SCM MICROSYSTEMS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10 – Q


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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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)

(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 November 7, 2003, 15,273,863 shares of common stock were outstanding.

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TABLE OF CONTENTS


	PART I. FINANCIAL INFORMATION
	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
EXHIBIT INDEX
EXHIBIT 10.27
EXHIBIT 10.28
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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


					Three Months Ended						Nine Months Ended
					September 30,						September 30,

					2003			2002			2003			2002

Net revenue					$	15,860		$	18,671		$	53,913		$	66,282
Cost of revenue						9,243			11,386			32,363			39,326

Gross profit						6,617			7,285			21,550			26,956

Operating expenses:
	Research and development					1,949			2,294			6,879			6,410
	Selling and marketing					2,748			2,769			8,571			7,472
	General and administrative					3,082			2,343			8,975			8,005
	Amortization of intangible assets					287			254			841			507
	Restructuring and infrequent charges (credits)					(647	)		1,438			1,779			3,401

			Total operating expenses			7,419			9,098			27,045			25,795

Income (loss) from operations						(802	)		(1,813	)		(5,495	)		1,161
Gain (loss) on investments						365			(1,242	)		(95	)		(1,242	)
Interest and other income (expense), net						75			(151	)		520			(664	)

Loss from continuing operations before income taxes						(362	)		(3,206	)		(5,070	)		(745	)
Benefit (provision) for income taxes						1,456			(3,055	)		1,235			(2,886	)

Net income (loss) from continuing operations						1,094			(6,261	)		(3,835	)		(3,631	)
Loss from discontinued operations, net of income taxes						(4,074	)		(13,490	)		(13,214	)		(15,721	)
Loss on sale of discontinued operations						(5,911	)		—			(11,800	)		—

Net loss					$	(8,891	)	$	(19,751	)	$	(28,849	)	$	(19,352	)

Net income (loss) per share from continuing operations:
		Basic			$	0.07		$	(0.40	)	$	(0.25	)	$	(0.23	)
		Diluted			$	0.07		$	(0.40	)	$	(0.25	)	$	(0.23	)

Loss per share from discontinued operations:
		Basic and diluted			$	(0.66	)	$	(0.86	)	$	(1.63	)	$	(1.01	)

Net loss per share:
		Basic and diluted			$	(0.59	)	$	(1.26	)	$	(1.88	)	$	(1.24	)

Shares used to compute basic net loss per share						15,169			15,629			15,334			15,588

Shares used to compute diluted net income (loss) per share						15,476			15,629			15,334			15,588

Comprehensive loss:
	Net loss				$	(8,891	)	$	(19,751	)	$	(28,849	)	$	(19,352	)
Unrealized gain (loss) on investments						(369	)		(1	)		(320	)		(15	)
	Foreign currency translation adjustment					1,263			135			1,386			3,205

				Total comprehensive loss	$	(7,997	)	$	(19,617	)	$	(27,783	)	$	(16,162	)

See notes to condensed consolidated financial statements.

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


			September 30,			December 31,
			2003			2002

ASSETS
Current assets:
	Cash and cash equivalents		$	34,134		$	50,133
	Short-term investments			5,314			5,384
	Accounts receivable, net of allowances of $3,848 and $5,327 as of September 30, 2003 and December 31, 2002, respectively			11,258			31,254
	Inventories			7,706			39,114
	Consideration due from sale of assets			21,550			—
	Other current assets			5,086			4,460
	Assets of discontinued operations held for sale			1,204			—

		Total current assets		86,252			130,345
Property and equipment, net				7,291			9,124
Intangible assets, net				3,172			4,317
Other assets				7,204			4,831

Total assets			$	103,919		$	148,617

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	8,856		$	21,470
	Accrued compensation and related benefits			3,634			3,206
	Accrued royalties			1,741			2,107
	Accrued restructuring and infrequent charges			7,718			8,175
	Accrued sales and marketing promotions			2,583			3,163
	Other accrued expenses			5,643			7,882
	Income taxes payable			2,865			2,514

		Total current liabilities		33,040			48,517

Stockholders’ equity:
	Common stock, $0.001 par value: 40,000 shares authorized; 15,189 and 15,582 shares issued and outstanding as of September 30, 2003 and December 31, 2002, respectively			16			16
	Additional paid-in capital			225,871			225,608
	Treasury stock			(2,778	)		(674	)
	Deferred stock compensation			(14	)		(417	)
	Accumulated deficit			(152,331	)		(123,482	)
	Other cumulative comprehensive income (loss)			115			(951	)

		Total stockholders’ equity		70,879			100,100

Total liabilities and stockholders’ equity			$	103,919		$	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)


					Nine Months
					Ended September 30,

					2003			2002

Cash flows from operating activities:
	Net loss				$	(28,849	)	$	(19,352	)
	Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
		Loss from discontinued operations				25,014			15,721
		Deferred income taxes				135			3,034
		Depreciation and amortization				2,892			1,882
		Loss on investments				89			1,242
		Loss on disposal of fixed assets				122			6
		Stock compensation expense				51			—
		Changes in operating assets and liabilities:
			Accounts receivable			3,214			6,578
			Inventories			6,807			(6,138	)
			Other assets			(807	)		74
			Accounts payable			(1,239	)		(3,608	)
			Accrued expenses			(3,957	)		1,082
			Income taxes payable			(216	)		245

				Net cash provided by operating activities from continuing operations		3,256			766

				Net cash provided by (used in) operating activities from discontinued operations		(16,226	)		825

				Net cash provided by (used in) operating activities		(12,970	)		1,591

Cash flows from investing activities:
	Capital expenditures					(1,045	)		(444	)
	Proceeds from disposal of fixed assets					13			7
	Purchase of long-term investments					(432	)		—
	Business acquired, net of cash received					—			(4,157	)
	Maturities of short-term investments					3,733			1,296
	Purchases of short-term investments					(3,663	)		(5,586	)

				Net cash used in investing activities from continuing operations		(1,394	)		(8,884	)

				Net cash used in investing activities from discontinued operations		(251	)		(368	)

				Net cash used in investing activities		(1,645	)		(9,252	)

Cash flows from financing activities:
	Proceeds from issuance of equity securities, net					461			953
	Repurchase of common stock					(2,104	)		—

				Net cash provided by (used in) financing activities		(1,643	)		953

Effect of exchange rates on cash and cash equivalents						259			1,044

Net decrease in cash and cash equivalents						(15,999	)		(5,664	)
Cash and cash equivalents at beginning of period						50,133			59,421

Cash and cash equivalents at end of period					$	34,134		$	53,757

Supplemental disclosures of cash flow information - cash paid for:
	Income taxes				$	101		$	553

	Interest				$	5		$	49

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 nine-month period ended September 30, 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” or “the Company”) Annual Report on Form 10-K for the year ended December 31, 2002.

