Other Income (Expense), Net. Interest and other income (expense), net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt and foreign currency gains or losses. For the second quarter of 2002, interest income and other, net, was a net gain of $0.01 million, consisting of net interest income of $0.41 million and a foreign exchange loss of $0.4 million. For the second quarter of 2001, we recorded a net gain of $1.1 million, resulting from net interest income of $0.6 million and a foreign exchange gain of $0.5 million. For the first six months of 2002, interest income and other, net, was a net expense of $163,000, resulting from net interest income of $680,000 and a foreign exchange loss of $843,000 million. For the first six months of 2001, interest income and other, net, was a net gain of $1.0 million, consisting of net interest income of $1.3 million offset by a foreign exchange loss of $0.3 million. The year over year decrease in interest and other, net in the second quarter of 2002 was primarily the result of lower market interest rates and unfavorable exchange rate movements. Net foreign currency loss for the second quarter of 2002 was $0.4 million compared to a gain of $0.5 million for the second quarter of 2001. The foreign exchange loss in the second quarter of 2002 was primarily due to unfavorable rate changes for the Singapore dollar ($1.8 million) and the British pound ($0.2 million) offset by favorable rate changes for the Euro ($1.1 million) and Japanese Yen ($0.5 million) compared to the United States dollar.

Benefit for Income Taxes. The benefit for income taxes for the second quarter of 2002 was $0.3 million compared to $0.9 million for the same period of 2001. The benefit for income taxes in the first six months of 2002 was $0.5 million compared to $6.0 million in the first six months of 2001. This effective benefit resulted principally from net losses in the United States, which were partially offset by taxable income generated in other tax jurisdictions. The effective tax benefit was further impacted by expenses not deductible for tax purposes primarily consisting of the amortization of goodwill and intangibles.

Minority interest. The minority interest in earnings reflects the proportional profits or losses that are attributable to the minority shareholder in an SCM subsidiary.

As of June 30, 2002, our working capital was $103.5 million, compared to working capital of $101.4 million as of December 31, 2001.

Cash, cash equivalents and short term investments for the six months ended June 30, 2002 increased by $0.8 million. Cash and cash equivalents for the six months ended June 30, 2002 decreased by $3.0 million primarily due to uses of cash from investing activities of $8.3 million being partially offset by cash provided from operations of $3.1 million, proceeds from the issuance of equity of $0.9 million and a favorable effect of exchange rates of $1.2 million. Cash provided by operations of $3.1 million was primarily due to net income of $0.4 million, the adding back of depreciation and amortization of $1.7 million and the amortization of deferred stock compensation of $0.2 million, a decrease in accounts receivable of $5.5 million, and a decrease in other assets of $0.8 million. These were only partially offset by an increase in deferred income taxes of $0.3 million, an increase in inventory of $3.4 million, a decrease in accounts payable of $1.3 million and a decrease in accrued expenses of $0.5 million. Cash used in investing activities was primarily for capital expenditures of $0.3 million, the purchase of Towitoko net of cash received of $4.1 million and the net purchase of short-term investments of $3.8 million.

The Company 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 June 30, 2002). The German line has no expiration date and bears interest at 7%. Borrowings under this line of credit are unsecured. The Company has an unsecured line of credit in France of 0.3 million Euro (approximately $0.3 million as of June 30, 2002), which bears interest at 4.76% and has no expiration date. In addition, the Company has a Singapore $1.2 million (approximately $0.7 million as of June 30, 2002) 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 6.5%. There were no amounts outstanding under any of these credit facilities as of June 30, 2002 and December 31, 2001.

We believe that our current capital resources and available borrowings will be sufficient to meet our operating and capital requirements through at least the next twelve months. We may, however, seek additional debt or equity financing prior to that time. We cannot assure you 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.

You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing our company. 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 adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment.

We have a history of losses with an accumulated deficit of $74.0 million as of June 30, 2002. Although we were profitable for the first and second quarters of 2002 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 maintain profitability.

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 the retail channel;

	•	the timing and amount of orders we receive from our customers that, in the case of our consumer products, products sold to the U.S. government and products sold to broadcasters, may be tied to seasonal demand, budgetary cycles or equipment roll-out schedules, respectively;

	•	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 selling 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 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.

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 revenue is not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected.

Over the past several quarters, economic conditions in the United States have resulted in decreased demand and constrained growth in demand from end users for many companies’ products, including ours. Throughout 2001 and during 2002 through the date hereof, we have experienced decreased demand as well as

decreased growth in demand for our retail digital video editing products and for our digital media reader/writers sold through the retail and OEM channels. Actual reductions or a constrained rate of growth 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.

