SCM MICROSYSTEMS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10 - Q


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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002


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

FOR THE TRANSITION PERIOD FROM_________TO _________

COMMISSION FILE NUMBER: 0-22689

SCM MICROSYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


DELAWARE		77-0444317
(STATE OR OTHER JURISDICTION OF		(I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION)		IDENTIFICATION NUMBER)

47211 Bayside Parkway, Fremont, CA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)

(510) 360- 2300
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

N/A
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST
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. [X] Yes [ ] No

At November 7, 2002, 15,694,723 shares of common stock were outstanding.

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TABLE OF CONTENTS


	Item 1. Financial Statements
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure about Market Risk
	Item 4. Controls and Procedures
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 3.2
EXHIBIT 99.1

Item 1. Financial Statements

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

Three months ended Nine months ended

September 30, September 30,

2002 2001 2002 2001

Net revenue
$ 40,887 $ 46,471 $ 129,285 $ 138,178

Cost of revenue
28,878 31,377 87,701 103,659

Gross profit
12,009 15,094 41,584 34,519

Operating expenses:

Research and development
3,465 3,059 9,366 10,030

Selling and marketing
7,005 6,862 20,461 22,551

General and administrative
2,965 4,914 10,230 15,729

Amortization of goodwill and intangibles
543 3,839 1,165 11,204

In-process research and development
— — — 115

Separation costs, restructuring and infrequent charges
1,794 — 4,045 3,615

Total operating expenses
15,772 18,674 45,267 63,244

Loss from operations
(3,763 ) (3,580 ) (3,683 ) (28,725 )

Loss from investments
(1,802 ) — (1,802 ) (5,679 )

Interest and other income (expense), net
(215 ) 986 (378 ) 2,034

Loss before income taxes and minority interest
(5,780 ) (2,594 ) (5,863 ) (32,370 )

Benefit (provision) for income taxes
(13,971 ) 547 (13,489 ) 6,588

Minority interest in loss of consolidated subsidiaries
— — — 164

Net loss
$ (19,751 ) $ (2,047 ) $ (19,352 ) $ (25,618 )

Basic net loss per share
($1.26 ) $ (0.13 ) $ (1.24 ) $ (1.67 )

Diluted net loss per share
($1.26 ) $ (0.13 ) $ (1.24 ) $ (1.67 )

Shares used to compute basic net loss per share
15,629 15,335 15,588 15,306

Shares used to compute diluted net loss per share
15,629 15,335 15,588 15,306

Comprehensive loss:

Net loss
$ (19,751 ) $ (2,047 ) $ (19,352 ) $ (25,618 )

Unrealized gain (loss) on investments, net of deferred taxes
(1 ) (750 ) (15 ) 405

Foreign currency translation adjustment
135 1,003 3,205 (2,202 )

Total comprehensive loss
$ (19,617 ) $ (1,794 ) $ (16,162 ) $ (27,415 )

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

September 30, December 31,

2002 2001

ASSETS

Current assets:

Cash, cash equivalents and short-term investments
$ 58,047 $ 59,421

Accounts receivable, net
33,462 44,368

Inventories
45,609 32,690

Other current assets
6,438 8,174

Total current assets
143,556 144,653

Property and equipment, net
10,107 10,464

Investments
809 1,482

Long-term deferred income taxes
— 11,252

Intangible assets, net
7,075 5,231

Goodwill, net
12,688 12,100

Other assets
41 406

Total assets
$ 174,276 $ 185,588

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

Accounts payable
$ 28,781 $ 28,252

Accrued compensation and related benefits
3,967 2,755

Accrued restructuring and professional fees
3,427 4,286

Accrued royalties
1,915 1,988

Accrued expenses
8,400 6,002

Total current liabilities
46,490 43,283

Deferred tax liability
— 434

Minority interest
90 90

Stockholders’ equity:

Capital stock
16 16

Additional paid-in capital
225,385 224,433

Deferred stock compensation
(589 ) (849 )

Accumulated deficit
(93,760 ) (74,408 )

Other cumulative comprehensive loss
(3,356 ) (7,411 )

Total stockholders’ equity
127,696 141,781

Total liabilities and stockholders’ equity
$ 174,276 $ 185,588

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)

Nine months ended

September 30,

2002 2001

Cash flows from operating activities:

Net loss
$ (19,352 ) $ (25,618 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

Deferred income taxes
13,960 (7,977 )

Depreciation and amortization
3,064 13,617

In-process research and development
— 115

Minority interest in earnings of subsidiary
— (164 )

Amortization of deferred stock compensation
260 643

Loss on long-term investments
1,802 5,679

Loss on disposal of fixed assets
20 352

Changes in operating assets and liabilities:
—

Accounts receivable
14,351 6,798

Inventories
(11,107 ) 177

Other assets
(1,200 ) (3,477 )

Accounts payable
(1,778 ) 1,826

Accrued expenses
1,571 3,759

Net cash provided by (used in) operating activities
1,591 (4,270 )

Cash flows from investing activities:

Capital expenditures
(812 ) (4,064 )

Proceeds from disposal of fixed assets
7 89

Purchase of long-term investment
(737 )

Business acquired, net of cash received
(4,157 ) (2,525 )

Maturities of short-term investments
1,296 60,697

Purchases of short-term investments
(5,586 ) (27,506 )

Net cash (used in) provided by investing activities
(9,252 ) 25,954

Cash flows from financing activities:

Proceeds from issuance of equity securities, net
953 508

Net cash provided by financing activities
953 508

Effect of exchange rates on cash and cash equivalents
1,044 (1,351 )

Net (decrease) increase in cash and cash equivalents
(5,664 ) 20,841

Cash and cash equivalents at beginning of period
59,421 33,699

Cash and cash equivalents at end of period
$ 53,757 $ 54,540

Supplemental disclosures of cash flow information:

Cash paid for income taxes
$ 553 $ 87

Cash paid for interest
$ 49 $ 7

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2002

1. BASIS OF PRESENTATION

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 nine months ended September 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.