2. DISCONTINUED OPERATIONS

In conjunction with a strategy to focus on its core Security business, in the second quarter of 2003, the Company’s Board of Directors authorized two transactions to sell SCM’s consumer Digital Media and Video business. On July 25, 2003, the Company completed the sale of selected assets of its digital video business, including substantially all product rights, inventory, intellectual property, trade names and other rights, to Pinnacle Systems, Inc. (“Pinnacle”). In return, Pinnacle issued to SCM 1,866,851 shares of Pinnacle common stock valued, for purposes of the agreement, at $21.5 million. The purchase price was subject to post-closing cash adjustments relating to inventory, backlog, receivables and prorated royalty fees. Under the agreement, Pinnacle has registered the shares with the Securities and Exchange Commission (“SEC”) and SCM intends to sell them over a period of several months. If the proceeds received from the sale of the Pinnacle shares are less than $21.5 million, Pinnacle will compensate SCM in cash to reach the $21.5 million level. Should the sale of Pinnacle stock yield more than $21.5 million, SCM will compensate Pinnacle for the excess value received. Pursuant to an agreement signed on October 31, 2003, Pinnacle has agreed to pay to SCM $2.0 million in cash including but not limited to the aforementioned adjustments.

On August 1, 2003, the Company completed the sale of its consumer digital media reader business to Zio Corporation, which will purchase and distribute existing inventories of digital media readers and also will assume certain liabilities and supply arrangements for the planned disposition of reader inventory. Consideration from the sale is limited to future purchases of reader inventory and assumptions of certain liabilities and contracts. As of September 30, 2003, Zio has purchased $1.8 million of reader inventory.

As a result of these sales, beginning in the second quarter of fiscal 2003 the Company has accounted for the consumer Digital Media and Video business as a discontinued operation, and statements of operations for all periods presented have been restated to reflect the discontinuance of this business. Accordingly, as of June 30, 2003, SCM is focused on its continuing Security business, which is to provide secure digital access solutions to original equipment manufacturer, or OEM customers in three markets: Digital TV, PC Security and Flash Media Interface. For comparability, certain 2002 amounts have been reclassified, where appropriate, to conform to the financial statement presentation used in 2003, including the adjustments necessary to conform to the discontinued operations presentation of the consumer Digital Media and Video business during 2002.

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The operating results for the discontinued operations of the consumer Digital Media and Video business for the three and nine months ended September 30, 2003 and 2002, are as follows (in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,

	2003			2002			2003			2002

Net revenue	$	1,132		$	22,216		$	22,865		$	63,003
Operating loss	$	(4,084	)	$	(1,950	)	$	(14,008	)	$	(4,844	)
Net loss before income taxes	$	(4,074	)	$	(2,574	)	$	(13,214	)	$	(5,118	)
Income tax provision	$	—		$	(10,916	)	$	—		$	(10,603	)
Loss from discontinued operations	$	(4,074	)	$	(13,490	)	$	(13,214	)	$	(15,721	)

3. SHORT-TERM AND STRATEGIC INVESTMENTS

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


	September 30, 2003						December 31, 2002

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

Corporate notes	$	3,375	$	13	$	3,388	$	3,769	$	(25	)	$	3,744
U.S. government agencies		1,422		2		1,424		520		3			523
U.S. Treasury notes		496		6		502		—		—			—

Total	$	5,293	$	21	$	5,314	$	4,289	$	(22	)	$	4,267

Strategic investments consist of corporate equity securities and investments in privately held companies. Those 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.

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


	September 30,		December 31,
	2003		2002

Investment in SmartDisk, at fair value	$	—	$	121
Investment in ActivCard, at fair value		—		996

Total	$	—	$	1,117

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 2003 and 2002, because of the continued deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties by SmartDisk and Cryptovision in obtaining additional funding, SCM determined that investments in SmartDisk, Cryptovision and ActivCard were impaired. Accordingly, in 2003 SCM wrote off the investments in SmartDisk and Cryptovision and in 2002 wrote down the investments in SmartDisk and ActivCard to their fair market value as of September 2002.

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4. INVENTORIES

Inventories consist of (in thousands):


	September 30,		December 31,
	2003		2002

Raw materials	$	4,262	$	16,733
Finished goods		3,444		22,381

	$	7,706	$	39,114

5. GOODWILL AND OTHER INTANGIBLE ASSETS

SCM adopted SFAS No. 142, Goodwill and Other Intangible Assets, as of January 1, 2002. As defined by SFAS No. 142, at the beginning of 2002 the Company identified two reporting units which constituted 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. In the second quarter of 2003, the Company disposed of one of the two reporting units.

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. During the second quarter of 2003, the Company wrote off intangible assets of $0.3 million related to the disposition of the consumer Digital Media and Video business.

The changes in the carrying amount of goodwill for the year ended December 31, 2002 and the nine months ended September 30, 2003 are as follows (in thousands):


				Discontinued
	Security			Operations			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 September 30, 2003	$	—		$	—		$	—

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Intangible assets consist of the following (in thousands):


		September 30, 2003							December 31, 2002

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

Core technology	60 months	$	3,680	$	(1,707	)	$	1,973	$	6,764	$	(3,949	)	$	—		$	2,815
Customer relations	60 months		1,669		(521	)		1,148		2,439		(1,033	)		—			1,406
Trade name	Indefinite		—		—			—		4,191		(1,703	)		(2,488	)		—
Non-compete agreements	24 months		154		(103	)		51		858		(762	)		—			96

Total intangible assets		$	5,503	$	(2,331	)	$	3,172	$	14,252	$	(7,447	)	$	(2,488	)	$	4,317

Amortization of intangible assets in the first nine months of 2003 was $0.8 million, compared with $0.5 million for the same period of 2002.

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


Fiscal Year	Amount

2003 (remaining 3 months)	$	287
2004		1,099
2005		921
2006		610
2007		255

Total	$	3,172

6. RESTRUCTURING AND INFREQUENT CHARGES

In the first nine months of 2003 and during 2002, SCM incurred net restructuring and infrequent charges related to continuing Security operations of approximately $1.8 million and $8.5 million, respectively, as well as charges related to discontinued operations of $7.9 million and $3.1 million, respectively.