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 half of 2002, we restructured our internal organization in order to independently manage our Security business and our Digital Media and Video business. We have continued to evaluate various options to separate the Digital Media and Video business, including trade sale or spin-off, in order to determine which will maximize value for our stockholders. Recent extreme volatility in the capital markets has made it difficult to predict the timing and success of any of these options. If the capital markets do not stabilize, we may not be able to successfully create a public market for the Digital Media and Video business, and potential acquirers may be unable or unwilling to purchase the business.

If we were unable to properly implement the separation, our revenues, results of operations and our stock price could be adversely affected. Risks related to our separation strategy include:


	•	the separation process and results thereof will occupy a significant portion of senior management time and effort and could distract management and employees from the operation of our 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 could otherwise adversely affect employee morale; and

	•	adverse market perception of the separation could 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.

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.

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 July 30, 2001 to July 30, 2002, the reported sale prices for our common stock on the Nasdaq market ranged between $4.70 and $17.23 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 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.

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 businesses 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.


	•	the slow pace and uncertainty of adoption in Europe of open systems platforms that require conditional access modules, such as ours, that use the Digital Video Broadcasting-Common Interface standard;

	•	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 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.

Furthermore, a number of our Digital Media and Video products incorporate technology developed by strategic third party technology providers. Reliance on these third parties exposes us to a number of risks:


	•	these technology providers often may have limited financial resources and operating histories;

	•	we may be unable to adequately control or influence the technology development and engineering process and must rely on these providers to timely deliver properly working technology meeting our specifications;

	•	our customers may prefer that we develop and own all our technology;

	•	we may acquire the technology only on a non-exclusive basis; and

	•	we must rely on the third party to protect their technology rights and ensure that they do not infringe the rights of others.

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

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.

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.


	•	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 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.

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 current 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.

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 fiscal 2001, with one customer, Aston-France S.A.R.L., accounting for 11% of our net revenue. For the first half of 2002, sales to our top 10 customers accounted for approximately 52% of our total net revenue, with Aston-France S.A.R.L. accounting for 14% 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 revenue and/or inventory or receivables write-offs and otherwise harm our business and operating results.

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-branded products;

	•	the need to protect the reputation of our brand 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, MicroCenter and CameraWorld.com. These retailers 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 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. If retailers choose not to purchase our products or choose to purchase less than we expect, our sales will decrease or not grow at the rate we expect.

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 revenue 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.

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.

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.

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.

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.

Our business has grown substantially, with net revenue increasing from $23.6 million in 1995 to $184.9 million in 2001. Net revenue was $88.4 million for the first half of 2002. 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. Recently, we have further reorganized into two distinct, internal, business divisions, with mostly separate management teams, to better address the demands of these different markets. This reorganization is a strategic step in our plan to eventually separate our core Security business from our Digital, Media and Video business. 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. As of June 30, 2002, we had 523 employees.

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.

Our initial sales cycle for a new OEM customer or retailer 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.

In the second quarter of 2002, we acquired Towitoko AG, a leading supplier of smart card-based security solutions for home banking and private PC access in the German-speaking market. We may buy or make investments in additional complementary companies, products and technologies. Any acquisition could expose us to significant risks.

A potential investment is likely to result in the use of our limited cash balances or require that we issue debt or equity securities to fund the acquisition. Future equity financings would be dilutive to the existing holders of our common stock. Our ability to use future equity financings to fund acquisitions may be limited by certain tax rules and we may be required to use debt financing instead. Future debt financings could involve restrictive covenants, and we may be unable to obtain debt financing on favorable terms or at all.


	Integration of an acquired company or technology is frequently a complex, time consuming and expensive process. The successful integration of an acquisition requires, among other things, that we:


	•	integrate and retain key management, sales and other personnel;

	•	integrate the acquired products into our product offerings both from an engineering and sales and marketing perspective;

	•	integrate and support pre-existing supplier, distribution and customer relationships;

	•	coordinate research and development efforts; and

	•	consolidate duplicate facilities and functions.

The geographic distance between the companies, the complexity of the technologies and operations being integrated, and the disparate corporate cultures being combined may increase the difficulties of integrating an acquired company or technology. Management’s focus on the integration of operations may distract attention from our day-to-day business and may disrupt key research and development, marketing or sales efforts. In addition, it is common in the technology industry for aggressive competitors to attract customers and recruit key employees away from companies during the integration phase of an acquisition.