2. LONG-TERM INVESTMENTS

Long-term investments consist of the following (in thousands):


		September 30,		December 31,
		2002		2001

Investment in ActivCard, at fair value		$	758	$	1,094
Investment in SmartDisk, at fair value			51		388

	Total	$	809	$	1,482

During each quarter, SCM evaluates investments for possible asset impairment by examining 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 third quarter of 2002, because of the continued deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties by SmartDisk in obtaining additional funding, SCM determined that investments in SmartDisk and ActivCard were impaired. Accordingly, SCM wrote down these investments to their fair market value as of September 30, 2002. The result was a charge to the income statement of $1.8 million.

During the first and fourth quarters of 2001, based on the aforementioned criteria, SCM determined that investments in SmartDisk, Spyrus Inc. and Satup Databroadcasting AG were impaired. Accordingly, in the first quarter of 2001, SCM wrote down the investment in SmartDisk to its fair market value as of March 31, 2001 and wrote down the investment in Spyrus to its estimated value, which approximated 20% of the original cost. In the fourth quarter of 2001, SCM wrote off the remaining balances for Spyrus, Satup Databroadcasting AG and the investment in a Singapore subsidiary of PC Card. The result was a charge to the income statement of $5.7 million in the first quarter of 2001 and $2.8 million in the fourth quarter of 2001.

As of September 30, 2002, SCM’s ownership of all outstanding shares of Spyrus was approximately 13.4% and SCM’s ownership in Satup was approximately 10%.

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3. INVENTORIES

Inventories consist of (in thousands):


	September 30,		December 31,
	2002		2001

Raw materials	$	20,710	$	20,498
Finished goods		24,899		12,192

	$	45,609	$	32,690

4. ACQUISITIONS

Dazzle Multimedia, Inc.

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.

Towitoko AG

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. 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, Germany. 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 valuation of the intangible assets related to the acquisition was completed in September 2002. A summary of the allocation of the purchase price is as follows (in thousands):


Cash		$	483
Tangible assets			2,694
Assumed liabilities			(1,854	)
Trade name			259
Customer relations			1,120
Core technology			1,270
Non-compete agreements			119
Goodwill			549

	Total	$	4,640

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.

Pro forma 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.

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5. GOODWILL AND OTHER INTANGIBLE ASSETS

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, we 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 SCM’s reporting units approximated or exceeded the reporting unit’s carrying amount and no impairment was indicated.

Intangible assets and goodwill consist of the following (in thousands):

September 30, 2002 December 31, 2001

Gross Gross

Amortization Carrying Accumulated Carrying Accumulated

Period Amount Amortization Net Amount Amortization Net

Core Technology
60 months $ 6,671 $ (3,653 ) $ 3,018 $ 5,290 $ (2,769 ) $ 2,521

Customer Relations
60 months 2,357 (885 ) 1,472 1,139 (673 ) 466

Trade name
Indefinite 4,183 (1,703 ) 2,480 3,903 (1,703 ) 2,200

Non-compete
24 months 848 (743 ) 105 719 (675 ) 44

Total intangible assets
14,059 (6,984 ) 7,075 11,051 (5,820 ) 5,231

Goodwill
29,373 (16,685 ) 12,688 28,785 (16,685 ) 12,100

Total
$ 43,432 $ (23,669 ) $ 19,763 $ 39,836 $ (22,505 ) $ 17,331

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 nine months ended September 30, 2002 are as follows:


			Digital Media
	Security		and Video		Total

Balance as of January 1, 2002	$	5,430	$	6,670	$	12,100
Goodwill acquired during the period		588		—		588

Balance as of September 30, 2002	$	6,018	$	6,670	$	12,688

Amortization of goodwill and intangibles in the first nine months of fiscal 2002 was $1.2 million compared with $11.2 million for the same period of 2001.

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Estimated future amortization expense is as follows (in thousands):


Fiscal Year	Amount

2002 (remaining 3 months)	$	458
2003		1,468
2004		1,073
2005		843
2006		527
2007		226

Total	$	4,595

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


		Three months ended						Nine months ended
		September 30,						September 30,

		2002			2001			2002			2001

Net loss, as reported		$	(19,751	)	$	(2,047	)	$	(19,352	)	$	(25,618	)
Add back amortization:
	Assembled workforce		—			133			—			392
	Trade name		—			317			—			937
	Goodwill		—			2,687			—			7,795
	Related income tax effect		—			(188	)		—			(279	)

Adjusted net income (loss)		$	(19,751	)	$	902		$	(19,352	)	$	(16,773	)

Net income (loss) per share:
Basic net loss per share, as reported		$	(1.26	)	$	(0.13	)	$	(1.24	)	$	(1.67	)
Add back above amortization and related income tax effect			—			0.19			—			0.57

Adjusted basic net income (loss) per share		$	(1.26	)	$	0.06		$	(1.24	)	$	(1.10	)

Diluted net loss per share, as reported		$	(1.26	)	$	(0.13	)	$	(1.24	)	$	(1.67	)
Add back above amortization and related income tax effect			—			0.19			—			0.57

Adjusted diluted net income (loss) per share		$	(1.26	)	$	0.06		$	(1.24	)	$	(1.10	)

6. SEPARATION COSTS, RESTRUCTURING, AND INFREQUENT CHARGES

During 2001, SCM incurred restructuring charges of approximately $5.2 million primarily relating to legal settlement, lease commitment and other costs and expenses resulting from the consolidation of operations in various facilities. In the first three quarters of 2002, SCM incurred net separation, restructuring and infrequent charges of approximately $0.8 million, $1.4 million, and $1.8 million, respectively, primarily due to costs incurred in preparation of the anticipated separation of our Digital Media and Video division and employee severance costs.