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

Continuing Security Operations:


							Asset
	Legal			Lease/Contract			Write						Other
	Settlements			Commitments			Downs			Severance			Costs			Total

Balances as of January 1, 2002	$	—		$	310		$	—		$	307		$	6		$	623

Provision for 2002		25			674			214			575			7,159			8,647
Changes in estimates		(25	)		(38	)		1			(16	)		(30	)		(108	)

		—			636			215			559			7,129			8,539
Payments or write offs in 2002		—			(85	)		(200	)		(618	)		(2,603	)		(3,506	)

Balances as of December 31, 2002		—			861			15			248			4,532			5,656
Provision for Q1 2003		—			—			—			103			235			338
Changes in estimates		—			(9	)		—			—			—			(9	)
Payments or write offs in Q1 2003		—			10			1			(348	)		(141	)		(478	)

Balances as of March 31, 2003		—			862			16			3			4,626			5,507
Provision for Q2 2003		—			284			139			1,381			318			2,122
Changes in estimates		—			(21	)		—			(3	)		—			(24	)
Payments or write offs in Q2 2003		—			(109	)		(110	)		(123	)		(1,456	)		(1,798	)

Balances as of June 30, 2003		—			1,016			45			1,258			3,488			5,807
Provision for Q3 2003		—			561			90			223			74			948
Changes in estimates		—			(938	)		(28	)		(52	)		(577	)		(1,595	)
Reclasses		—			—			—			(40	)		1,393			1,353
Payments or write offs in Q3 2003		—			(379	)		(85	)		(1,360	)		(301	)		(2,125	)

Balances as of September 30, 2003	$	—		$	260		$	22		$	29		$	4,077		$	4,388

Discontinued Operations:


							Asset
	Legal			Lease/Contract			Write						Other
	Settlements			Commitments			Downs			Severance			Costs			Total

Balances as of January 1, 2002	$	578		$	1,205		$	43		$	—		$	267		$	2,093

Provision for 2002		731			1,363			817			383			145			3,439
Changes in estimates		(158	)		(190	)		—			—			—			(348	)

		573			1,173			817			383			145			3,091
Payments or write offs in 2002		(817	)		(340	)		(818	)		(284	)		(406	)		(2,665	)

Balances as of December 31, 2002		334			2,038			42			99			6			2,519
Provision for Q1 2003		—			—			18			7			—			25
Changes in estimates		—			(16	)		16			—			—			—
Payments or write offs in Q1 2003		(334	)		(233	)		(34	)		(51	)		—			(652	)

Balances as of March 31, 2003		—			1,789			42			55			6			1,892
Provision for Q2 2003		—			—			102			545			1,673			2,320
Changes in estimates		—			(40	)		6			—			(6	)		(40	)
Payments or write offs in Q2 2003		—			(156	)		(95	)		(195	)		(14	)		(460	)

Balances as of June 30, 2003		—			1,593			55			405			1,659			3,712
Provision for Q3 2003		—			1,953			1,372			1,637			661			5,623
Changes in estimates		—			—			—			(64	)		—			(64	)
Reclasses		—			—			—			(39	)		—			(39	)
Payments or write offs in Q3 2003		—			(1,671	)		(1,372	)		(1,261	)		(1,598	)		(5,902	)

Balances as of September 30, 2003	$	—		$	1,875		$	55		$	678		$	722		$	3,330

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Restructuring costs related to continuing Security operations for the three and nine months ended September 30, 2003 consisted of severance costs of $0.2 million and $1.7 million, respectively; credits to lease commitments of $(0.4) million and $(0.1) million, respectively; and $0.1 million and $0.2 million, respectively, of asset write-downs related to the closure and relocation of certain SCM facilities as well as $0.1 million of associated legal costs for the three- and nine-month periods stated. These charges were in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Severance costs for the three months ended September 30, 2003 related to the termination of three employees in Europe. Of these, one was from General and Administrative and two were from Sales and Marketing. For the nine-month period, severance costs related to the termination of 24 employees, of which four were in the United States, ten in Europe and ten in Asia. Of these, six were from General and Administrative, nine from Operations, four from Sales and Marketing, and five from Research and Development. The Company has substantially completed the restructuring actions and does not expect to incur further significant charges during the fourth quarter of 2003.

Restructuring costs related to continuing Security operations for the three and nine months ended September 30 2002 were $0.6 million and $0.8 million respectively and consisted primarily of severance costs of $0.1 million and $0.3 million respectively; and lease commitments of $0.5 million for the three and nine month periods. Severance costs for the three months ended September 30, 2002 related to the termination of two employees, of which one was in the United States and one in Europe. Of these, one was from General and Administrative and one from Operations. For the nine-month period, severance costs related to the termination of nine employees, of which three were in the United States, one in Europe and five in Asia. Of these, one was from General and Administrative, two from Operations and six from Sales and Marketing.

Infrequent charges and credits related to continuing Security operations for the three and nine months ended September 30, 2003 were $(0.6) million and $(0.2) million, respectively. These credits related to changes in estimates related to certain tax obligations in Europe. Infrequent charges related to continuing Security operations for the three and nine months ended September 30, 2002 were $0.8 million and $2.6 million, respectively, and consisted primarily of legal and professional costs relating to the announced separation of the Digital Media and Video division.

Exit costs related to discontinued operations apply for the second and third quarters of fiscal 2003. For the three and six months ended September 30, 2003, these exit costs consisted of severance costs of $1.6 million and $2.1 million, respectively; legal and professional fees of $0.6 million and $2.3 million, respectively; and lease commitments of $0.5 million, contract settlements of $1.5 million and asset write downs of $1.4 million for both the three- and six-month periods. These charges were in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, and were related to the sale of the consumer Digital Media and Video business. For the three-month period ended September 30, 2003, severance costs associated with discontinued operations related to the termination of 81 employees, of which 26 were from Operations, 31 from Sales and Marketing; 10 from Research and Development; and 14 from General and Administrative. Of these, 78 were from the United States and three were from Europe. For the six-month period ended September 30, 2003, severance costs associated with discontinued operations related to the termination of 94 employees, of which 28 were from Operations; 39 from Sales and Marketing; 10 from Research and Development; and 17 from General and Administrative. Of these, 80 were from the United States and 14 were from Europe. The Company expects to incur additional charges for exit costs during the next three months of approximately $6.0 to $10.0 million.

Restructuring costs related to discontinued operations apply for the first quarter of fiscal 2003. For the three months ended March 31, 2003, restructuring costs were $25,000 and consisted primarily of asset write-downs. Restructuring and infrequent charges related to discontinued operations for the three and nine months ended September 30, 2002 consisted primarily of severance of $13,000 and $0.2 million respectively; $0.3 million of legal settlements and legal costs for the three-month period, and $0.1 million of asset write downs for the nine-month period. For the three-month period ended September 30, 2002, severance costs related to the termination of three employees in the United States, of which one was from Operations and two were from Sales and Marketing. For the nine-month period ended September 2002, severance related to the termination of 25 employees. Five were from Operations, three from Research and Development, 15 from Sales and Marketing, and two from General and Administrative functions. Sixteen were from the United States and nine from Europe.