	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 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. Approximately 49% of our revenues for the quarter ended June 30, 2002 was 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 revenue. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, including:


	•	changes in foreign currency exchange rates;

	•	changes in a specific country’s or region’s political or economic condition and stability, particularly in emerging markets;

	•	unexpected changes in foreign laws and regulatory requirements;

	•	trade protection measures and import or export licensing requirements;

	•	potentially adverse tax consequences;

	•	longer accounts receivable collection cycles;

	•	difficulty in managing widespread sales and manufacturing operations; and

	•	less effective protection of intellectual property.

We have made strategic minority investments in private and public companies and in the future we may make additional strategic minority investments. Our strategic investments involve a number of risks and we have written down a number of these investments in 2001, including SmartDisk, Spyrus and Satup. We may not realize the expected benefits of these transactions and we may lose all or a portion of our investment, particularly in the case of our private investments. If we were to lose these investments or if the investments were determined to be impaired, we would be forced to write off all or a portion of these investments, which would have a negative impact on our earnings in any given quarter.

Highly complex products such as our Digital Media and Video hardware and software products may contain defects for many reasons, including defective design or defective material. Often, these defects are not detected until after the products have been shipped. If any of our products contain defects or have reliability, quality or compatibility problems, our reputation might be damaged significantly, we could lose or experience a delay in market acceptance of the affected product or products, and we might be unable to retain existing customers or attract new customers. In addition, these defects could interrupt or delay sales. We may have to invest significant capital, technical, managerial and other resources to correct potential problems and potentially divert these resources from other development efforts. If we fail to provide solutions to potential problems, we could also incur product recall, repair or replacement costs. These potential problems might also result in claims against us by our customers or others.

In addition, customers of our Security business rely on our token-based security products to prevent unauthorized access to their digital information. A malfunction of or design defect in our products could result in legal or warranty claims. Although we place warranty disclaimers and liability limitation clauses in our sales agreements and maintain product liability insurance, these measures may be ineffective in limiting our liability. Liability for damages resulting from security breaches could be substantial and the adverse publicity associated with this liability could adversely affect our reputation. These costs could have a material adverse effect on our business and operating results. In addition, a well-publicized security breach involving token-based and other security systems could adversely affect the market’s perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. In that event, the demand for our products could decline, which would cause our business and operating results to suffer.

Most of our products are manufactured outside the United States because we believe that global sourcing enables us to achieve greater economies of scale, improve gross margins and maintain uniform quality standards for our products. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative sources would materially and adversely affect our business and operating results. In an effort to reduce our manufacturing costs, we have shifted volume production of many of our Security Division product components to our wholly owned subsidiary in Singapore, SCM Microsystems (Asia) Pte. Ltd. More recently we have transferred our Digital Media and Video product production from Singapore to independent contract manufacturers in Asia in preparation for the separation of these two businesses. Foreign manufacturing poses a number of risks, including:


	•	transportation delays and interruptions;

	•	difficulties in staffing;

	•	currency fluctuations;

	•	potentially adverse tax consequences;


	•	unexpected changes in regulatory requirements;

	•	tariffs and other trade barriers; and

	•	political and economic instability.

If we or any of our contract manufacturers cannot meet our production requirements, we may have to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. Despite efforts to do so, we may be unable to identify or qualify new contract manufacturers in a timely manner and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements.

We design and manufacture new products and technologies to address emerging markets that are early in their life cycles. In many cases, our products are the first of their kind to address the evolving business requirements of our customers. While we perform initial beta testing on all our products, in certain cases we are unable to test the efficacy of the design or functionality of our products for mass production. If we are successful in securing large contracts for our products, we cannot be certain that we will be able to produce them in sufficient quantities and that they will meet customer specifications.

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. These delays could have a material adverse effect on our business and operating results and could also damage relationships with current and prospective customers.

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. Our software, documentation and other written materials are protected 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.

Our SmartOS and SmartReady trademarks are registered in the United States, and 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 U.S. 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 or 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. 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. Because many of our products are sold and a portion of our business is conducted overseas, primarily in Europe, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate.

We have from time to time received claims that we are infringing upon third parties’ intellectual property rights. For example, the Massachusetts Institute of Technology and Electronics for Imaging, Inc. have sued us for patent infringement. See “Part II, Item 1. Legal Proceedings.”