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The following summarizes the expenses related to these activities during 2001 and the first nine months of 2002 (in thousands):


	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
Provision for Q3 2002		723			611			33			698			2,065
Change in estimate		(25	)		(195	)		(5	)		(46	)		(271	)
Payments or write offs in Q3 2002		(628	)		(203	)		(38	)		(375	)		(1,244	)

Balances as of September 30, 2002	$	143		$	1,423		$	32		$	397		$	1,995

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 eight 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 and other costs for the quarter ended September 30, 2002 primarily related to legal and consulting costs of approximately $0.6 million, and $0.1 million of severance and related costs. The severance costs for the first three quarters of 2002 related to the termination of 34 employees, of which 19 were in the United States, ten were in Europe and five were in Asia. Approximately 21 employees were from Sales and Marketing, seven were from Operations, three were from Research and Development and three were from General and Administrative functions.

7. RECENT ACCOUNTING PRONOUNCEMENTS

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. SCM will adopt the provisions of SFAS

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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 cash flows.

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. SCM 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 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.

8. DEFERRED TAX ASSET

Prior to September 30, 2002, SCM’s deferred tax assets were comprised of net operating loss carryforwards, and deferred expenses of $23.2 million offset by a valuation allowance of $9.4 million. During the third quarter of 2002, the Company determined that it is unable to conclude that all of the deferred tax assets are more likely than not to be realized from the results of operations. Accordingly, a valuation allowance was provided for the net deferred tax assets of $13.8 million, resulting in a full valuation allowance against the net deferred tax asset. The valuation allowance does not impact the Company’s ability to utilize the underlying net operating loss carryforwards.

9. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS

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 three 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 three quarters of 2001 has been restated to reflect the new business segments.

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


		Three months ended				Nine months ended
		September 30,				September 30,

		2002		2001		2002		2001

Digital Media and Video:
	Revenue	$	26,609	$	22,377	$	70,760	$	71,392
	Gross margin		6,481		6,600		18,081		16,212
Security:
	Revenue	$	14,278	$	24,094	$	58,525	$	66,786
	Gross margin		5,528		8,494		23,503		18,307

Total:
	Revenue	$	40,887	$	46,471	$	129,285	$	138,178
	Gross margin		12,009		15,094		41,584		34,519

Geographic revenue breakdowns are based on the country where the customers are located. Information regarding revenue by geographic region for the three and nine months ended September 30, 2002 and 2001 are as follows (in thousands):


	Three months ended				Nine months ended
	September 30,				September 30,

	2002		2001		2002		2001

United States	$	24,925	$	20,626	$	67,228	$	57,622
Europe		10,756		15,853		45,258		51,688
Asia—Pacific		5,206		9,992		16,799		28,868

	$	40,887	$	46,471	$	129,285	$	138,178

One customer represented 12% of SCM’s total revenue for the third quarter of 2002 and. No customers exceeded 10% of total net revenue for the nine months ended September 30, 2002 and for the three and nine months ended September 30, 2001.

10. RELATED PARTY TRANSACTIONS

During 2002, SCM has recognized revenue of approximately $1.6 million from sales to ActivCard S.A., a supplier of electronic identity and smart-card solutions. Although SCM is not a sole supplier of specific products to ActivCard, the companies do share the services of Steven Humphreys. Mr. Humphreys is both the CEO of ActivCard and the Chairman of SCM’s Board of Directors. Mr. Humphreys is not directly compensated for revenue transactions between the two companies.

During 2002, SCM has also recognized revenue of approximately $1.2 million from sales to Telenor Conax AS, a company engaged in the development and provision of smart-card based systems. Oystein Larsen serves as both CEO of Telenor Conax and director of SCM Microsystems. Mr. Larsen is not directly compensated for revenue transactions between the two companies.

11. SUBSEQUENT EVENTS

Repurchase Plan

On October 24, 2002, the Company announced its Board of Directors’ approval of a stock repurchase program in which up to $5 million may be used to purchase shares of its common stock on the open market in the United States or Germany from time to time over the next two years, depending on market conditions, share prices and

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other factors. As of November 14, 2002, the Company had not made any repurchases under this program.

Stockholder Rights Plan

On November 8, 2002, the Company’s Board of Directors approved the adoption of a Stockholder Rights Plan. Under the plan, SCM will issue a dividend of one right to purchase one one-thousandth of a share of SCM Series A participating preferred stock at an exercise price of $30.00, subject to adjustment, for each outstanding share of common stock. The dividend is payable on November 25, 2002, the record date, to stockholders of record as of the close of business on that date. However, the rights are not immediately exercisable and will become exercisable only upon the occurrence of certain events. In addition, under certain circumstances, the Company may exchange or redeem the rights. The rights expire on the earlier of November 25, 2012 or the date of the exchange or redemption of the rights.

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

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 revenue 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.