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7. RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest Entities, which clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not provide sufficient equity at risk for the entity to support its activities. FIN No. 46 is effective for all variable interest entities created after January 31, 2003. For variable interest entities acquired or created prior to February 1, 2003, the provisions of FIN No. 46 must be applied to the first interim or annual period beginning after September 15, 2003. The Company is currently evaluating the impact of FIN No. 46 on its financial position, results of operations and cash flows.

In December 2002, 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 11 concerning the reserve for warranty costs.) The recognition and measurement provisions apply to guarantees issued or modified after December 31, 2002. The adoption of the recognition and measurement provisions did not have a material effect on the Company’s 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. The adoption did not have an impact on the Company’s historical results of operations or cash flows.

8. ACQUISITIONS

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 Towitoko’s 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.

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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.

9. 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.

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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):


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

	2003			2002			2003			2002

Net loss, as reported	$	(8,891	)	$	(19,751	)	$	(28,849	)	$	(19,352	)
Add: Stock-based compensation included in reported net loss		58			156			168			259
Less: Stock-based compensation expense determined under fair value method for all awards		(922	)		(4,296	)		(3,696	)		(6,192	)

Pro forma net loss	$	(9,755	)	$	(23,891	)	$	(32,377	)	$	(25,285	)

Net loss per share, as reported - basic and diluted	$	(0.59	)	$	(1.26	)	$	(1.88	)	$	(1.24	)

Pro forma loss per share - basic and diluted	$	(0.64	)	$	(1.53	)	$	(2.11	)	$	(1.62	)

10. 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. There were no repurchases during the three months ended September 30, 2003 and repurchases for the nine months ended September 30, 2003 totaled approximately $2.1 million. As of September 30, 2003, total repurchases made by the Company under this program totaled $2.8 million.

11. COMMITMENTS AND CONTINGENCIES

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. The Company currently establishes 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.

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Components of the reserve for warranty costs during the nine months ended September 30, 2003 and the year ended December 31, 2002 were as follows (in thousands):


	Continuing
	Security			Discontinued
	Operations			Operations			Total

Balance at January 1, 2002	$	465		$	282		$	747
Additions related to current period sales		540			106			646
Warranty costs incurred in the current period		(466	)		(97	)		(563	)
Adjustments to accruals related to prior period sales		(116	)		(25	)		(141	)

Balance at December 31, 2002		423			266			689
Additions related to current period sales		234			235			469
Warranty costs incurred in the current period		(206	)		(262	)		(468	)
Adjustments to accruals related to prior period sales		(74	)		(183	)		(257	)

Balance at September 30, 2003	$	377		$	56		$	433

Certain claims and lawsuits have been filed or are pending against us. In the opinion of management, all such matters have been adequately provided for, are without merit, or are of such kind that if disposed of unfavorably, would not have a material adverse effect on our consolidated financial position or results of operations.

In September 2003, we were served with a complaint in YOUCre8, Inc. a/k/a DVDCre8, Inc. v. Pinnacle Systems, Inc., Dazzle Multimedia, Inc., and SCM Microsystems, Inc. (Superior Court of California, Alameda County Case No. RG03114448). The Complaint was filed by a software company whose software was distributed by Dazzle Multimedia, now SCM Multimedia. The complaint alleges that in connection with our sale of certain assets of our former Dazzle video products business, we tortiously interfered with DVDCre8’s relationship with SCM Multimedia and others, engaged in acts to restrain competition in the DVD software market, misappropriated DVDCre8’s trade secrets, and engaged in unfair competition. The complaint seeks unspecified damages against SCM and SCM Multimedia. Pursuant to the Asset Purchase Agreement between SCM and Pinnacle, we are seeking indemnification from Pinnacle for all or part of the damages and the expenses incurred to defend such claims. SCM believes the claims by DVDCre8 are without merit and intends to vigorously defend the action.

12. 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 the executive staff consisting of the Chief Executive Officer and Chief Financial Officer.

In conjunction with a strategy to focus on its core Security business, in the second quarter of 2003 the Company’s Board of Directors authorized two transactions to sell SCM’s consumer Digital Media and Video business. The Company completed the sale of its digital video business to Pinnacle Systems on July 25, 2003 and completed the sale of its consumer digital media reader business to Zio Corporation on August 1, 2003. As a result of these sales, beginning in the second quarter of 2003, the Company has accounted for the consumer Digital Media and Video business as a discontinued operation, and all periods presented have been restated to reflect the discontinuance of this business. Accordingly, as of June 30, 2003, SCM is focused on its continuing Security business, which is to provide secure digital access solutions to OEM customers in three markets: Digital TV, PC Security and Flash Media Interface.

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Information regarding revenues by segment for the three- and nine-month periods ended September 30, 2003 and 2002 is as follows (in thousands):.


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2003			2002			2003			2002

Digital TV:
	Revenue	$	8,086		$	5,074		$	29,913		$	35,083
	Gross profit		3,112			2,199			11,031			15,589
	Gross profit %		38	%		43	%		37	%		44	%
PC Security:
	Revenue	$	5,075		$	9,203		$	16,490		$	23,442
	Gross profit		1,960			3,330			6,277			7,912
	Gross profit %		39	%		36	%		38	%		34	%
Flash Media Interface:
	Revenue	$	2,699		$	4,394		$	7,510		$	7,757
	Gross profit		1,545			1,756			4,242			3,455
	Gross profit %		57	%		40	%		56	%		45	%

Total:
	Revenue	$	15,860		$	18,671		$	53,913		$	66,282
	Gross profit		6,617			7,285			21,550			26,956
	Gross profit %		42	%		39	%		40	%		41	%

Geographic revenues are based on the country where the revenue is recognized. Information regarding revenues by geographic region for the three- and nine-month periods ended September 30, 2003 and 2002 is as follows (in thousands):


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2003		2002		2003		2002

United States	$	3,794	$	7,513	$	13,573	$	19,619
Europe		9,946		6,813		31,777		32,915
Asia-Pacific		2,120		4,345		8,563		13,748

	$	15,860	$	18,671	$	53,913	$	66,282

Long-lived assets by geographic location as of September 30, 2003 and December 31, 2002, are as follows (in thousands):


		September 30,		December, 31
		2003		2002

Property and equipment, net:
	United States	$	661	$	1,732
	Europe		2,471		3,042
	Asia-Pacific		4,159		4,350

	Total	$	7,291	$	9,124

Intangible assets, net:
	United States	$	886	$	1,763
	Europe		2,286		2,554

	Total	$	3,172	$	4,317

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One customer represented 23% of SCM’s total net revenue for the third quarter of 2003 and two customers represented 19% and 14% of SCM’s total net revenue for the first nine months of 2003. Three customers each represented 12% and one customer represented 11% of total net revenue for the three months ended September 30, 2002. No customer represented more than ten percent of total net revenue for the nine months ended September 30, 2002.