We expect the likelihood of infringement claims to increase as the number of products and competitors in our markets grows and as we increasingly incorporate third party technology into our products. Any claims or litigation may be time-consuming and costly, cause product shipment delays, or require us to redesign our products. Furthermore, as a result of these claims, we could be required to license intellectual property from a third party. These licenses may not be offered when we need them or on acceptable terms. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments or we may be required to license some of our intellectual property to others in return for such licenses. In addition, if we are unable to obtain a license that is necessary for us to manufacture our allegedly infringing products, we could be required to suspend the manufacture of products or stop our suppliers from using processes that may infringe the rights of third parties. We may be unsuccessful in redesigning our products or in obtaining the necessary licenses under reasonable terms or at all.

Our suppliers and customers may also receive infringement claims based on intellectual property included in our products. We have historically agreed to indemnify suppliers and customers for alleged patent infringement. The scope of this indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney’s fees. In the fourth quarter of 2000, we incurred a $3.8 million charge related to a customer’s alleged infringement of a third party’s patent rights. Although it was unclear that our technology violated any patent or other right or that we were obligated to do so, we elected to indemnify the customer to preserve the customer relationship. We may periodically engage in litigation as a result of these indemnification obligations. Our insurance policies exclude coverage for third party claims for patent infringement.

Although our contractual obligations to accept returned products from our retail, distributor and OEM customers are limited, if consumer demand is less than anticipated these customers may ask that we accept returned products. We may determine that it is in our best interest to accept returns in order to maintain good relations. While we have experienced some product returns to date, returns may increase more than present levels in the future.

We believe that brand recognition will be important to our success, particularly the recognizability of our Dazzle brand. We plan to continue to market this brand to increase awareness. If we fail to promote our brand successfully or if our marketing expenses are too large, our business may not grow as we anticipate. The ability of competitors to increase the recognition and acceptance of their brands may affect the relative value of our brand. Also, if our products perform poorly or have other problems, the value of our brand will decrease.

In connection with our previous acquisitions accounted for under the purchase method of accounting, in future periods we may experience significant charges related to the amortization of certain intangible assets. In addition, if we later determine that our intangible assets or goodwill are impaired, we will be required to take a related non-recurring charge to earnings. For example, in 2001 we recorded an asset impairment of approximately $36.1 million based on management’s findings that intangible assets and goodwill from previous acquisitions were impaired.

We face a number of potential business interruption risks that are beyond our control. In recent periods, the State of California experienced intermittent power shortages and interruptions of service to some business customers. Additionally, we may experience natural disasters that could interrupt our business. Our corporate headquarters are located near a major earthquake fault. The potential impact of a major earthquake on our facilities, infrastructure and overall operations is not known. An earthquake could seriously disturb our entire business process.

Item 3. Quantitative and Qualitative Disclosure about Market Risk Foreign Currencies

SCM Microsystems transacts business in various foreign currencies, primarily in certain European countries, the United Kingdom, Singapore and Japan. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to yen-denominated sales in Japan and local currency denominated operating expenses in the UK, Europe and Singapore, where we sell in both local currencies and U.S. dollars. We currently do not use financial instruments to hedge local currency activity at any of our foreign locations. Instead, we believe that a natural hedge exists, in that local currency revenues substantially offset the local currency denominated operating expenses. We assess the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis.

Our foreign currency transactions gains and losses are primarily the result of the revaluation of intercompany receivables/payables (denominated in U.S. dollars) and trade receivables (denominated in a currency other than the functional currency) to the functional currency of the subsidiary.

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments for speculative or trading purposes. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy. The policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. We do not expect any material loss with respect to our investment portfolio.

We do not use derivative financial instruments in our investment portfolio to manage interest rate risk. We do, however, limit our exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. At the present time, the maximum duration of all portfolio investments is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue or issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria established in our investment guidelines, the exposure to market and credit risk is not expected to be material.

The Massachusetts Institute of Technology, or MIT, and Electronics for Imaging, Inc., or EFI, have sued us for infringing a patent relating to a color reproduction system that is allegedly imbedded in our bundled products. This patent expired on May 4, 2002. In total, MIT and EFI have sued 214 companies under this patent. We are defending and do not believe our products infringe this patent or that this claim is valid.

No matters were submitted to a vote of security holders during the second quarter of 2002.


*	Filed previously as an exhibit to SCM’s Form 10-Q for the quarter ended June 30, 2001 (See SEC File No. 000-22689).

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


	SCM MICROSYSTEMS, INC.

