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 MARCH 31, 2003


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

466 Kato Terrace, Fremont, CA 94539
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)

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

47211 Bayside Parkway, Fremont, CA 94538
(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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ]

At April 23, 2003, 15,495,323 shares of common stock were outstanding.

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TABLE OF CONTENTS


	Item 1. 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 Foreign Currencies
	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
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
EXHIBIT INDEX
EXHIBIT 10.21
EXHIBIT 10.22
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 March 31,

			2003			2002

Net revenue			$	31,026		$	43,429
Cost of revenue				21,256			28,849

Gross profit				9,770			14,580

Operating expenses:
	Research and development			3,451			2,851
	Selling and marketing			7,050			6,427
	General and administrative			3,214			4,147
	Amortization of intangible assets			409			289
	Restructuring and infrequent charges			353			789

		Total operating expenses		14,477			14,503

Income (loss) from operations				(4,707	)		77
Interest and other, net				1,089			(172	)

		Loss before income taxes		(3,618	)		(95	)
Benefit (provision) for income taxes				(106	)		208

Net income (loss)			$	(3,724	)	$	113

Basic net income (loss) per share			$	(0.24	)	$	0.01

Diluted net income (loss) per share			$	(0.24	)	$	0.01

Shares used to compute basic net income (loss) per share				15,551			15,542

Shares used to compute diluted net income (loss) per share				15,551			16,211

Comprehensive income (loss):
	Net income (loss)		$	(3,724	)	$	113
Unrealized gain on investments, net of deferred taxes				133			24
	Foreign currency translation adjustment			(670	)		203

		Total comprehensive income(loss)	$	(4,261	)	$	340

See notes to condensed consolidated financial statements.

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


				March 31,			December 31,
				2003			2002

ASSETS
Current assets:
	Cash and cash equivalents			$	51,300		$	50,133
	Short-term investments				4,557			5,384
	Accounts receivable, net of allowances of $4,554 and $5,327 as of March 31, 2003 and December 31, 2002, respectively				19,645			31,254
	Inventories				40,919			39,114
	Other current assets				6,444			6,629

		Total current assets			122,865			132,514
Property and equipment, net					9,146			9,124
Investments					429			—
Intangible assets, net					3,966			4,317
Other assets					2,881			2,662

Total assets				$	139,287		$	148,617

			LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	17,310		$	21,470
	Accrued compensation and related benefits				3,990			3,206
	Accrued restructuring and infrequent charges				7,399			8,175
	Accrued sales and marketing promotions				2,412			3,163
	Other accrued expenses				9,910			9,989
	Income taxes payable				2,603			2,514

		Total current liabilities			43,624			48,517

Stockholders’ equity:
	Common stock, $0.001 par value: 40,000 shares authorized; 15,495 and 15,582 shares issued and outstanding as of March 31, 2003 and December 31, 2002, respectively				16			16
	Additional paid-in capital				225,608			225,608
	Treasury stock				(923	)		(674	)
	Deferred stock compensation				(344	)		(417	)
	Accumulated deficit				(127,206	)		(123,482	)
	Other cumulative comprehensive loss				(1,488	)		(951	)

		Total stockholders’ equity			95,663			100,100

Total liabilities and stockholders’ equity				$	139,287		$	148,617

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)


				Three Months
				Ended March 31,

				2003			2002

Cash flows from operating activities:
	Net income (loss)			$	(3,724	)	$	113
	Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
		Deferred income taxes			—			31
		Depreciation and amortization			1,181			1,059
		Loss on disposal of fixed assets			30			—
		Amortization of deferred stock compensation			73			88
		Changes in operating assets and liabilities:
			Accounts receivable		11,563			4,044
			Inventories		(1,723	)		(4,582	)
			Other assets		99			(36	)
			Accounts payable		(4,116	)		(983	)
			Accrued expenses		(1,082	)		403
			Income taxes payable		82			(257	)

			Net cash provided by (used in) operating activities		2,383			(120	)

Cash flows from investing activities:
	Capital expenditures				(790	)		(438	)
	Proceeds from disposal of fixed assets				—			13
	Purchase of long-term investments				(432	)		—
	Maturities of short-term investments				960			—
	Purchases of short-term investments				—			(2,597	)

			Net cash used in investing activities		(262	)		(3,022	)

Cash flows from financing activities:
	Proceeds from issuance of equity securities, net				—			26
	Repurchase of common stock				(248	)		—

			Net cash provided by (used in) financing activities		(248	)		26

Effect of exchange rates on cash and cash equivalents					(706	)		666

Net increase (decrease) in cash and cash equivalents					1,167			(2,450	)
Cash and cash equivalents at beginning of period					50,133			59,421

Cash and cash equivalents at end of period				$	51,300		$	56,971

Supplemental disclosures of cash flow information - cash paid for:
	Income taxes			$	6		$	208

	Interest			$	4		$	7

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003

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 three-month period ended March 31, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems’ (“SCM”) December 31, 2002 Annual Report on Form 10-K.

Reclassifications – Certain reclassifications have been made to the 2002 financial statement presentation to conform to the 2003 presentation.

2. SHORT-TERM AND STRATEGIC INVESTMENTS

The Company’s available-for-sale short-term investments are as follows (in thousands):


	March 31, 2003						December 31, 2002

			Unrealized		Estimated				Unrealized			Estimated
	Cost		Gain		Value		Cost		Gain (Loss)			Value

Corporate notes	$	2,774	$	12	$	2,786	$	3,769	$	(25	)	$	3,744
U.S. government agencies		520		1		521		520		3			523

Total	$	3,294	$	13	$	3,307	$	4,289	$	(22	)	$	4,267

Strategic investments consist of corporate equity securities and investments in privately held companies, in which SCM holds less than 20% ownership and does not have the ability to exercise control, are accounted for by the cost method. Corporate securities are included in either short-term investments or long-term investments and stated at fair value based on quoted market price. Investments in privately held companies are included in long-term investments.

Strategic investments designated as short-term consist of the following (in thousands):


	March 31,		December 31,

	2003		2002

Investment in SmartDisk, at fair value	$	101	$	121
Investment in ActivCard, at fair value		1,149		996

Total	$	1,250	$	1,117

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Strategic investments designated as long-term consist of the following (in thousands):


	March 31,		December 31,
	2003		2002

Investment in Cryptovision, at cost	$	429	$	—

During each quarter, the Company evaluates its investments for possible asset impairment by examining a number of factors including the current economic conditions and markets for each investment, as well as their cash position and anticipated cash needs for the short- and long-term. During 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 2002.