Overview

SCM Microsystems designs, develops and sells hardware, software and silicon that enables people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We were organized in Delaware in 1996. 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. On October 25, 2002, we further announced that difficult market conditions have led us to conclude that the full value of the Digital Media and Video business is not realizable at the current time. Although we continue to evaluate the external environment for its suitability for a spin-off or sale of the division, we do not expect this to occur in the immediate future. We intend to continue to build value in this division as a part of SCM.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses SCM’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these 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 revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, 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 the basis for making judgments about the carrying values of

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assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

       •    SCM recognizes revenue 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,” which requires us to analyze our goodwill and intangible assets for impairment on a periodic basis.

       •    The carrying value of our net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. If these estimates and related assumptions change in the future, we may be required to reverse current valuation allowances against our deferred tax assets resulting in tax benefits in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets quarterly. In the third quarter of fiscal 2002, we reevaluated the realizability of the deferred tax assets and recorded a valuation allowance of $13.8 million.

       •    SCM accrues the estimated cost of product warranties at the time revenue is 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.

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Recent Accounting Pronouncements

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. This statement is effective for our fiscal year beginning January 1, 2002. SCM 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 rather will 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 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.

Acquisitions

Dazzle Multimedia, Inc.

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, 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.

Towitoko AG

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. 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, Germany. The acquisition has been accounted for under the purchase method of accounting and the results of operations were included in our results of operations since the date of the acquisition. In connection with the acquisition, SCM incurred acquisition costs of approximately $0.1 million.

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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.

Results of Operations

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 September 30, 2002 was $40.9 million, down 12% compared to $46.5 million for the same quarter of 2001. The decrease in revenue in the third quarter of 2002 compared with the same quarter in 2001 was due primarily to lower revenue from our Security division of $9.8 million, partially offset by an increase in revenue from our Digital Media and Video division of $4.2 million. Revenue within our Security division was lower in the third quarter of 2002 versus the same quarter of the previous year due to the creation of a revenue reserve of approximately $4 million taken during the quarter as a result of modifications to the payment terms for a digital television customer. This was only 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 consumer demand for our digital media reader/writers and our digital video hardware and software products in the third quarter. For the first nine months of 2002, net revenue was $129.3 million, compared to $138.2 million for the same period of 2001, a decrease of 6%. The decrease in revenue in the first nine months of 2002 compared with the same period in 2001 was due primarily to lower revenue from our conditional access modules of $8.3 million, particularly in the third quarter as detailed above. Sales to SCM’s top 10 customers accounted for 49% and 40% of total net revenue in the first nine months of 2002 and 2001, respectively.

Gross Profit. Gross profit for the third quarter of 2002 was $12.0 million, or 29% of total net revenue, compared to $15.1 million, or 32%, for the third quarter of 2001. The decrease in gross profit as a percentage of revenue for the third quarter of 2002 as compared to the same period in 2001 was primarily due to an increase in the overall revenue contribution of lower margin Digital Media and Video product revenue compared to Security product revenue.

Digital Media and Video products were 65% of total revenue in the third quarter of 2002 compared to 48% for the same quarter in 2001. Digital Media and Video product margins were 24% for the third quarter of 2002 compared to 29% for the same quarter in 2001 due primarily to a higher proportion of low margin media product sales compared to the same period in 2001. For the first nine months of 2002, gross profit was $41.6 million, or 32% of revenue, compared to gross profit of $34.5 million, or 25% of revenue for the first nine months of 2001. Lower gross profit levels for the first nine months of 2001 resulted from 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 as a percentage of revenue for the first nine months of 2001 would have been 32%, which is comparable to the gross profit percentage for the first nine months of 2002.

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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, product returns, 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. In those instances where we develop software, to date, the period between achieving technological feasibility and completion of the 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 third quarter of 2002, research and development expenses were $3.5 million, or 8% of revenue, an increase of 13% compared with $3.1 million, or 7% of revenue, in the third quarter of 2001 and an increase of $0.4 million compared with the second quarter of 2002. The sequential increase from the second to third quarter 2002 is primarily due to increased project costs for new product development within the Digital Media and Video division. For the first nine months of 2002, research and development expenses were $9.4 million, or 7% of revenue, a decrease of 7% compared with $10.0 million, or 7% of revenue, in the first nine months of 2001. The decrease in absolute amounts between the two nine-month periods reflects the results of our 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 third quarter of 2002 were $7.0 million, or 17% of net revenue, an increase of 2% compared with $6.9 million or 15% of net revenue, in the third quarter of 2001. For the first nine months of 2002, selling and marketing expenses were $20.5 million, or 16% of revenue, down 9% compared with $22.6 million, or 16% of revenue, in the same period of 2001. For the nine-month period, selling and marketing expenses were lower in 2002 than in 2001 because of decreases in the U.S. and Europe, primarily due to personnel related expense reductions and lower office administrative costs.

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 third quarter of 2002, general and administrative expenses were $3.0 million, or 7% of revenue, a decrease of 40% compared with $4.9 million, or 11% of revenue, in the third quarter of 2001. For the first nine months of 2002, general and administrative expenses were $10.2 million, or 8% of revenue, down 35% compared with $15.7 million, or 11% of revenue for the first nine months of 2001. This decrease in absolute amounts for the three- and nine-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 the first nine months of 2002, and the nine-month period comparison is also affected by a reduction in allowance for doubtful accounts of $1.6 million from 2001 to 2002. 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 third quarter of 2002 was $0.5 million compared with $3.8 million for the same period of 2001. For the first nine months of 2002, amortization of goodwill and intangibles was $1.2 million compared with $11.2 million for the first nine months of 2001. Amortization of goodwill and intangibles was lower in the first nine months of 2002 because the previous year period included amortization of goodwill and intangibles that have 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 Towitoko. Including Towitoko, amortization of intangibles for all of fiscal 2002 is expected to be approximately $1.6 million.

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 during the quarter. These development efforts had no alternative future uses as of this acquisition date.