13. RELATED PARTY TRANSACTIONS

During the three months ended September 30, 2003 and 2002, SCM recognized revenue of approximately $32,000 and $1.2 million, respectively, from sales to ActivCard Corporation, a digital identity management software company. During the nine months ended September 30, 2003 and 2002, SCM recognized revenue of approximately $2.8 million and $1.5 million, respectively, from sales to ActivCard. As of September 30, 2003 there were no accounts receivable amounts due from ActivCard and as of December 31, 2002, accounts receivable amounts due from ActivCard were $0.7 million. Although SCM is not a sole supplier of specific products to ActivCard, the companies have shared the services of Steven Humphreys. Mr. Humphreys was the Chairman and Chief Executive Officer of ActivCard through September 30, 2003, and is the Chairman of SCM’s Board of Directors. Mr. Humphreys was not directly compensated for revenue transactions between the two companies.

During the three months ended September 30, 2003 and 2002, SCM 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. During the nine months ended September 30, 2003 and 2002, SCM recognized revenue of approximately $0.5 million and $1.2 million, respectively, from sales to Conax. As of September 30, 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 member 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 the announced separation of its Digital Media and Video business. 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 September 30, 2003 and December 31, 2002, the Company had an accounts receivable due from Pexagon of $0.7 million and $2.9 million, respectively. Brian Campbell, a former Executive Vice President of the Company, is the majority shareholder 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.

On August 1, 2003, the Company completed the sale of its consumer digital media reader business to Zio Corporation, a company based in California that had been formed by Andrew Warner, the Company’s former Chief Financial Officer. The agreement with Zio Corporation includes provisions for distributing existing inventories of the Company’s digital media readers, with the Company being reimbursed for product per agreed terms in the sales agreement. As of September 30, 2003, SCM has recognized no revenue from sales to Zio Corporation. Also as of September 30, 2003, the Company had an accounts receivable due from Zio Corporation of $1.8 million.

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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 affect our business, including the disclosures under Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors and the audited financial statements and notes thereto contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 27, 2003.

Overview

Prior to the second quarter of 2003, SCM operated in two segments, Security, and Digital Media and Video. In conjunction with a strategy to focus on our core Security business, in the second quarter of 2003 our Board of Directors authorized two transactions to sell SCM’s consumer Digital Media and Video business. We completed the sale of our consumer digital video business to Pinnacle Systems on July 25, 2003 and completed the sale of our consumer digital media reader business to Zio Corporation on August 1, 2003. As a result, beginning in the second quarter of 2003, we have accounted for the consumer Digital Media and Video business as a discontinued operation, and statements of operations for all periods presented have been restated to reflect the discontinuance of this business. Accordingly, as of June 30, 2003, SCM is focused on our continuing Security business, which is to provide secure digital access solutions to OEM customers in three markets: Digital TV, PC Security and Flash Media Interface.

In our continuing Security business, we design, develop and sell hardware, software and silicon products that enable people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We sell our products primarily into the smart card-based security markets for digital TV and PC/network access. Our target customers are primarily original equipment manufacturers in the consumer electronics, computer, digital photography and conditional access system industries, as well as digital television operators, the government sector and corporate enterprises. We sell and license our products through a direct sales and marketing organization, as well as through distributors, value added resellers and systems integrators worldwide. SCM was organized in Delaware in 1996.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our condensed 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 us 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, we evaluate our 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

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

We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our condensed 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. Maintenance revenue is deferred and amortized over the period of the maintenance contract.

• 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 our 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. Based on such judgments, we wrote down approximately $2.0 million of inventory in 2002 and $0.8 million of inventory in the first nine months of 2003.

• From time to time, SCM holds minority interests in companies with 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. We record 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. We realized impairment charges of approximately $1.2 million related to our investments in 2002, and $0.5 million in the first nine months of 2003.

• 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 $6.6 million of asset impairment based on conclusions that the goodwill and intangible assets from past acquisitions were impaired.

• The carrying value of 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. We evaluate 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. The divestiture of our consumer Digital Media and Video business to Pinnacle Systems and Zio Corporation as well as future changes to the operating structure of our new strategic focus on our Security business may limit our ability to utilize current deferred tax assets.

• 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

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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, Accounting for Costs Associated with Exit or Disposal Activities, 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 January 2003, the FASB issued FASB Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest Entities, which clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not provide sufficient equity at risk for the entity to support its activities. FIN No. 46 is effective for all variable interest entities created after January 31, 2003. For variable interest entities acquired or created prior to February 1, 2003, the provisions of FIN No. 46 must be applied to the first interim or annual period beginning after September 15, 2003. We are currently evaluating the impact of FIN No. 46 on our financial position, results of operations or cash flows.

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 SCM’s 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. The adoption did not have an impact on our historical results of operations or cash flows.

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Acquisitions

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 Towitoko’s results of operations were included in our 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 revenues consist of sales of conditional access modules and equipment test tools used in digital TV broadcast decryption (our Digital TV products); smart card readers used to provide secure access to PCs and networks in the government, enterprise and financial sectors (our PC Security products); and ASIC technology and other products used for transferring digital data between flash media cards and electronic devices such as PCs (our Flash Media Interface products). Net revenue for the quarter ended September 30, 2003 was $15.9 million, compared with $18.7 million for the third quarter of 2002, a decrease of 15%. This decrease primarily reflects weaker demand for our PC Security and Flash Media Interface products.

Net revenues in our PC Security product segment declined 45% in the third quarter of 2003 compared with the same period of 2002. This was primarily because the U.S. government, which was our largest customer for smart card readers in the 2002 period, has substantially completed its deployment of readers in conjunction with the Department of Defense Common Access Card program, and therefore did not place significant orders for smart card readers during recent months. Although we believe new smart card projects are being planned by the U.S. government that will require smart card readers, none are yet active. Sales in our Flash Media Interface product segment declined 39% in the third quarter of 2003 compared with the same period of 2002, due to variability in the level of orders received on a quarterly basis. Sales in our Digital TV product segment increased 59% in the third quarter of 2003 versus the same period of the prior year. This is primarily because sales levels in the third quarter of 2002 were negatively impacted by a $4.0 million revenue reserve related to a major customer in Europe. Sales for our Digital TV products are, in general, lower than in previous periods. This is primarily due to the loss of the aforementioned customer, poor economic conditions in Europe, and in the most recent quarter, to new competition from companies offering modules that provide access to pay-TV content for a limited period of time rather than through ongoing subscription.