3. INVENTORIES

Inventories consist of (in thousands):


	March 31,		December 31,

	2003		2002

Raw materials	$	18,336	$	16,733
Finished goods		22,583		22,381

	$	40,919	$	39,114

4. GOODWILL AND OTHER INTANGIBLE ASSETS

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

The changes in the carrying amount of goodwill for the year ended December 31, 2002 and the three months ended March 31, 2003 are as follows (in thousands):


				Digital
				Media and
	Security			Video			Total

Balance as of January 1, 2002	$	5,342		$	6,612		$	11,954
Reclassification of assembled workforce in accordance with SFAS No. 142		88			58			146
Goodwill acquired during the period		860			—			860
Impairment loss		(6,290	)		(6,670	)		(12,960	)

Balance as of December 31, 2002		—			—			—
Goodwill acquired during the period		—			—			—

Balance as of March 31, 2003	$	—		$	—		$	—

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Intangible assets consist of the following (in thousands):


				March 31, 2003							December 31, 2002

		Gross							Gross
	Amortization	Carrying		Accumulated					Carrying		Accumulated			Impairment
	Period	Value		Amortization			Net		Value		Amortization			Loss			Net

Core technology	60 months	$	6,799	$	(4,224	)	$	2,575	$	6,764	$	(3,949	)	$	—		$	2,815
Customer relations	60 months		2,470		(1,161	)		1,309		2,439		(1,033	)		—			1,406
Trade name	Indefinite		—		—			—		4,191		(1,703	)		(2,488	)		—
Non-compete agreements	24 months		862		(780	)		82		858		(762	)		—			96

Total intangible assets		$	10,131	$	(6,165	)	$	3,966	$	14,252	$	(7,447	)	$	(2,488	)	$	4,317

Amortization of intangible assets in the first quarter of 2003 was $0.4 million compared with $0.3 million for the same period of 2002.

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


Fiscal Year	Amount

2003 (remaining 9 months)	$	1,128
2004		1,130
2005		891
2006		575
2007		242

Total	$	3,966

Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company recorded an impairment charge of $15.4 million in the fourth quarter of 2002 related to the goodwill and trade names acquired in past acquisitions in order to adjust goodwill and intangible assets to their estimated fair value as of December 31, 2002.

5. RESTRUCTURING AND INFREQUENT CHARGES

In the first quarter of 2003 and 2002, SCM incurred net restructuring and infrequent charges of approximately $0.4 million and $0.8 million, respectively.

Restructuring costs for the three months ended March 31, 2003 consisted of approximately $0.1 million for severance costs and asset write downs related to the closure and relocation of certain SCM facilities. These charges were in accordance with SFAS 146 and represent the total amount expected to be incurred in the restructuring action. The severance costs related to the reduction in force of approximately 11 employees. Approximately eight of these employees were from Operations, two from Research and Development and one from General and Administrative functions. Approximately 10 were from Asia and one from Europe. Restructuring costs for the three months ended March 31, 2002 consisted of approximately $0.3 million of severance costs relating to the termination of nine employees, eight in the United States and one in Europe. Approximately four employees were from Sales and Marketing, two from Operations, two from General and Administrative functions and one from Research and Development.

Infrequent charges for the three months ended March 31, 2003 and March 31, 2002 consisted primarily of costs relating to the announced separation of the Digital Media and Video division of approximately $0.3 million and $0.4 million, respectively, for legal, accounting and professional fees. Infrequent charges for the three months ended March 31, 2002 also included $0.1 million of asset impairment.

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Accrued liabilities related to restructuring actions and infrequent activities during the first quarter of 2003 and during 2002 consist of the following (in thousands):


							Asset
	Legal			Lease			Write						Other
	Settlements			Commitments			Downs			Severance			Costs			Total

Balances as of January 1, 2002	$	578		$	1,515		$	43		$	307		$	273		$	2,716
Provision for 2002		756			2,037			1,031			958			7,305			12,087
Changes in estimates		(183	)		(229	)		2			(16	)		(30	)		(456	)

		573			1,808			1,033			942			7,275			11,631
Payments or write offs in 2002		(817	)		(425	)		(1,019	)		(902	)		(3,009	)		(6,172	)

Balances as of December 31, 2002		334			2,898			57			347			4,539			8,175
Provision for Q1 2003		—			—			17			111			234			362
Changes in estimates		—			(25	)		16			—			—			(9	)

		—			(25	)		33			111			234			353
Payments or write offs in Q1 2003		(334	)		(223	)		(32	)		(400	)		(140	)		(1,129	)

Balances as of March 31, 2003	$	—		$	2,650		$	58		$	58		$	4,633		$	7,399

6. RECENT ACCOUNTING PRONOUNCEMENTS

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for the Company’s fiscal year beginning January 1, 2003. The Company adopted the disclosure requirements of SFAS No. 148 in 2002. The Company has not yet determined the impact, if any, that SFAS No. 148 may have on its financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, (FIN No. 45). FIN No. 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. The Company adopted the disclosure requirements of FIN No. 45 in 2002. (See Note 10 concerning the reserve for warranty costs.) The recognition and measurement provisions apply to guarantees issued or modified after December 31, 2002. The Company does not expect the adoption of the recognition and measurement provisions to have a material effect on our financial position, results of operations or cash flows.

In June 2002, the FASB 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 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 No. 94-3, a liability for an exit cost, as defined in Issue No. 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. In 2003, the Company adopted the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002 and the adoption did not have an impact on the historical results of operations or cash flows.

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7. ACQUISITIONS

Towitoko AG

On May 22, 2002, SCM paid $4.5 million in cash in exchange for all the outstanding share capital of Towitoko AG, a privately held smart card-based security solutions 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 finalized in December 2002. A summary of the allocation of the purchase price is as follows (in thousands):


Cash		$	483
Tangible assets			2,476
Assumed liabilities			(1,854	)
Trade name			259
Customer relations			1,120
Core technology			1,270
Non-compete agreements			119
Goodwill			775

	Total	$	4,648

Intangible assets and goodwill from the acquisition approximated $3.5 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The goodwill and trade name of $1.1 million were evaluated for impairment in accordance with SFAS No. 142 in the fourth quarter of 2002 and were written off. Intangible assets with definite lives are being amortized over their useful lives which range from two to five years.

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.

8. STOCK BASED COMPENSATION

The Company accounts for its employee stock option plan in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (FIN No. 44). Accordingly, no compensation is recognized for employee stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at date of grant. If the exercise price is less than the market value at the date of grant, the difference is recognized as deferred compensation expense, which is amortized over the vesting period of the options. The Company accounts for stock options issued to non-employees in accordance with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and EITF Issue No. 96-18 under the fair value based method.

Pursuant to FIN No. 44, options assumed in a purchase business combination are valued at the date of acquisition at their fair value calculated using the Black-Scholes option pricing model. The fair value of the assumed options is included as part of the purchase price. The intrinsic value attributable to the unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the related options. Options assumed by the Company related to the business acquisitions made subsequent to July 1, 2000 (the effective date of FIN No. 44) have been accounted for pursuant to FIN No. 44.