Separation Costs, Restructuring and Infrequent Charges. During the third quarter of 2002, SCM incurred separation costs, restructuring and infrequent charges of $1.8 million, primarily related to the planned separation of our Digital Media and Video division. These expenses included legal and consulting costs of $1.2 million, lease

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commitments of $0.4 million, and severance and related costs of $0.1 million. For the first nine months of 2002, separation costs, restructuring and infrequent charges were $4.0 million. These expenses included legal and consulting costs of $2.1 million, investment banking fees of $0.8 million, lease commitments of $0.4 million, severance and related costs of $0.5 million and an asset impairment of $0.1 million. For the first nine months of 2001, SCM incurred restructuring and infrequent charges of $3.6 million primarily related to legal settlement costs and expenses related to the consolidation of operations at various facilities

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 third quarter of 2002, because of the continued deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties involved in obtaining additional funding by SmartDisk, we determined that our investments in SmartDisk and ActivCard had been impaired. Accordingly, we wrote down our investments in SmartDisk and ActivCard to their fair market value as of September 30, 2002. The result was a charge to the income statement of $1.8 million. During the first quarter of 2001, we determined that our investments in SmartDisk and Spyrus had been impaired and 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.

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 third quarter of 2002, interest income and other, net, was a net expense of $0.2 million, consisting of net interest income of $0.3 million and a foreign exchange loss of $0.5 million. For the third quarter of 2001, we recorded a net gain of $1.0 million, resulting from net interest income of $0.5 million and a foreign exchange gain of $0.5 million. For the first nine months of 2002, interest income and other, net, was a net expense of $0.4 resulting from net interest income of $0.9 million and a foreign exchange loss of $1.3 million. For the first nine months of 2001, interest income and other, net, was a net gain of $2.0 million, consisting of net interest income of $1.8 million and a foreign exchange gain of $0.2 million. The period over period decrease in interest and other, net in the third quarter of 2002 was primarily the result of lower market interest rates and unfavorable exchange rate movements. Net foreign currency loss for the third quarter of 2002 was $0.5 million compared to a gain of $0.5 million for the third quarter of 2001. The foreign exchange loss in the third quarter of 2002 was primarily due to unfavorable rate changes for the Euro ($0.6 million) and the British pound ($0.1 million) offset by favorable rate change for the Singapore dollar ($0.2 million) compared to the United States dollar. 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 revenue substantially offsets the local currency denominated operating expenses. 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.

Benefit (Provision) for Income Taxes. The provision for income taxes for the third quarter of 2002 was $14.0 million compared to a benefit for income taxes of $0.5 million for the same period of 2001. This resulted from an increase in the valuation allowance for deferred tax assets of $13.8 million taken during the quarter in accordance with SFAS 109. For the first nine months of 2002, we recorded a provision for income taxes of $13.5 million, due to the valuation allowance increase noted above. This compares with a benefit for income taxes of $6.6 million in the first nine months of 2001.

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

Liquidity and Capital Resources

As of September 30, 2002, our working capital was $97.1 million, compared to working capital of $101.4 million as of December 31, 2001.

Cash, cash equivalents and short term investments for the nine months ended September 30, 2002 decreased by $1.4 million. Cash and cash equivalents for the nine months ended September 30, 2002 decreased by $5.7 million

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primarily due to uses of cash for investing activities of $9.3 million being partially offset by cash provided from operations of $1.6 million and proceeds from the issuance of equity of $1.0 million. Cash provided by operations of $1.6 million was primarily due to a $19.4 million net loss, the adding back of the impairment of the deferred tax asset of $13.8 million, the loss on investments of $1.8 million, depreciation and amortization of $3.1 million and the amortization of deferred stock compensation of $0.3 million, a decrease in accounts receivable of $14.4 million and increases in accrued expenses of $1.6 million. These were offset by increases in inventories of $11.1 million, other assets of $1.2 million, and a decrease in accounts payable of $1.8 million. Cash used in investing activities was primarily for the net purchase of short-term investments of $4.3 million, the purchase of Towitoko net of cash received of $4.2 million and capital expenditures of $0.8 million.

On October 24, 2002, we announced a stock repurchase program under which we intend to repurchase up to $5.0 million of our common stock in the open market over the next two years, subject to market conditions, share price and other factors. As of November 14, 2002, we had not made any purchases under this program.

We have 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 September 30, 2002). The German line has no expiration date and bears interest at 7%. Borrowings under this line of credit are unsecured. We have an unsecured line of credit in France of 0.3 million Euro (approximately $0.3 million as of September 30, 2002), which bears interest at 4.76% and has no expiration date. In addition, we have three separate overdraft facilities for our Singapore manufacturing facility of 4.0 million, 4.0 million and 5.9 million Singapore Dollars with base interest rates of 4.8%, 6.5% and 7.0%, respectively. All of the facilities are unsecured and due upon demand. Our various available facilities totaled approximately $7.8 million as of September 30, 2002. There were no amounts outstanding under any of these credit facilities as of September 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 us on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

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FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only 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, cash flows 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 incurred operating losses and may not achieve profitability.

We have a history of losses with an accumulated deficit of $93.8 million as of September 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 were not profitable in the third quarter of 2002. We may continue to incur losses in the future and may be unable to maintain profitability.

Our quarterly operating results will likely fluctuate.

Our quarterly operating results have varied greatly in the past and will likely vary greatly in the future depending upon a number of factors. Many of these factors are beyond our control. Our revenue, 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 revenue may not increase or remain at 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.

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

We do not typically maintain a significant level of backlog. As a result, revenue in any quarter depends 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 revenue 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.