	/s/ ANDREW WARNER

	Andrew Warner
	Vice President, Finance and Chief Financial Officer
	(Principal Financial and Accounting Officer)


*	Filed previously as an exhibit to SCM’s Form 10-Q for the quarter ended June 30, 2001 (See SEC File No. 000-22689).


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended June 30, 2002

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the transition period from to


Delaware		77-0444317
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)


	Item 1. Financial Statements
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure about Market Risk Foreign Currencies
PART II: OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 99.1



			Three Months Ended						Six Months Ended
			June 30,						June 30,

			2002			2001			2002			2001


			(Unaudited)
			(In thousands, except per share data)
Net revenue			$	44,969		$	46,600		$	88,398		$	91,707
Cost of revenue				29,974			31,419			58,823			72,282

		Gross profit		14,995			15,181			29,575			19,425

Operating expenses:
	Research and development			3,050			3,389			5,901			6,971
	Selling and marketing			7,029			6,875			13,456			15,689
	General and administrative			3,118			4,860			7,265			10,815
	Amortization of goodwill and intangibles			333			3,657			622			7,365
	In-process research and development			—			—			—			115
	Separation costs and restructuring charges			1,462			3,615			2,251			3,615

		Total operating expenses		14,992			22,396			29,495			44,570

		Income (loss) from operations		3			(7,215	)		80			(25,145	)
Loss from investments				—			—			—			(5,679	)
Interest and other income (expense), net				9			1,081			(163	)		1,048

Income (loss) before income taxes and minority interest				12			(6,134	)		(83	)		(29,776	)
Benefit for income taxes				274			853			482			6,041
Minority interest in loss of consolidated subsidiaries				—			64			—			164

		Net income (loss)	$	286		$	(5,217	)	$	399		$	(23,571	)

	Basic net income (loss) per share		$	0.02		$	(0.34	)	$	0.03		$	(1.54	)

	Diluted net income (loss) per share		$	0.02		$	(0.34	)	$	0.02		$	(1.54	)

	Shares used to compute basic net income (loss) per share			15,592			15,318			15,567			15,293

	Shares used to compute diluted net income (loss) per share			16,096			15,318			16,154			15,293

Comprehensive income (loss):
Net income (loss)			$	286		$	(5,217	)	$	399		$	(23,571	)
Unrealized gain (loss) on investments, net of deferred taxes				(427	)		106			(403	)		1,155
Foreign currency translation adjustment				2,867			(763	)		3,070			(3,205	)

Total comprehensive income (loss)			$	2,726		$	(5,874	)	$	3,066		$	(25,621	)


			June 30,			December 31,
			2002			2001


			(Unaudited)
			(In thousands)
ASSETS
Current assets:
	Cash, cash equivalents and short-term investments		$	60,219		$	59,421
	Accounts receivable, net			42,142			44,368
	Inventories			37,799			32,690
	Other current assets			8,166			8,174

		Total current assets		148,326			144,653
Property and equipment, net				10,466			10,464
Investments				834			1,482
Long-term deferred income taxes				11,405			11,252
Intangible assets, net				7,417			5,231
Goodwill, net				12,827			12,100
Other assets				58			406

		Total assets	$	191,333		$	185,588

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	29,295		$	28,252
	Accrued compensation and related benefits			2,545			2,755
	Accrued restructuring and professional fees			3,237			4,286
	Accrued royalties			2,322			1,988
	Accrued expenses			7,466			6,002

		Total current liabilities		44,865			43,283
Deferred tax liability				434			434
Minority interest				90			90

Stockholders’ equity:
	Capital stock			16			16
	Additional paid-in capital			225,361			224,433
	Deferred stock compensation			(674	)		(849	)
	Accumulated deficit			(74,009	)		(74,408	)
	Other cumulative comprehensive loss			(4,750	)		(7,411	)

		Total stockholders’ equity		145,944			141,781

		Total liabilities and stockholders’ equity	$	191,333		$	185,588

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					Six Months
					Ended June 30,

					2002			2001


					(Unaudited)
					(In thousands)
Cash flows from operating activities:
	Net income (loss)				$	399		$	(23,571	)
	Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
		Deferred income taxes				(257	)		(6,053	)
		Depreciation and amortization				1,680			9,048
		In-process research and development				—			115
		Minority interest in earnings of subsidiary				—			(164	)
		Amortization of deferred stock compensation				174			405
		Loss on long-term investments				—			5,679
		Loss on disposal of fixed assets				13			352
		Changes in operating assets and liabilities:
			Accounts receivable			5,487			9,506
			Inventories			(3,375	)		446
			Other assets			760			(1,255	)
			Accounts payable			(1,298	)		(1,160	)
			Accrued expenses			(531	)		587