For purposes of pro forma disclosure under SFAS No. 123, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting period, using the multiple option method. Pro forma information is as follows (in thousands, except per share amounts):

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	Three months ended
	March 31,

	2003			2002

Net income (loss), as reported	$	(3,724	)	$	113
Add: Stock-based compensation included in reported net income (loss), net of related tax effects		73			51
Less: Stock-based compensation expense determined under fair value method for all awards, net of related tax effects		(2,224	)		(9	)

Pro forma net income (loss)	$	(5,875	)	$	155

Net income (loss) per share, as reported - basic	$	(0.24	)	$	0.01

Net income (loss) per share, as reported - diluted	$	(0.24	)	$	0.01

Pro forma income (loss) per share, as reported - basic	$	(0.38	)	$	0.01

Pro forma income (loss) per share, as reported - diluted	$	(0.38	)	$	0.01

9. STOCK REPURCHASE PROGRAM

In October 2002, the Company’s Board of Directors approved a stock repurchase program in which up to $5.0 million may be used to purchase shares of the Company’s 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 other factors. Repurchases during the three months ended March 31, 2003 totaled approximately $0.2 million and the total repurchases made by the Company under this program totaled $0.9 million as of March 31, 2003.

10. COMMITMENTS

The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These agreements expire at various dates during the next fourteen years.

The Company provides warranties on certain product sales (generally one year) and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or to replace the products under warranty. We currently establish warranty reserves based on historical warranty costs for each product line combined with liability estimates based on the prior twelve months’ sales activities. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

Components of the reserve for warranty costs during the three months ended March 31, 2003 and the year ended December 31, 2002 were as follows (in thousands):


Balance at January 1, 2002	$	747
Additions related to current period sales		646
Warranty costs incurred in the current period		(563	)
Adjustments to accruals related to prior period sales		(141	)

Balance at December 31, 2002		689
Additions related to current period sales		164
Warranty costs incurred in the current period		(214	)
Adjustments to accruals related to prior period sales		(53	)

Balance at March 31, 2003	$	586

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11. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS

SCM adopted the provisions of 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.

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. In the first quarter of 2003 and 2002, the executive staff reviewed financial information and business performance along these two reportable segments based on contribution or loss from operations before amortization of deferred compensation and intangible assets, interest and income taxes, not including non-recurring gains and losses. We do not include intercompany transfers between segments for management purposes.

Summary information by segment for the quarters ended March 31, 2003 and 2002 is as follows (in thousands):


		Three Months Ended March 31,

		2003			2002

Security:
	Revenues	$	16,085		$	22,381
	Gross profit		6,779			9,103
	Divisional operating expenses		7,187			6,456
	Operating contribution (loss)		(408	)		2,647
DMV:
	Revenues	$	14,941		$	21,048
	Gross profit		2,991			5,477
	Divisional operating expenses		6,455			6,881
	Operating loss		(3,464	)		(1,404	)
Total:
	Revenues	$	31,026		$	43,429
	Gross profit		9,770			14,580
	Divisional operating expenses		13,642			13,337
	Operating contribution (loss)		(3,872	)		1,243

A reconciliation of the totals reported for the reportable segments to the applicable line items in the condensed consolidated financial statements is set forth below (in thousands):


		Three Months Ended March 31,

		2003			2002

Total operating contribution from reportable segments		$	(3,872	)	$	1,243
	Amortization of deferred stock compensation		73			88
	Amortization of intangible assets		409			289
	Restructuring and infrequent charges		353			789

	Income (loss) from operations		(4,707	)		77
	Interest and other, net		1,089			(172	)

Loss before income taxes			(3,618	)		(95	)
	Benefit (provision) for income taxes		(106	)		208

Net income (loss)		$	(3,724	)	$	113

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Geographic revenues are based on the country where the revenue is recognized. Information regarding revenues by geographic region for the three months ended March 31, 2003 and 2002 is as follows (in thousands):


	Three Months Ended March 31,

	2003		2002

United States	$	13,431	$	19,158
Europe		13,657		16,494
Asia-Pacific		3,938		7,777

	$	31,026	$	43,429

Long-lived assets by geographic location as of March 31, 2003 and December 31, 2002, are as follows (in thousands):


		March 31,		December, 31
		2003		2002

Property and equipment, net:
	United States	$	1,735	$	1,732
	Europe		2,818		3,042
	Asia-Pacific		4,593		4,350

	Total	$	9,146	$	9,124

Intangible assets, net:
	United States	$	1,513	$	1,763
	Europe		2,453		2,554

	Total	$	3,966	$	4,317

Two customers represented 13% and 10% of SCM’s total net revenue for the quarter ended March 31, 2003. One customer represented 16% of SCM’s total net revenue for the quarter ended March 31, 2002.

12. RELATED PARTY TRANSACTIONS

During the three months ended March 31, 2003 and 2002, SCM has recognized revenue of approximately $2.0 million and $0.2 million, respectively, from sales to ActivCard Corporation, a digital identity management software company. As of March 31, 2003 and December 31, 2002, accounts receivable amounts due from ActivCard were $1.5 million and $0.7 million, respectively. 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 Chairman and Chief Executive Officer 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 the three months ended March 2003 and 2002, SCM has recognized revenue of approximately $0.2 million and $0.4 million, respectively, from sales to Conax AS, a company engaged in the development and provision of smart-card based systems. As of March 31, 2003, there were no accounts receivable amounts due from Conax and as of December 31, 2002, the accounts receivable amounts due were $0.3 million. Oystein Larsen serves as the Executive Vice President, Business Development and New Business, of Conax and is a board director of SCM Microsystems. Mr. Larsen is not directly compensated for revenue transactions between the two companies.

During 2002, the Company discontinued sales of media and storage products as part of its announced separation of its Digital Media and Video division. This discontinuation included the sale of on hand, media and storage inventory to Pexagon, a company based in Connecticut. SCM recognized no revenue from these sales. As of March 31, 2003 and December 31, 2002, the Company had an accounts receivable due from Pexagon of $2.3 million and $2.9 million, respectively. Brian Campbell, an executive vice president of the Company is the majority shareholder

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of Pexagon. SCM and Pexagon continue to have an ongoing trading relationship, in the form of inventory transactions which are expected to have no material revenue or earnings impact on the results of operations of SCM.

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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 revenues or losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this Quarterly Report on Form 10-Q, the words “will,” “believe,” “anticipate,” “estimate,” “expect” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. You should not place undue reliance on these forward-looking statements. Although we believe that our plans, intentions and expectations reflected in or suggested by the forward-looking statements that we make in this Quarterly Report on Form 10-Q are reasonable, we can give no assurance these plans, intentions or expectations will be achieved. We disclose important factors that could cause our actual results to differ materially from our expectations under “Factors That May Affect Future Operating Results.” These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.

The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto set forth in Item 1 of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that could effect 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, 2003.

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.