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

Over the past several quarters, economic conditions in the United States and abroad have resulted in decreased demand and constrained growth in demand from end users for many companies’ products, including ours. In our Security business, decreased demand, particularly in the European digital television industry, has contributed to declining and lower than expected revenue. If these trends continue, revenue and results of operations in our Security business will be adversely affected. Also, in our Digital Media and Video business, throughout 2001 and during 2002, we have experienced decreased demand as well as decreased growth in demand for our retail digital media and video products 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 cancelled orders for our products could lead to decreased sales in a particular period and, because many of our products are custom made for particular customers, could also cause us to write off inventory. In some cases, customers could delay payment or be unable to pay for orders made to us, causing us to increase our allowance for doubtful accounts or to write off certain receivables. In addition, if we anticipate that demand for our products will not increase, we may decide to reduce our operating expense base in order to maintain or reach profitability. Decreased sales, expense base decreases or any write-offs, or any combination of these, could have a materially adverse affect on our operating results.

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

On February 28, 2002, we announced our intention to create two distinct businesses within SCM, a Security business and a Digital Media and Video business. In addition, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. During the first nine months 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 either of these options. As a result of these factors, on October 25, 2002, we announced that, although we continue to believe that separation is the best long-term strategy, we do not expect a spin-off or sale to occur in the immediate future. 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 not be able to secure funding to purchase the business.

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

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

       •    adverse market perception of the separation may cause our stock price to decline.

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

Our common stock currently 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. 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. In addition, in September 2002, the Deutsche Börse AG announced that it intended to close trading on the Neuer Markt by the end of 2003 and relist certain stocks on alternative indices which they plan to create. Because our stock is currently traded on the Neuer Markt, this decision could adversely affect our stock price. We believe that the Deutsche Börse AG intends to allow SCM to trade its shares on the new Prime Standard of the Frankfurt Stock Exchange. However, there is no assurance that this will occur. Moreover, plans for the operation of the new Prime Standard have not yet been fully communicated. Because we have a significant number of German stockholders, if the Prime Standard’s new structure is not communicated effectively or implemented efficiently, then our stock price could be adversely affected.

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

The stock market has recently experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. During the 12-month period from October 31, 2001 to October 30, 2002, the reported sale prices for our common stock on the Nasdaq market ranged between $17.23 and $3.20 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 or other market 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.

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

We sell our products primarily to emerging markets that have not yet reached a stage of mass adoption or deployment. If demand for products in these markets does not develop and grow sufficiently, revenue 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.

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

       •    the slow pace and uncertainty of adoption in Europe of open systems platforms that require conditional access modules, such as ours, that use the 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.

For instance, we believe that, over time, the European digital television industry will transition to removable, modular security, and that our Security business will benefit from this transition. However, as this transition occurs, we believe that large television operators in Europe are struggling because of their inefficient delivery models and that smaller operators have also been adversely affected by turmoil in the industry. We believe these factors have contributed to recent revenue declines in our Security business. If these conditions continue, the revenue and results of operations in our Security business could continue to be adversely affected.

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 that will drive demand for solutions such as ours to create and publish digital content.

We rely heavily on our strategic relationships.

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:

       •    our 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

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

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

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

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

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

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

       •    the extent to which products support existing industry standards and provide interoperability;

       •    technical features;

       •    ease of use;

       •    quality and reliability;

       •    level of security;

       •    brand name, particularly in retail channels;

       •    strength of distribution channels; and

       •    price.

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

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

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

• Carry Computer Engineering, DataFab, Lexar, SanDisk, Simple Technology and SmartDisk for digital media readers; and

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• ADS, Adaptec, 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.

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

Our business and operating results normally reflect seasonal trends. We have typically experienced lower revenue and operating income in the first quarter and second quarter and higher revenue in the third quarter and fourth quarter of each calendar year. 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. Revenue in our Digital Media and Video business was higher during the third quarter of 2002 than was revenue during either the first quarter or the second quarter of 2002. However, revenue in our Security business declined in the third quarter of 2002. Because of the seasonal aspect of our business and other factors, there is no assurance we can sustain the quarterly revenue increases we had in our Digital Media and Video business. Because of the current unpredictability of the U.S. and world economies, there is no assurance that demand will increase or remain as strong in the fourth quarter of 2002.

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

Our products are generally targeted at OEM customers in the consumer electronics, computer, digital appliance, digital media and conditional access system industries, and to retail distributors. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. For example, sales to our top 10 customers accounted for approximately 42% of our total net revenue in fiscal 2001, with one customer, Aston-France S.A.R.L., accounting for 11% of our net revenue. For the first nine months of 2002, sales to our top 10 customers accounted for approximately 49% of our total net revenue, with no customer accounting for 10% or more 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.

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

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

• increased exposure to demand cycles caused as a result of seasonal or economic trends;

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       •    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, Circuit City, CompUSA, Dixons/PC World, Fry’s Electronics, Office Depot, Radio Shack, Staples, Sears, B&H Photo and MicroCenter. 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 can not 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 what we expect, our sales will decrease or not grow at the rate we expect.

We also sell our digital media and 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.

We may have to take back unsold inventory from our customers.

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

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

       •    divert a significant amount of time and energy to manage employees and contractors from diverse cultural backgrounds and who speak different languages;

       •    manage different product lines for different markets;

       •    manage our supply and distribution channels across different countries and business practices; and

       •    coordinate these efforts to produce an integrated business effort, focus and vision.