For the first nine months of 2003, net revenue was $53.9 million, compared with $66.3 million for the first nine months of 2002, a decrease of 19%. This decrease was primarily related to a 30% decline in sales of our PC Security products in the first nine months of 2003, compared with the same period of 2002. This decline was related to the decreased level of smart card reader deployments under the U.S. government’s Common Access Card program, as detailed above. Sales of our Digital TV products declined 15%, primarily due to general economic conditions affecting demand in Europe. Sales of our Flash Media Interface products remained at constant levels for the first nine months of 2003 and 2002, respectively. We expect that sales of our PC Security and Digital TV products will continue to be under pressure over the next several quarters as a result of economic conditions in our markets and the timing of U.S. government projects.

Sales to SCM’s top 10 customers accounted for 57% and 62% of total net revenues in the three- and nine-month periods ended September 30, 2003, respectively, with sales to our largest customer accounting for 23% and 19% of total net revenues, respectively, during those periods. This compares with 91% and 59% of total net revenues coming from our top ten customers in the three- and nine-month periods of 2002, respectively. One customer accounted for 12% of net revenues in the three-month period ended September 30, 2002. No single customer accounted for more than 10% of our revenues for the nine-month period ended September 30, 2002.

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Gross Profit. Gross profit for the third quarter of 2003 was $6.6 million, or 42% of net revenue, compared with $7.3 million, or 39%, for the third quarter of 2002. Gross profit in the first nine months of 2003 was $21.6 million, or 40% of net revenue, compared with $27.0 million, or 41%, for the first nine months of 2002. The increase in gross profit in percentage of revenue in the third quarter was primarily due to a favorable mix of higher margin products sold during the quarter, in particular, our Flash Media Interface products. Gross profit was lower in terms of absolute dollars in the first nine months of 2003 compared with the previous year period due to a lower level of sales in the period.

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, inventory write-downs, 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 third quarter of 2003, research and development expenses were $1.9 million, or 12% of net revenue, compared with $2.3 million, or 12% of net revenue, in the third quarter of 2002. In the third quarter of 2003, research and development costs include a credit of $0.3 million for the completion of development efforts which were recognized as costs of sales. Without the credit, research and development expenses in the third quarter of 2003 would have been $2.2 million, or 14% of net revenue. For the first nine months of 2003, research and development expenses were $6.9 million, or 13% of net revenue, compared with $6.4 million, or 10% of net revenue for the first nine months of 2002. The increase in absolute amounts year to date in 2003 was primarily due to the integration of research and development headcount from the acquisition of Towitoko in May 2002. 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 other marketing costs. Selling and marketing expenses for the third quarter of 2003 were $2.7 million, or 17% of net revenue, compared with $2.8 million, or 15% of net revenue in the third quarter of 2002. For the first nine months of 2003, selling and marketing expenses were $8.6 million, or 16% of net revenue, compared with $7.5 million, or 11% of revenue for the first nine months of 2002, an increase of 15%. The 2003 increase year to date was primarily due to increased headcount in Europe associated with the acquisition of Towitoko in May 2002.

General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing SCM’s administrative functions, professional fees such as legal, audit, tax and consulting fees, and changes to allowances for doubtful accounts receivable. In the third quarter of 2003, general and administrative expenses were $3.1 million, or 19% of total net revenue, compared with $2.3 million, or 13% of revenue in the third quarter of 2002, an increase of 32%. For the first nine months of 2003, general and administrative expenses were $9.0 million, or 17% of total net revenue, compared with $8.0 million, or 12% of revenue in the first nine months of 2002. The increase in absolute amounts in 2003 compared to the same period in 2002 was primarily due to increased administrative costs associated with the Towitoko acquisition as well as increased administrative costs in India and Japan. We expect that general and administrative costs will fluctuate as a percentage of total net revenue.

Amortization of Intangible Assets. Amortization of intangible assets in the third quarter of both 2003 and 2002 was $0.3 million. For the first nine months of 2003, amortization of intangible assets was $0.8 million, compared with $0.5 million for the first nine months of 2002. Since our adoption on January 1, 2002 of SFAS No. 142, Goodwill and Other Intangible Assets, 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 $1.1 million.

Restructuring and Infrequent Charges. During the third quarter of 2003, SCM recorded a credit to restructuring and infrequent charges of $0.6 million, which resulted from changes in management estimates related to facility closures associated with the restructuring of our continuing Security operations. For the nine months ended September 30, 2003, SCM incurred restructuring and infrequent charges of $1.8 million, including the $0.6 million

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credit taken in the third quarter. These charges primarily related to the restructuring of our continuing Security operations along functional lines, following the sale of our consumer Digital Media and Video business. Charges in the second quarter included facility closure costs of $0.4 million, severance of $1.4 million and legal and professional fees of $0.3 million. In the first quarter of 2003, restructuring and infrequent charges included severance of $0.1 million and $0.2 million of legal and professional fees. During the third quarter of 2002 and for the nine months ended September 30, 2002, SCM incurred restructuring and infrequent charges of $1.4 million and $3.4 million, respectively. In the second and third quarters of 2002, restructuring and infrequent charges primarily consisted of $1.3 million and $1.4 million, respectively, of legal and professional fees related to the announced separation of the Digital Media and Video division. In the first quarter of 2002, these charges related to $0.2 million of severance and $0.4 million of legal and professional fees.

Gain (loss) on Investments. During the third quarter of 2003, we recorded a gain on investments of $0.4 million from the sale of our holdings in ActivCard. For the nine-month period ended September 30, 2003, we recorded a loss on investments of $0.1 million, resulting primarily from a write down of our investment in Cryptovision. During the third quarter of 2002, because of the continued deterioration of general economic conditions and changes in specific market conditions, we determined that our investment in ActivCard had been impaired. Accordingly, we wrote down our investment in ActivCard to its fair market value as of September 30, 2002. The result was a charge to the income statement of $1.2 million

Interest and Other, Net. Interest and other, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt, other income and expenses, and foreign currency gains or losses. In the third quarter of 2003, interest and other, net, was income of $0.1 million, compared to a loss of $0.2 million in the third quarter of 2002. For the nine months ended September 30, 2003, interest and other, net, was income of $0.5 million, compared to a loss of $0.7 million for the nine months ended September 30, 2002. Foreign currency transaction losses for the third quarter of 2003 were $0.9 million, compared to losses of $0.4 million for the third quarter of 2002. For the nine months ended September 30, 2003, foreign currency transaction losses were $0.7 million, compared to losses of $1.3 million for the same period in 2002. Losses in 2003 were primarily a result of unfavorable rate changes for the U.S. dollar compared to the Singapore dollar and the euro. The foreign exchange losses in 2002 were primarily due to unfavorable rate changes for the U.S. dollar compared to the Singapore dollar and the British pound. These losses resulted primarily from the revaluation of receivables (especially U.S. dollar denominated receivables) to the functional currency of the subsidiary. Interest income for the three months ended September 30, 2003 and 2002 was $0.4 million and $0.2 million, respectively, and for the nine months ended September 30, 2003 and 2002, interest income was $0.7 million and $0.8 million, respectively. The decrease in interest income in 2003 was primarily a result of lower average cash balances and lower interest rates, offset by the receipt in the third quarter of 2003 of $0.3 million of interest related to a tax refund in the U.S.