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. During 2002 we evaluated various strategies to separate the Digital Media and Video business, including a spin-off or sale. On October 25, 2002, we further announced that difficult market conditions had led us to conclude that the full value of the Digital Media and Video business was not realizable at that time. We continue to evaluate market and other conditions for the advisability of pursuing, and may elect to pursue, a possible spin-off or sale of the division, or a sale to management.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses SCM’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, bad debts, inventories, asset impairment, deferred tax assets, accrued warranty reserves, restructuring costs, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various

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other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

• SCM recognizes product revenue upon shipment, net of estimated returns, provided that risk and title have transferred, a purchase order has been received, collection is determined to be probable and no significant obligations remain. Product return from distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection when given, and rebates, at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. While management believes we can make reliable estimates for these matters, nevertheless unsold products in these distribution channels are exposed to rapid changes in consumer preferences or technological obsolescence, product updates or competing products. Accordingly, it is possible that these estimates will change in the near future or that the actual amounts could vary materially from our estimates and that the amounts of such changes could seriously harm our business.

• SCM maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of SCM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

• SCM writes down 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 the level of total demand is less favorable than the projections or the mix of sales between products is different to that projected by management, additional inventory write-downs may be required. In 2002 SCM wrote down approximately $4.0 million of inventory based on such judgments.

• SCM holds minority interests in companies having operations or technologies in areas within or adjacent to our strategic focus. Some of these investments are in publicly traded companies and some are in non-publicly traded companies, whose value is difficult to determine. SCM records an investment’s 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 2002 SCM realized impairment charges of approximately $1.8 million related to our investments.

• 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 not previously recorded. On January 1, 2002, SCM adopted SFAS No. 142, Goodwill and Other Intangibles Assets, and is required to analyze our goodwill and intangible assets for impairment issues on a periodic basis. In the fourth quarter of 2002 we recorded $15.4 million of asset impairment based on conclusions that the goodwill and intangible assets from past acquisitions were impaired.

• The carrying value of the SCM’s net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. Management evaluates the realizability of the deferred tax assets on a quarterly basis. In 2002, we reevaluated the realizability of the deferred tax assets and recorded an additional valuation allowance of $12.7 million, reducing our 2002 net income. The deferred tax assets are still available for us to use in the future to offset taxable income, which would result in the recognition of a tax benefit and a reduction in our effective tax rate.

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• SCM accrues the estimated cost of product warranties during the period of sale. 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.

• On January 1 2003, we adopted SFAS No. 146, which requires that a liability for a cost associated with an exit or disposal activity initiated after December 31, 2002 be recognized when the liability is incurred and that the liability be measured at fair value. During 2002 the accounting for restructuring costs required us to record provisions and charges when we had a formal and committed plan. In connection with plans we had adopted, we recorded estimated expenses for severance and outplacement costs, lease cancellations, asset write-offs and other restructuring costs. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.

Recent Accounting Pronouncements

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for our fiscal year beginning January 1, 2003. We adopted the disclosure requirements of SFAS No. 148 in 2002. We have not yet determined the impact, if any, that SFAS No. 148 may have on our financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN No. 45). FIN No. 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. SCM adopted the disclosure requirements of FIN No. 45 in 2002. The recognition and measurement provisions will be applied to guarantees issued or modified after December 31, 2002. We do not expect the adoption of the recognition and measurement provisions to have a material effect on our financial position, results of operations or cash flows.

In June 2002, the FASB 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 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 No. 94-3, a liability for an exit cost as defined in Issue No. 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. In 2003, SCM adopted the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002, and the adoption did not have an impact on the historical results of operations or cash flows.

Acquisitions

During 2002 we made the following acquisition:

Towitoko AG

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results of operations since the date of acquisition. In connection with the acquisition, SCM incurred acquisition costs of approximately $0.1 million. At the time of the acquisition, Towitoko had no significant research and development projects that were incomplete.

Intangible assets and goodwill from the acquisition approximated $3.5 million and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. Non-compete agreements entered into in connection with the acquisition are being amortized on a straight-line basis over the term of the agreements of two years. The trade name and goodwill of $1.1 million were evaluated for impairment in the fourth quarter of 2002 and were written off. All other intangible assets are being amortized on a straight-line basis over an estimated useful life of five years.

RESULTS OF OPERATIONS

Net Revenue. Net revenue for the quarter ended March 31, 2003 was $31.0 million, compared with $43.4 million for the first three months of 2002, a decrease of 29%. The decrease in revenue in the first quarter of 2003 compared with the same quarter in 2002 was due to decreased shipments of both our Security products and our Digital Media and Video products.

Summary information by segment for the three months ended March 31, 2003 and 2002 is as follows (in thousands):


		Three months ended

		March 31,

		2003			2002

Security:
	Revenues	$	16,085		$	22,381
	Gross profit		6,779			9,103
	Gross profit %		42	%		41	%
Digital Media and Video:
	Revenues	$	14,941		$	21,048
	Gross profit		2,991			5,477
	Gross profit %		20	%		26	%
Total:
	Revenues	$	31,026		$	43,429
	Gross profit		9,770			14,580
	Gross profit %		31	%		34	%

Revenue from our Security division was $16.1 million in the first quarter of 2003, down $6.3 million, or 28%, from revenue of $22.4 million in the first quarter of 2002. This decrease reflects weaker demand across our Security business, including our conditional access modules used in European digital TV broadcast decryption as well as our smart card reader products, which are sold both to the U.S. government and to corporations and financial institutions worldwide. Sales of our smart card readers decreased primarily due to lower orders related to the U.S. government’s Common Access Program, which slowed deployments in the first quarter. Revenue from our Digital Media and Video division was $14.9 million in the first quarter of 2003, down $6.1 million, or 29%, from revenue of $21.0 million in the first quarter of 2002. Decreased sales in this division reflect a generally weaker retail market, especially in North America and the U.K.

Sales to SCM’s top 10 customers accounted for 60% and 50% of total net revenues in the first quarter of 2003 and 2002, respectively.

Gross Profit. Gross profit for the first quarter of 2003 was $9.8 million, or 31% of total net revenue, compared with $14.6 million, or 34%, for the first quarter of 2002. The decrease in gross profit in both absolute dollars and

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percentage of revenues was due to lower revenues in the 2003 quarter, as well as higher costs of products sold, in the Digital Media and Video division arising from high redemption rates on rebate programs run during the quarter. Gross profit for our Security products was $6.8 million, or 42% in the first quarter of 2003, and gross profit for our Digital Media and Video products was $3.0 million, or 20% of revenue. Our gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to fluctuate from period to period.

Research and Development. Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, SCM has not capitalized any software development costs. For the first quarter of 2003, research and development expenses were $3.5 million, compared with $2.9 million in the first quarter of 2002, an increase of 21%. As a percentage of total net revenue, research and development expenses were 11% and 7% in the first quarter of 2003 and 2002, respectively. The increase in absolute amounts was primarily due to increased investment in our Security division’s Indian and European research centers. 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 first quarter of 2003 were $7.1 million, or 23% of net revenues, compared with $6.4 million in the first quarter of 2002, or 15% of net revenues, an increase of 10%. This increase in absolute amounts of $0.6 million in 2003 is primarily due to increased headcount in selling and marketing costs in our Security Division in the U.S. and Europe, as well as promotional activities in our Digital Media and Video division.