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

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

We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel leave and are not adequately replaced, our business would be adversely affected. We provide compensation incentives such as bonuses, benefits and option grants, which are typically subject to vesting over four years, to attract and retain qualified employees. In addition, certain of our executive officers are subject to one-year non-compete agreements. Non-compete agreements are, however, generally difficult to enforce. Retention of employees and key management may become more difficult because of the uncertainty associated with the proposed 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.

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

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

The increased size and complexity of our businesses may create significant burdens on our systems.

Our business has grown substantially, with net revenue increasing from $23.6 million in 1995 to $184.9 million in 2001. Net revenue was $129.3 million for the nine months ended September 30, 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 September 30, 2002, we had 524 employees.

Although our revenue has not increased in fiscal 2002, our business model contemplates continued revenue growth in certain markets. If this growth occurs and we do not manage it effectively, our stock price and financial condition could be materially and adversely affected. Our growth and our growth plans have placed and are likely to continue to place a significant burden on our operating and financial systems and increase responsibility for senior management and other personnel. Our existing management or any new members of management may not be able to improve our existing systems and controls or implement new systems and controls in response to our anticipated growth. In addition, our intention to reduce or re-deploy personnel to reduce expenses from time to time may limit our capacity to grow.

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

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

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receipt of new revenue and might cause us to expend more resources to obtain new customer wins.

We face risks associated with our past and future acquisitions.

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.

     Use of Cash or Issuance of Securities



     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.

     Acquisition Charges



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

     Integration Risks



     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 train 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.

     Unanticipated Assumption of Liabilities



     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 the 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 sales.

We were originally a German corporation, and we continue to conduct a substantial portion of our business in Europe. Approximately 58%, 48% and 52% of our revenue for the years ended December 31, 2001, 2000 and 1999, respectively, was derived from customers located outside the United States. Approximately 48% of our revenue for the nine months ended September 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;

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

       •    unexpected changes in foreign laws and regularity 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 could lose money and our stock price could decrease as a result of write downs of our strategic investments.

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, including ActivCard, 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.

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.

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 and even litigation 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.

Our business could suffer if we or our contract manufacturers cannot meet production requirements.

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 proposed separation of these two businesses. Foreign manufacturing poses a number of risks, including:

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       •    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 have a limited number of suppliers of key components.

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, DVD Cre8 and Cineform. 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.

We may be exposed to risks of intellectual property infringement by third parties.

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.

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We may face claims of infringement of the intellectual rights of third parties, which could subject us to costly litigation, supplier and customer indemnification claims and the possible restriction on the use of our intellectual property.

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 intellectually 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.

Our failure to promote our brand successfully and achieve strong brand recognition in our target markets could limit or reduce demand for our Digital Media and Video products.

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, we may not be able to generate demand for our products and our revenue might not grow. If our marketing expenses are disproportionately large in relation to our revenue, our results of operations could be adversely affected. 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.

We may experience significant amortization charges and may have future non-recurring charges as a result of past acquisitions.

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.

Factors beyond our control could disrupt our operations and increase our expenses.

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.

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Provisions in our agreements, charter documents, Delaware law and our rights plan may delay or prevent acquisition of us, which could decrease the value of your shares.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include a classified board of directors and limitations on actions by our stockholders by written consent. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.

SCM has adopted a stockholder rights plan. The rights are not intended to prevent a takeover of SCM. However, the rights may have the effect of rendering more difficult or discouraging an acquisition of SCM deemed undesirable by the SCM Board of Directors. The rights would cause substantial dilution to a person or group that attempts to acquire SCM on terms or in a manner not approved by the SCM Board of Directors, except pursuant to an offer conditioned upon redemption of the rights

Although we believe the above provisions and the adoption of a rights plan provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions apply even if the offer may be considered beneficial by some stockholders. Also, because these provisions may discourage a change of control, they could decrease the value of our common stock.

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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 revenue substantially offsets 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.

Fixed Income Investments

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.

Item 4. Controls and Procedures

During the 90-day period prior to the filing of this quarterly report, an evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended). Our Chief Executive Officer and Chief Financial Officer believe, based on the evaluation, that the design and operation of our disclosure controls and procedures are effective to ensure that material information relating to SCM is made known to them by others within SCM during the period in which this Report on Form 10-Q was being prepared. There have been no significant changes in our internal controls or, to our knowledge, in other factors that could significantly affect internal controls subsequent to that evaluation, including any corrective actions with regard to significant deficiencies and material weakness.

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PART II: OTHER INFORMATION

Item 1. Legal Proceedings

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 embedded in our bundled products. This patent expired on May 4, 2002. We believe that, 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.

Item 2. Changes in Securities and Use of Proceeds

On November 8, 2002, our Board of Directors approved a stockholders rights plan. Under the plan, we declared a dividend of one preferred share purchase right for each share of SCM common stock held by our stockholders of record as of the close of business on November 25, 2002. Each preferred share purchase right entitles the holder to purchase from us one one-thousandth of a share of Series A Participating Preferred Stock, par value $0.001 per share, at a price of $30.00, subject to adjustment. The rights are not immediately exercisable, however, and will become exercisable only upon the occurrence of certain events. If a person or group acquires, or announces a tender or exchange offer that would result in the acquisition of, 15 percent or more of our common stock while the stockholder rights plan remains in place, then, unless the rights are redeemed by us for $0.001 per right, the rights will become exercisable by all rights holders except the acquiring person or group for shares of SCM or the third party acquirer having a value of twice the right’s then-current exercise price. The stockholder rights plan may have the effect of deterring or delaying a change in control of SCM.

Item 3. Defaults upon Senior Securities

Not applicable.

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

At the Annual Meeting of Stockholders of the Company, held on July 10, 2002, the following matters were acted upon by the stockholders of the Company:

1. The election of Steven Humphreys, Oystein Larsen and Ng Poh Chuan as directors of the Company, each to hold office for a three-year term or until a successor is elected and qualified.