Benefit/Provision for Income Taxes. We recorded a tax benefit of $1.5 million in the third quarter of 2003, resulting from a U.S. tax refund of $2.1 million related to prior years, offset by required tax provisions in non-U.S. tax jurisdictions. This compares with an income tax provision of $3.1 million in the third quarter of 2002. The benefit for income taxes in the first nine months of 2003 was $1.2 million, compared with a provision of $2.9 million in the first nine months of 2002.

Discontinued Operations. During the third quarter of 2003, we completed two transactions to sell our consumer Digital Media and Video business. On July 25, 2003, we completed the sale of our digital video business to Pinnacle Systems and on August 1, 2003, we completed the sale of our consumer digital media reader business to Zio Corporation. Net revenue for the consumer Digital Media and Video business for the quarter ended September 30, 2003 and 2002, was $1.1 million and $22.2 million, respectively. Operating loss for the same periods was $4.1 million and $2.0 million, respectively and net loss was $4.1 million and $13.5 million, respectively.

For the nine months ended September 30, 2003 and 2002, net revenue for the consumer Digital Media and Video business was $22.9 million and $63.0 million, respectively. Operating loss for the same periods was $14.0 million and $4.8 million and net loss was $13.2 million and $15.7 million, respectively.

During the quarter ended September 30, 2003, net loss on disposal of the consumer Digital Media and Video was $5.9 million and included net inventory write-downs of $0.5 million, asset write-downs of $1.4 million, decreased liabilities of $0.2 million, severance of $1.6, contract settlements and lease commitments of $1.9 million and transactional costs to sell the businesses of $0.7 million. For the six month period ended September 30, 2003, the

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total net loss on disposal was $11.8 million and included net inventory write-downs of $2.3 million, asset write-downs of $2.9 million, increased liabilities of $0.2 million, severance of $2.1 million, contract settlements and lease commitments of $1.9 million, and transactional costs to sell the businesses of $2.4 million.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2003, our working capital, which we have defined as current assets less current liabilities, was $53.2 million, compared to our working capital of $81.8 million as of December 31, 2002. Working capital decreased in the first nine months of 2003 by approximately $28.6 million, due to a decrease in current assets of $44.1 million, partially offset by a decrease in current liabilities of $15.5 million.

Cash and cash equivalents decreased by $16.0 million during the first nine months of 2003, primarily due to cash used in operating activities of $13.0 million, cash used in investing activities of $1.6 million, cash used in financing activities of $1.6 million, and the effect of exchange rates on cash and cash equivalents of $0.2 million. Cash provided by continuing operations of $3.3 million was primarily due to a $28.8 million net loss, the adding back of loss from discontinued operations of $25.0 million, depreciation and amortization of $2.9 million, loss on investments of $0.1 million, loss on disposal of fixed assets of $0.1 million, stock compensation of $0.1 million, an increase in deferred tax liability of $0.1 million, and decreases in accounts receivable of $3.2 million and inventories of $6.8 million. These were partially offset by decreases in accounts payable of $1.2 million, accrued expenses of $4.0 million, income taxes payable of $0.2 million and an increase in other assets of $0.8 million. Cash used in operating activities from discontinued operations was $16.2 million. Cash used in investing activities from continuing operations was primarily for capital expenditures of $1.0 million, purchases of long-term investments of $0.4 million, and net purchases of short-term investments of $0.1 million. Cash used in investing activities from discontinued operations was $0.3 million for capital expenditures. Cash used in financing activities was primarily for the repurchase of common stock of $2.1 million offset by issuance of equity securities of $0.5 million.

We have a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million euros (approximately $0.9 million as of September 30, 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 0.1 million euros (approximately $0.1 million as of September 30, 2003) which bears interest at 3.14% and has no expiration date. In addition, we have three separate overdraft facilities for our manufacturing facility of 4.0 million, 1.2 million and 5.9 million Singapore dollars (approximately $2.3 million, $0.7 million and $3.4 million as of September 30, 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 September 30, 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 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 September 30, 2003, we had repurchased 618,400 shares of our common stock for an aggregate of $2.8 million pursuant to this program. During the third quarter of 2003 we made no purchases under this program.

During the fourth quarter of 2003, we expect to continue making significant cash disbursements related to the disposition of our consumer Digital Media and Video business, some of which relate to charges already taken. In the fourth quarter of 2003, we also expect to generate more than $20 million of cash from the sale of Pinnacle stock, cash payments from Pinnacle and the Zio transaction. As a result, we expect our cash balances to increase in the fourth quarter of 2003 by the net amount of these disbursements and receipts. For a description of related risks, you should read, “Factors that May Affect Future Operating Results — There Are Risks Related to Our Ability to Collect the Proceeds of the Disposition of Our Consumer Digital Media and Video Business.”

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 $152.3 million as of September 30, 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 may be tied to our customers’ budgetary cycles, project plans or equipment roll-out schedules;

• 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, our disposition of the consumer Digital Media and Video business, litigation and write-down of investments or inventory.

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 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 worldwide have resulted in decreased demand and constrained growth in demand from end users for many companies’ products, including ours. Decreased demand in the European digital television market has contributed to declining and lower than expected sales of our conditional access modules. In the U.S. and in Europe, economic conditions have continued to delay or minimize deployments of smart card readers by corporations and financial institutions. These trends have had an adverse effect on our revenues during 2002 and 2003, and we expect these trends to continue to adversely affect sales during the fourth quarter. 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.

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 November 8, 2002 to November 7, 2003, the reported sale prices for our common stock on the Nasdaq market ranged between $2.50 and $8.85 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;

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• 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.

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, digital photography, computer and conditional access system industries, as well as digital television operators, the government sector and corporate enterprises. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. For example, a single customer accounted for approximately 23% of our total net revenue in the three months ended September 30, 2003. The divestiture of our consumer Digital Media and Video business increases our dependence on a small number of customers. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in our market segments, could result in decreased revenues and/or inventory or receivables write-offs and otherwise harm our business and operating results. For instance, lower sales of our conditional access modules in the first nine months of 2003 compared with the first nine months of 2002 were significantly impacted by the loss of a significant customer in Europe.