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 first quarter of 2003, general and administrative expenses were $3.2 million, a decrease of 22% compared with $4.1 million in the first quarter of 2002, and representing 10% of total net revenue in the each of the first quarters of 2003 and 2002. This decrease in the absolute amount in 2003 compared to the same quarter in 2002 was primarily due to a decrease in expense for allowances of doubtful accounts receivable of $0.5 million, combined with reduced office administration and associated expenses related to the restructuring activities completed in 2002. We expect that general and administrative costs will fluctuate as a percentage of total net revenue.

Segment Operating Expenses. Throughout 2002, SCM organized, reported and measured our operating performance within two separate divisions: Security, and Digital Media and Video. Segment operating expenses include research and development, sales and marketing, and general and administrative. Operating expenses that are directly attributable to a division have been reported within that division. Shared operating expenses, such as facility and general and administrative costs have been allocated by management using consistent and reasonable assumptions. For detail of segment operating expenses prepared in accordance with G.A.A.P., see Note 11 in Item 1.

Security operating expenses for the first quarter of 2003 were $7.2 million, compared with $6.5 million in the first quarter of 2002, an increase of 11%. The increase was primarily due to higher headcount and associated personnel costs in both sales and marketing and research and development functions.

Digital Media and Video expenses for the first quarter of 2003 were $6.5 million, compared with $6.9 million in the first quarter of 2002, a decrease of 6%. This decrease was primarily due to reduced sales and marketing costs resulting from lower revenue levels for the period.

Amortization of Intangible Assets. Amortization of intangible assets in the first quarter of 2003 was $0.4 million compared with $0.3 million for the same period of 2002. Since our adoption of SFAS No. 142, Goodwill and Other Intangible Assets, on January 1, 2002, we have ceased to amortize goodwill and indefinite-lived intangible assets that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles for all of fiscal 2003 is expected to be approximately $1.5 million.

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Restructuring and Infrequent Charges. During the first quarter of 2003, SCM incurred restructuring and infrequent charges of $0.4 million. These expenses were primarily related to legal and consulting costs of $0.3 million related to the announced separation of our Digital Media and Video Division and $0.1 million relating to severance and other costs relating to reduction in workforce. During the first quarter of 2002, SCM incurred restructuring and infrequent charges of $0.8 million. These expenses consisted of $0.4 million related to legal and consulting costs in connection with the announced separation of our Digital Media and Video division, $0.3 million related to severance and other costs, and $0.1 million related to an asset impairment.

Interest and Other, Net. Interest and other, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt and foreign currency gains or losses. In the first quarter of 2003, interest and other income net, was $1.1 million, compared to a net expense of $0.2 million in the first quarter of 2002. Net interest income for the first quarter of 2003 was $0.2 million compared to $0.3 million for the same period in 2002. The decrease was primarily the result of lower average investable cash balances and lower interest rates. Foreign currency transaction gains for the first quarter of 2003 were $1.0 million compared to losses of $0.4 million for the first quarter of 2002. Gains in the first quarter of 2003 were primarily a result of favorable rate changes for the U.S. dollar compared to the Singapore dollar and the euro. The foreign exchange loss in the first quarter of 2002 was primarily due to unfavorable rate changes for the Singapore dollar and the British pound compared to the United States dollar. These gains and losses resulted primarily from the revaluation of receivables (especially U.S. dollar denominated receivables) to the functional currency of the subsidiary.

Benefit/Provision for Income Taxes. The provision for income taxes in the first quarter of 2003 was $0.1 million, compared to an income tax benefit of $0.2 million in the first quarter of 2002. The charge for the period was a result of taxes payable in foreign jurisdictions, which are not offset by operating loss carryforwards.

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2003, our working capital, which is defined as current assets less current liabilities, was $79.2 million compared to our working capital of $84.0 million as of December 31, 2002. Working capital decreased in the first quarter of 2003 by approximately $4.8 million, due to a decrease in accounts receivable of $11.6 million, partially offset by an increase in inventory of $1.7 million and a decrease in current liabilities of $5.1 million.

Cash and cash equivalents increased by $1.2 million during the first quarter of 2003, primarily due to cash provided by operating activities of $2.4 million being partially offset by cash used in investing activities of $0.3 million and in financing activities of $0.2 million, and the effect of exchange rates on cash and cash equivalents of $0.7 million. Cash provided by operations of $2.4 million was primarily due to a $3.7 million net loss, the adding back of depreciation and amortization of $1.2 million, and the amortization of deferred stock compensation of $0.1 million, decreases in accounts receivable of $11.6 million and in other assets of $0.1 million, and an increase in income taxes payable of $0.1 million. These were offset by an increase in inventories of $1.7 million and decreases in accounts payable of $4.1 million and accrued expenses of $1.1 million. Cash used in investing activities was primarily for capital expenditures of $0.8 million offset by $0.5 million provided by net short-term investments. Cash used in financing activities was primarily for the repurchase of common stock of $0.2 million.

We have a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million Euro (approximately $0.8 million as of March 31, 2003). The German line has no expiration date and bears interest at 6%. Borrowings under this line of credit are unsecured. We have an unsecured line of credit in France of 0.3 million euros (approximately $0.3 million as of March 31, 2003) which bears interest at 3.86% and has no expiration date. In addition, the Company has three separate overdraft facilities for the Company’s manufacturing facility of 4.0 million, 1.2 million and 5.9 million Singapore dollars (approximately $2.3 million, $0.7 million and $3.3 million as of March 31, 2003) with base interest rates of 4.8%, 6.5% and 7.0% respectively. All of the facilities are unsecured and due upon demand. There were no amounts outstanding under any of these credit facilities as of March 31, 2003.

During the fourth quarter of 2002, our Board of Directors authorized a stock repurchase program under which up to $5 million may be used to purchase shares of SCM’s stock on the open market in the United States or Germany

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from time to time over the next two years, depending on market conditions, share prices and other factors. Such repurchases could be used to offset the issuance of additional shares resulting from employee stock option exercises and the sale of shares under the employee stock purchase plan. As of March 21, 2003, we had repurchased 199,400 shares of our common stock for an aggregate of $0.9 million pursuant to this program.

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

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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 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 $127.2 million as of March 31, 2003. We may continue to incur losses in the future and may be unable to achieve or 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 revenues, gross margins and operating results may fluctuate significantly from quarter to quarter due to, among other things:

• business and economic conditions overall and in our markets,

• 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 or large enterprises and products sold to customers in the digital television market, 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 sales and marketing organization and programs;

• technological changes in the market for our products;

• increased competition or reductions in the average selling prices that we are able to charge;

• fluctuations in the value of foreign currencies against the U.S. dollar;

• the timing and amount of marketing and research and development expenditures;

• our investment experience related to our strategic minority equity investments; and

• costs related to events such as acquisitions, litigation and write-off of investments.

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

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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 revenues difficult. The timing of closing larger orders increases the risk of quarter-to-quarter fluctuation. If orders forecasted for a specific group of customers for a particular quarter are not realized or revenues are not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected.