				Net cash provided by (used in) operating activities		3,052			(6,065	)

Cash flows from investing activities:
	Capital expenditures					(335	)		(3,600	)
	Proceeds from disposal of fixed assets					—			89
	Purchase of long-term investment					—			(470	)
	Business acquired, net of cash received					(4,096	)		(5,745	)
	Maturities of short-term investments					491			54,732
	Purchases of short-term investments					(4,322	)		(25,460	)

				Net cash (used in) provided by investing activities		(8,262	)		19,546

Cash flows from financing activities:
	Proceeds from issuance of equity securities, net					929			399

				Net cash provided by financing activities		929			399
Effect of exchange rates on cash and cash equivalents						1,248			(161	)

Net (decrease) increase in cash and cash equivalents						(3,033	)		13,719
Cash and cash equivalents at beginning of period						59,421			33,699

Cash and cash equivalents at end of period					$	56,388		$	47,418

Supplemental disclosures of cash flow information:
	Cash paid for income taxes				$	369		$	712

	Cash paid for interest				$	11		$	—



			June 30, 2002							December 31, 2001

			Gross							Gross
	Amortization		Carrying		Accumulated					Carrying		Accumulated
	Period		Amount		Amortization			Net		Amount		Amortization			Net

Core technology		60 months	$	6,602	$	(3,323	)	$	3,279	$	5,290	$	(2,769	)	$	2,521
Customer relations		60 months		2,261		(691	)		1,570		1,139		(673	)		466
Trade name		Indefinite		4,141		(1,703	)		2,438		3,903		(1,703	)		2,200
Non-compete agreements		24 months		855		(725	)		130		719		(675	)		44

Total intangible assets				13,859		(6,442	)		7,417		11,051		(5,820	)		5,231
Goodwill				29,512		(16,685	)		12,827		28,785		(16,685	)		12,100

Total			$	43,371	$	(23,127	)	$	20,244	$	39,836	$	(22,505	)	$	17,331


			Digital Media
	Security		and Video		Total

Balance as of January 1, 2002	$	5,430	$	6,670	$	12,100
Goodwill acquired during the period		727		—		727

Balance as of June 30, 2002	$	6,157	$	6,670	$	12,827


Fiscal Year	Amount

2002 (remaining 6 months)	$	992
2003		1,438
2004		1,040
2005		809
2006		495
2007		205

Total	$	4,979


	Legal			Lease			Asset			Severance and
	Settlements			Commitments			Write Downs			Other Costs			Total

Provision for 2001	$	1,830		$	1,675		$	336		$	1,423		$	5,264
Changes in estimates		—			(15	)		(53	)		(2	)		(70	)

		1,830			1,660			283			1,421			5,194
Payments or write offs in 2001		(1,252	)		(145	)		(240	)		(841	)		(2,478	)

Balance as of December 31, 2001		578			1,515			43			580			2,716
Provision for Q1 2002		—			—			20			769			789
Payments or write offs in Q1 2002		(355	)		(171	)		(21	)		(1,251	)		(1,798	)

Balances as of March 31, 2002		223			1,344			42			98			1,707
Provision for Q2 2002		63			—			23			1,526			1,612
Change in estimate		(150	)		—			—			—			(150	)
Payments or write offs in Q2 2002		(63	)		(134	)		(23	)		(1,504	)		(1,724	)

Balances as of June 30, 2002	$	73		$	1,210		$	42		$	120		$	1,445


Cash		$	483
Tangible assets			2,694
Assumed liabilities			(1,854	)
Trade name			219
Customer relations			1,032
Core technology			1,205
Non-compete agreements			125
Goodwill			675

	Total	$	4,579


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


	*We have incurred operating losses and may not maintain profitability.*


	*Our quarterly operating results will likely fluctuate.*


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


1.	Basis of Presentation


2.	Long-Term Investments


3.	Inventories


5.	Separation and Restructuring Charges


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


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


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


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


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


	*Our future success will depend on our ability to keep pace with technological change and meet the needs of our target markets and customers.*


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


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


	*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.*


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


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


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


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


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


	*We face risks associated with our past and future acquisitions.*


	We may incur acquisition related charges in connection with any acquisition.


	We conduct a significant portion of our operations outside the United States. Economic, political, regulatory and other risks associated with international sales and operations could have an adverse effect on our business.


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


	Our products may have defects, which could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in liability to us, including costly litigation.