2. To ratify the appointment of Deloitte & Touche LLP as independent auditors of the Company for the fiscal year ending December 31, 2002.

The number of shares of Common Stock outstanding and entitled to vote at the Annual Meeting was 15,607,454 and 6,061,641 shares were represented in person or by proxy, constituting a quorum, which is defined as at least one-third of shares outstanding. The results of the voting on each of the matters presented to stockholders at the Annual Meeting are set forth below:

1. Election of Directors


	Votes For		Votes Withheld

a) Steven Humphreys		6,006,430		0
b) Oystein Larsen		6,061,641		0
c) Ng Poh Chuan		6,060,641		0


							Broker
	Votes For		Votes Withheld		Abstentions		Non-Votes

2. Ratification of Independent Accountants		5,900,414		68,790		115,707		0

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Item 5. Other Information

Not applicable.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit No. Description

3.2 Amended and Restated Bylaws of SCM Microsystems, Inc.

3.3 (*) Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of SCM Microsystems, Inc.

4.1 (*) Preferred Stock Rights Agreement, dated as of November 8, 2002, between SCM Microsystems, Inc. and American Stock Transfer and Trust Company.

99.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(*)

Incorporated by reference from SCM’s Current Report on Form 8-K filed on November 14, 2002

(b) Reports on 8-K

A current report on the Form 8-K was filed pursuant to the Securities and Exchange Act of 1934, as amended, on November 14, 2002, to announce the adoption of a stockholder rights plan and file a certificate of designation for the Series A Participating Preferred Stock and the stockholder rights plan.

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SIGNATURES

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.

Date: November 14, 2002

/s/ ANDREW WARNER

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

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SCM Microsystems, Inc.

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Robert Schneider, Chief Executive Officer of SCM Microsystems, Inc., certify that as of the date hereof:

1.    I have reviewed this quarterly report on Form 10-Q of SCM Microsystems, Inc.;

2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.    The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

        a)    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

        b)    evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

        c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 14, 2002 By: /s/ ROBERT SCHNEIDER

Robert Schneider

Chief Executive Officer

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SCM Microsystems, Inc.

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Andrew Warner, Vice President, Finance and Chief Financial Officer of SCM Microsystems, Inc., certify that as of the date hereof:

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 14, 2002 By: /s/ ANDREW WARNER

Andrew Warner

Vice President, Finance and Chief Financial Officer

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EXHIBIT INDEX

Exhibit No. Description

3.2 Amended and Restated Bylaws of SCM Microsystems, Inc.

3.3 (*) Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of SCM Microsystems, Inc.

4.1 (*) Preferred Stock Rights Agreement, dated as of November 8, 2002, between SCM Microsystems, Inc. and American Stock Transfer and Trust Company.

99.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(*)

Incorporated by reference from SCM’s Current Report on Form 8-K filed on November 14, 2002

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		September 30, 2002							December 31, 2001

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

Core Technology	60 months	$	6,671	$	(3,653	)	$	3,018	$	5,290	$	(2,769	)	$	2,521
Customer Relations	60 months		2,357		(885	)		1,472		1,139		(673	)		466
Trade name	Indefinite		4,183		(1,703	)		2,480		3,903		(1,703	)		2,200
Non-compete	24 months		848		(743	)		105		719		(675	)		44

Total intangible assets			14,059		(6,984	)		7,075		11,051		(5,820	)		5,231
Goodwill			29,373		(16,685	)		12,688		28,785		(16,685	)		12,100

Total		$	43,432	$	(23,669	)	$	19,763	$	39,836	$	(22,505	)	$	17,331

	•		SCM recognizes revenue 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,” which requires us to analyze our goodwill and intangible assets for impairment on a periodic basis.

	•		The carrying value of our net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. If these estimates and related assumptions change in the future, we may be required to reverse current valuation allowances against our deferred tax assets resulting in tax benefits in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets quarterly. In the third quarter of fiscal 2002, we reevaluated the realizability of the deferred tax assets and recorded a valuation allowance of $13.8 million.

	•		SCM accrues the estimated cost of product warranties at the time revenue is 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.

	•		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.

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

	•		adverse market perception of the separation may cause our stock price to decline.

	•		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 or other market 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.

	•		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.

	•		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 that will drive demand for solutions such as ours to create and publish digital content.

	•		our 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

	•		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.

	•		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.

	•		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.


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


	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 train 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.


	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 the acquisition.

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

	•		unexpected changes in foreign laws and regularity 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.

	•		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.

	1.		The election of Steven Humphreys, Oystein Larsen and Ng Poh Chuan as directors of the Company, each to hold office for a three-year term or until a successor is elected and qualified.

	2.		To ratify the appointment of Deloitte & Touche LLP as independent auditors of the Company for the fiscal year ending December 31, 2002.


Exhibit No.		Description

3.2		Amended and Restated Bylaws of SCM Microsystems, Inc.

3.3 (*)		Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of SCM Microsystems, Inc.

4.1 (*)		Preferred Stock Rights Agreement, dated as of November 8, 2002, between SCM Microsystems, Inc. and American Stock Transfer and Trust Company.

99.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

1.		I have reviewed this quarterly report on Form 10-Q of SCM Microsystems, Inc.;

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and



Date: November 14, 2002	By:	/s/ ROBERT SCHNEIDER

		Robert Schneider
		Chief Executive Officer



Date: November 14, 2002	By:	/s/ ANDREW WARNER

		Andrew Warner
		Vice President, Finance and Chief Financial Officer