Weakness in the economy could decrease 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 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 in the European digital television market has contributed to declining and lower than expected revenue. If this trend continues, future revenues and results of operation in our Security business will be adversely affected. Also, current market forecasts for consumer spending in 2003 indicate that demand may decrease for our digital media and video products sold through the retail and OEM channels. Actual reductions or constrained rate of growth in consumer spending impacts our OEM business as well as our retail business because our OEM customers may reduce or cancel orders for our products if their own visibility of future orders is compromised by decreased demand or if increased pricing pressures force them to reduce costs by ceasing to bundle our products along with their own. Decreased or lower than expected sales will most likely adversely affect our stock price. Also, reduced or canceled orders for our products could lead to decreased sales in a particular period and, because many of our products are custom made for particular customers, could also cause us to write off inventory. In some cases, customers could delay payment or be unable to pay for orders made to us, causing us to increase our allowance for doubtful accounts or to write off certain receivables. In addition, if we anticipate that demand for our products will not increase, we may decide to reduce our operating expense base in order to maintain or reach profitability. Decreased sales, expense base decreases or any write-offs, or any combination of these, could have a material adverse effect 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 2002, we restructured our internal organization in order to manage separately our Security and Digital Media and Video businesses. On October 25, 2002, we further announced that difficult market conditions had led us to conclude that the full value of the Digital Media and Video business was not realizable at that time. We have continued to evaluate various options to separate the Digital Media and Video business, including trade sale, a spin-off or a sale of the business to management, in order to determine which will maximize value for our stockholders. Continued weak performance in the capital markets has made it difficult to predict the timing and success of either of these options. If the capital markets do not stabilize, we may not be able to successfully create a public market for the Digital Media and Video business, and potential acquirers may not be able to secure funding to purchase the business. Other factors, such as the Digital Media and Video business’s operating performance, may affect our ability to sell or spin off the business.

If we are unable to properly implement the separation, our revenue and results of operations and our stock price could be adversely affected. The 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 it. 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:

• the separation process and results thereof 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 further delayed or cancelled;

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• we may incur accounting charges in connection with the separation;

• as a result of the separation, or our customers’ perceptions about the announced separation, we may be unable to sell and required to write off some of our existing Digital Media and Video inventory;

• as a result of the separation, or our customers’ perceptions about the announced separation, we may be unable to collect and required to write off some of our existing accounts receivable;

• our separation strategy could be perceived negatively by our customers or cause them to choose our competitors’ products instead of ours;

• implementation of the separation strategy could make it more difficult for us to retain employees and may otherwise adversely affect employee morale; and

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

Our listing on the Prime Standard of 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 Prime Standard 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 Prime Standard specifically, regardless of the Nasdaq market conditions, could negatively impact our stock price.

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

The stock market has recently experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. During the 12-month period from April 24, 2002 to April 23, 2003, the reported sale prices for our common stock on the Nasdaq market ranged between $13.90 and $2.50 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 Prime Standard 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.

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.

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We cannot predict the future growth rate, if any, or size or composition of the market for 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 and Asia of open systems digital television platforms that require conditional access modules, such as ours, to decrypt pay-TV broadcasts;

• 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;

• the uncertainty of adoption of smart cards by the U.S. government for large scale security programs beyond those in place today; 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 financially because of their high-cost delivery models and that smaller operators have also been adversely affected by turmoil in the industry. We believe these factors have contributed to revenue declines over the past year 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 media content.

If we do not achieve our targeted levels of revenues or anticipate the correct mix of products that will be sold we may be required to record further charges related to excess inventories.

Due to the unpredictable nature of the demand for our products in both our Security and Digital Media and Video businesses we are required to place orders with our suppliers for components, finished products and services in advance of actual customer commitments to purchase these products. Significant unanticipated fluctuations in demand could result in costly excess production or inventories. In order to minimize the negative financial impact of this excess production we may be required to significantly reduce the sales price of the product to increase demand which in turn could result in a reduction in the value of the original inventory purchase. This could result in a charge adversely impacting our cost of revenues and financial condition.

During 2002 we recorded charges related to inventory in our Digital Media and Video division due in part to the reduced demand for specific products. The relatively large number of products in the portfolio of this division increases the complexity of forecasting which in turn increases the risk that certain products may be purchased that become excess to demand. The announced separation of the Digital Media and Video Division may impact further our ability within that division to effectively execute adequate inventory forecasting and management, and failure of execution may result in further inventory related charges.

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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

• 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 Secure Card, Secure PINpad, Secure Retail and Secure Trusted 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 to a lesser degree by financial institutions, 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:

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• 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, OmniKey and STMicroelectronics in smart card readers, ASICs and universal smart card reader interfaces.

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

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

• ADS, Canopus, Pinnacle Systems, Roxio and ULead for digital video capture and editing products.

We also experience indirect competition from some of our customers who sell alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these competitors and new competitors, such as Motorola, that develop digital 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 second half of 2002 than during the first half of the year. However, revenue in our Security business declined during the second half of 2002. Because of the seasonal aspect of our business and other factors, there is no assurance that 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 for any of our products will increase or remain as strong in 2003.

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Revenues in our Security division depend on U.S. government budgetary allocations for information technology (IT) projects.

We sell a significant proportion of our Security products to the U.S. government. Expenditures on IT projects has varied in the past and we expect it to continue in the future. As a result of shifting defense priorities, U.S. government spending may be reallocated away from IT projects, such as the Common Access Card Program. For example, sales of our smart card readers decreased during the first quarter of 2003 because the U.S. government’s Common Access Program slowed deployments. The slowing of such government projects could negatively impact our sales.

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 television broadcasting 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 60% of our total net revenue in the three months ended March 31, 2003. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant OEM or retail customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business or digital media and video business, could result in decreased revenues and/or inventory or receivables write-offs and otherwise harm our business and operating results.

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

We now sell a significant percentage of our Digital Media and Video products through our retail channel. Direct retail distribution creates risks for us including:

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

• generally lower margins for products due to, among other factors, greater price competition and increased promotional and distribution costs;

• higher cost of revenue than projected as a result of unexpectedly high levels of participation in rebate or other promotional programs we use to stimulate sales;

• the need to develop, and the related marketing expense of developing brand recognition for our Dazzle branded products;

• reliance on our retail distributors maintaining appropriate levels of our products to meet consumer demand;

• difficulties associated with assessing appropriate product return reserves;

• the risk that, if we lower our prices, we would have to compensate distributors or retailers who bought our products at higher prices;

• risks associated with retailers and distributors selling our competitors’ products, including the risk that retailers and distributors may not recommend, or continue to recommend, our products;

• the need to protect the reputation of our brands for quality and value; and

• the need to successfully and cost-effectively maintain current retail channels and develop new retail distribution channels for these products.

For instance, in the first quarter of 2003 cost of revenues in our Digital Media and Video division were adversely affected by high redemption rates on rebate programs we ran during the quarter.

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 and Sears. These retail distributors may have limited capital to invest in inventory, and their decisions to purchase our products are partly a function of pricing, terms and special promotions offered by 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

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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 Media and 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 of competition in the retail market for shelf space and 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 request 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 that the customers do not believe they can sell. 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 beyond present levels in the future. Once these products have been returned, and although the products are in good working order, we may be required to take additional inventory reserves to reflect the decreased market value of slow-selling returned inventory.

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

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

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

• manage different product lines for different markets;

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

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

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

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

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

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

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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. For example, in the past, SanDisk Corporation purchased various digital media reader/writer products from us and marketed them under the SanDisk brand. In the first quarter of 2001, SanDisk began marketing digital media reader/writers that they had developed internally and canceled orders for our products. 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 $177.7 million in 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. During 2002, we reorganized our internal operations into two distinct business divisions to better address the demands of our different markets and prepare for the separation of our Digital Media and Video business. These two divisions are led by separate management teams and share only a few employees and operational resources. Managing them independently 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 480 as of March 31, 2003.

Although our revenue did not increase in 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 receipt of new revenue and might cause us to expend more resources to obtain new customer wins.

We face risks associated with our past and future acquisitions.

A component of our business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. In 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

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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 frequently is 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 a sales and marketing perspective;

• integrate and support pre-existing supplier, distributor 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 48%, 58% and 48% of our revenues for the years ended December 31, 2002, 2001 and 2000, respectively, and approximately 57% and 56% of our revenues for the three months ended March 31, 2003 and 2002, respectively, were derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, including:

• changes in foreign currency exchange rates;

• 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 regulatory 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.

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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. Total strategic investments were $1.7 million at March 31, 2003.

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 or 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 third-party manufacturers cannot meet their performance obligations.

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. More recently we have transferred our Digital Media and Video product production to independent contract manufacturers in Asia. Foreign manufacturing poses a number of risks, including:

• difficulties in staffing;

• currency fluctuations;

• potentially adverse tax consequences;

• unexpected changes in regulatory requirements;

• tariffs and other trade barriers;

• political and economic instability;

• lack of control over the manufacturing process and ultimately over the quality of our products;

• late delivery of our products, whether because of limited access to our product components, transportation delays and interruptions, difficulties in staffing, or disruptions such as natural disasters;

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• capacity limitations of our manufacturers, particularly in the context of new large contracts for our products, whether because our manufacturers lack the required capacity or are unwilling to produce the quantities we desire; and

• obsolescence of our hardware products at the end of the manufacturing cycle.

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 must manage and coordinate our relationships with our third-party distribution service properly.

We have recently contracted with a third-party distribution service to package and distribute our Digital Media and Video products to the retail channel. Timely distribution to our retail customers requires coordination between our third-party distribution service, SCM and our contract manufacturers. Our failure to coordinate the logistics of product production, pack-out and distribution for our customers, or our failure to manage the relationship between ourselves and our contract distributor, could result in late or incorrect shipments to customers, and this could harm our business.

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 a limited number of suppliers could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Some of these suppliers have experienced and are continuing to experience financial difficulties. Disruption or termination of the supply of these components or software 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 Dazzle, Dazzle Digital Video Creator, SmartOS and SwapSmart 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

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rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to as great an extent as do the laws of the United States. Because many of our products are sold and a portion of our business is conducted overseas, primarily in Europe, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate.

We 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.

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 results of operations could be adversely affected. The ability of our competitors to increase the recognition and acceptance of their brands may also affect the relative value of our brand. Also, if our products perform poorly or have other problems, the value of our brands 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 2002 and 2001 we recorded asset impairments of approximately $15.4 million and $36.1 million respectively, based on management’s conclusions that intangible assets and goodwill from previous acquisition were impaired.

We are exposed to credit risk on our accounts receivable. This risk is heightened as economic conditions worsen.

We distribute our products through third-party resellers and retailers and directly to certain customers. A substantial majority of our outstanding trade receivables are not covered by collateral or credit insurance. While we have procedures in place to monitor and limit exposure to credit risk on our trade and non-trade receivables, these

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procedures may not be effective in limiting credit risk and avoiding losses. Additionally, if the global economy and regional economies fail to improve or continue to deteriorate, it becomes more likely that we will incur a material loss or losses as a result of the weakening financial condition of one or more of our customers.

External factors such as the SARS virus and potential terrorist attacks could have a material adverse effect on the U.S. and global economies.

Concerns about the SARS virus and the possibility of potential terrorist attacks could have an adverse effect upon an already weakened world economy and could cause U.S. and foreign businesses to slow spending on products and services and to delay sales cycles. The economic uncertainty resulting from these concerns may continue to negatively impact consumer as well as business confidence at least in the short term.

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 interruption of service to some business customers. Additionally, we may experience natural disasters that could disrupt 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.

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

Foreign Currencies

SCM transacts business in various foreign currencies, primarily in certain European countries, the U.K., 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 assess the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis.

SCM’s foreign currency transactional 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

SCM’s exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments. 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 portfolios is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria we have established, our exposure to market and credit risk is not expected to be material.

At March 31, 2003, we had $51.3 million in cash and cash equivalents and $4.6 million in short term investments. Based on our cash and cash equivalents and short term investments as of December 31, 2002, a hypothetical 10% change in interest rates along the entire interest rate yield curve would not materially affect the fair value of our financial instruments that are exposed to changes in interest rates.

Item 4. Controls and Procedures

Evaluation and disclosure controls and procedures

Within 90 days prior to the date of this report (the Evaluation Date), the Company’s Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-14). Based on that evaluation, these officers have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and designed to ensure that material information relating to the Company and the Company’s consolidated subsidiaries would be made known to them by others within those entities.

Changes in internal controls

There were no significant changes in the Company’s internal controls, or to the Company’s knowledge, in other factors that could significantly affect the Company’s disclosure controls and procedures subsequent to the Evaluation Date.

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PART II: OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable.

Item 2. Changes in Securities and Use of Proceeds

Not applicable.

Item 3. Defaults upon Senior Securities

Not applicable.

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

No matters were submitted to a vote of security holders during the first quarter of 2003.

Item 5. Other Information

Not applicable.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.


Exhibit
Number		Description of Document

3.1*		Fourth Amended and Restated Certificate of Incorporation.

3.2***		Amended and Restated Bylaws of Registrant.

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

4.1*		Form of Registrant’s Common Stock Certificate.

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

10.20*****		Shuttle Technology Group Unapproved Share Option Scheme

10.21		Lease dated March 3, 2003 between SCM Microsystems, Inc and CarrAmerica Realty Corporation.

10.22		Lease dated March 18, 2003 between SCM Microsystems, Inc. and CalWest Industrial Holdings, LLC.

21.1**		Subsidiaries of the Registrant.

99.1		Certifications 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.

Filed previously as an exhibit to SCM’s Registration Statement on Form S-1 (See SEC File No. 333-29073).

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**		Filed previously as an exhibit to SCM’s Annual Report on Form 10-K for the year ended December 31, 2000 (See SEC File No. 000-22689).

***		Filed previously as an exhibit to SCM’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (see SEC File No. 000-22689).

****		Filed previously as an exhibit to SCM’s Registration Statement on Form 8-A (See SEC File No. 000-29440).

*****		Filed previously as an exhibit to SCM’s Registration Statement on Form S-8 (See SEC File No. 333-73061).

(b) Reports on Form 8-K

A current report on the Form 8-K was filed pursuant to the Securities and Exchange Act of 1934, as amended, on April 24, 2003, reporting under Item 5 the announcement that on April 24, 2003, SCM Microsystems issued a press release regarding its financial results for the first quarter of 2003.

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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: April 30, 2003


	/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: April 30, 2003	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:


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: April 30, 2003	By:	/s/ ANDREW WARNER Andrew Warner
		Vice President, Finance and Chief Financial Officer

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EXHIBIT INDEX


Exhibit No.		Description

10.21		Lease dated March 3, 2003 between SCM Microsystems, Inc and CarrAmerica Realty Corporation.

10.22		Lease dated March 18, 2003 between SCM Microsystems, Inc. and CalWest Industrial Holdings, LLC.

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.

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	•		SCM recognizes product revenue upon shipment, net of estimated returns, provided that risk and title have transferred, a purchase order has been received, collection is determined to be probable and no significant obligations remain. Product return from distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection when given, and rebates, at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. While management believes we can make reliable estimates for these matters, nevertheless unsold products in these distribution channels are exposed to rapid changes in consumer preferences or technological obsolescence, product updates or competing products. Accordingly, it is possible that these estimates will change in the near future or that the actual amounts could vary materially from our estimates and that the amounts of such changes could seriously harm our business.

	•		SCM maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of SCM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

	•		SCM writes down 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 the level of total demand is less favorable than the projections or the mix of sales between products is different to that projected by management, additional inventory write-downs may be required. In 2002 SCM wrote down approximately $4.0 million of inventory based on such judgments.

	•		SCM holds minority interests in companies having operations or technologies in areas within or adjacent to our strategic focus. Some of these investments are in publicly traded companies and some are in non-publicly traded companies, whose value is difficult to determine. SCM records an investment’s 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 2002 SCM realized impairment charges of approximately $1.8 million related to our investments.

	•		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 not previously recorded. On January 1, 2002, SCM adopted SFAS No. 142, Goodwill and Other Intangibles Assets, and is required to analyze our goodwill and intangible assets for impairment issues on a periodic basis. In the fourth quarter of 2002 we recorded $15.4 million of asset impairment based on conclusions that the goodwill and intangible assets from past acquisitions were impaired.

	•		The carrying value of the SCM’s net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. Management evaluates the realizability of the deferred tax assets on a quarterly basis. In 2002, we reevaluated the realizability of the deferred tax assets and recorded an additional valuation allowance of $12.7 million, reducing our 2002 net income. The deferred tax assets are still available for us to use in the future to offset taxable income, which would result in the recognition of a tax benefit and a reduction in our effective tax rate.

	•		SCM accrues the estimated cost of product warranties during the period of sale. 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.

	•		On January 1 2003, we adopted SFAS No. 146, which requires that a liability for a cost associated with an exit or disposal activity initiated after December 31, 2002 be recognized when the liability is incurred and that the liability be measured at fair value. During 2002 the accounting for restructuring costs required us to record provisions and charges when we had a formal and committed plan. In connection with plans we had adopted, we recorded estimated expenses for severance and outplacement costs, lease cancellations, asset write-offs and other restructuring costs. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.

	•		business and economic conditions overall and in our markets,

	•		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 or large enterprises and products sold to customers in the digital television market, 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 sales and marketing organization and programs;

	•		technological changes in the market for our products;

	•		increased competition or reductions in the average selling prices that we are able to charge;

	•		fluctuations in the value of foreign currencies against the U.S. dollar;

	•		the timing and amount of marketing and research and development expenditures;

	•		our investment experience related to our strategic minority equity investments; and

	•		costs related to events such as acquisitions, litigation and write-off of investments.

	•		the separation process and results thereof 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 further delayed or cancelled;

	•		we may incur accounting charges in connection with the separation;

	•		as a result of the separation, or our customers’ perceptions about the announced separation, we may be unable to sell and required to write off some of our existing Digital Media and Video inventory;

	•		as a result of the separation, or our customers’ perceptions about the announced separation, we may be unable to collect and required to write off some of our existing accounts receivable;

	•		our separation strategy could be perceived negatively by our customers or cause them to choose our competitors’ products instead of ours;

	•		implementation of the separation strategy could make it more difficult for us to retain employees and may otherwise adversely affect employee morale; and

	•		adverse market perception of the separation or the delay in 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 Prime Standard 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 and Asia of open systems digital television platforms that require conditional access modules, such as ours, to decrypt pay-TV broadcasts;

	•		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;

	•		the uncertainty of adoption of smart cards by the U.S. government for large scale security programs beyond those in place today; 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 media 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

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

	•		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.

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

	•		ADS, Canopus, Pinnacle Systems, Roxio and ULead for digital video capture and editing products.

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

	•		generally lower margins for products due to, among other factors, greater price competition and increased promotional and distribution costs;

	•		higher cost of revenue than projected as a result of unexpectedly high levels of participation in rebate or other promotional programs we use to stimulate sales;

	•		the need to develop, and the related marketing expense of developing brand recognition for our Dazzle branded products;

	•		reliance on our retail distributors maintaining appropriate levels of our products to meet consumer demand;

	•		difficulties associated with assessing appropriate product return reserves;

	•		the risk that, if we lower our prices, we would have to compensate distributors or retailers who bought our products at higher prices;

	•		risks associated with retailers and distributors selling our competitors’ products, including the risk that retailers and distributors may not recommend, or continue to recommend, our products;

	•		the need to protect the reputation of our brands for quality and value; and

	•		the need to successfully and cost-effectively maintain current retail channels and develop new retail distribution channels for these products.

	•		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.

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

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

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

	•		coordinate research and development efforts; and

	•		consolidate duplicate facilities and functions.

	•		changes in foreign currency exchange rates;

	•		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 regulatory 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.

	•		difficulties in staffing;

	•		currency fluctuations;

	•		potentially adverse tax consequences;

	•		unexpected changes in regulatory requirements;

	•		tariffs and other trade barriers;

	•		political and economic instability;

	•		lack of control over the manufacturing process and ultimately over the quality of our products;

	•		late delivery of our products, whether because of limited access to our product components, transportation delays and interruptions, difficulties in staffing, or disruptions such as natural disasters;

	•		capacity limitations of our manufacturers, particularly in the context of new large contracts for our products, whether because our manufacturers lack the required capacity or are unwilling to produce the quantities we desire; and

	•		obsolescence of our hardware products at the end of the manufacturing cycle.