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 our business could level off or decline. We cannot predict the future growth rate, if any, or size or composition of the market for our products. 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.

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 and timing of planned smart card projects 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 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 business. If these conditions continue, the revenue and results of operations in our business could continue to be adversely affected.

Approximately half of our forecasted revenues in 2004 are dependent on new products, some of which are still under development.

We are currently developing products that are expected to generate approximately half our planned revenue in 2004. If we cannot complete development of these products, or if development is delayed, we could lose business to

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competition or lose the opportunity to introduce new technology to the market, and our sales could suffer significantly. For example, we are currently developing new smart card readers designed to provide secure physical access to government buildings. If we are unable to complete prototypes of these readers in time for sales demonstrations with our systems integration partners, we may not be selected to participate in any proposals to the U.S. government for secure access projects. If we are selected to provide new readers for secure physical access, we must be able to deliver the product on time or we would risk losing the business to competition.

There are risks related to our transition following the disposition of our consumer Digital Media and Video business.

We recently sold substantially all of the assets related to our consumer Digital Media and Video business. Net revenues from our Digital Media and Video business were 56% of our total net revenues in 2002. Our senior management must adjust to managing a smaller company with less of a retail emphasis, greater dependence on fewer customers, a higher percentage of international sales and higher potential volatility in operational results due to a smaller revenue and cost base. If we fail to manage these risks effectively, our operating results and financial position could be adversely affected.

There are risks related to our ability to collect the proceeds of the disposition of our consumer Digital Media and Video business.

We recently sold substantially all of the assets related to the digital video portion of our consumer Digital Media and Video business to Pinnacle Systems. We received $21.5 million of Pinnacle stock as consideration for this sale, which we expect to sell before the end of 2003. If we do not receive the sales proceeds when expected, our financial position could be adversely affected. Our agreement with Pinnacle requires Pinnacle to pay us the shortfall in cash if our aggregate gross proceeds from these sales are less than $21.5 million. We are also required to make cash repayments to Pinnacle for any proceeds received in excess of $21.5 million. However, realization of these proceeds is subject to the following risks:

• We have agreed to indemnify Pinnacle for breaches of representations, warranties and covenants we made to Pinnacle in the agreement and for losses Pinnacle incurs related to liabilities we retained and other related matters.

• If Pinnacle’s stock price or trading volume declines significantly and Pinnacle otherwise experiences financial difficulties, we may have difficulty disposing of the shares of Pinnacle stock that we own, and Pinnacle may have difficulty complying with its obligation to pay us the shortfall that results.

We also recently agreed to sell substantially all of the assets related to the consumer digital media reader portion of our Digital Media and Video business to Zio Corporation. Our agreement with Zio required only a small initial cash payment from Zio. Zio is obligated to pay the remainder of the consideration over time, and the amount of consideration we receive depends in large part on Zio’s success. Zio is a newly formed entity, and there is no assurance that it will be successful. As a result, there is no assurance that we will receive a meaningful amount of cash from the transaction with Zio.

Our agreement with Zio includes provisions for Zio to purchase and distribute existing inventories of SCM digital media readers, and to make payments to SCM for readers they purchase from us. Under the agreement, SCM is responsible for collecting accounts receivable for digital media readers sold into the retail channel prior to the sale of this business to Zio. Zio is a newly formed entity, and there is no assurance that it will be successful. If Zio is unsuccessful at distributing SCM digital media readers or does not purchase readers from us, we may be required to take further write downs to inventory associated with our discontinued operations. If we are unable to collect accounts receivable from customers who received digital media readers from us prior to the sale of this business to Zio, we may be required to take further write downs to accounts receivable associated with discontinued operations.

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, 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

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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.

We rely 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.

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 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:

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

• technical features;

• ease of use;

• quality and reliability;

• level of security; and

• price.

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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. Our competitors include: Advanced Card Systems, BridgePoint Systems, Gemplus, O2Micro, OmniKey, STMicroelectronics and XTec in smart card readers, ASICs and universal smart card reader interfaces. In recent months we have also experienced competition in our digital TV business from new companies offering conditional access modules that are designed to provide access to pay-TV content for a limited time period rather than through ongoing subscription.

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

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

Our smart card reader sales largely depend on U.S. government project timelines and budgetary allocations for information technology (IT) projects.

We sell a significant proportion of our smart card reader products to the U.S. government. The timing of U.S. government smart card projects is not always certain. Expenditures on IT projects have varied in the past and we expect them to vary in the future. As a result of shifting priorities in the federal budget and in Homeland Security, U.S. government spending may be reallocated away from IT projects, such as smart card deployments. The slowing or delay of such government projects could negatively impact our sales. For instance, sales of our smart card reader products were lower in the first nine months of 2003 compared with the same period in 2002 due to the decreased level of deployments under the U.S. government’s Common Access Card program, as well as the lack of new projects at a stage to require smart card readers.

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

Although our contractual obligations to accept returned products from our 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 or of products that were specifically designed for a single customer. In this regard, we incurred charges related to inventory write-downs in the second half of 2002 and the first half of 2003.

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.

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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. Even though we provide competitive compensation arrangements to our executive officers and other employees, we cannot be certain that we will be able to retain them, including those individuals that are subject to non-compete agreements.

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

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

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

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 customer usually takes three to six 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 common stock, and 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.

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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 the majority 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 70% of our revenues for the year ended December 31, 2002, and approximately 75% and 70% of our revenues for the nine months ended September 30, 2003 and 2002, respectively, were derived from customers located outside the United States. Because most of our principal customers are located in other countries, we anticipate that international sales will continue to account for a large percentage of our revenues. As a result, our sales and operations may continue to be subject to certain international 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.

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

From time to time, we make strategic minority investments in private and public companies. Our strategic investments involve a number of risks. We may not realize the expected benefits of these investments 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. For example, we have written down a number of our investments over the past two years, including ActivCard, Cryptovision, SmartDisk, Spyrus and Satup. We had no strategic investments at September 30, 2003.

Our products may have defects, which could damage our reputation, decrease market acceptance of our products,

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cause us to lose customers and revenue and result in liability to us, including costly litigation.

Products such as our conditional access modules or smart card readers 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, our customers 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. 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. 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;

• 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 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 Philips and Atmel to produce our ASICs for our digital TV modules and we utilize the foundry services of Atmel and Samsung to produce our ASICS for our smart cards readers. Our reliance

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on a limited number of suppliers could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of these components 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 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 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 the majority 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. 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.

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-

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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 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 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 potential terrorist attacks could have a material adverse effect on the U.S. and global economies.

Concerns about 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. For example, in 2002, 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, Singapore, Japan and the U.K. 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.

Our 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

Our 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 September 30, 2003, we had $34.1 million in cash and cash equivalents and $5.3 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

With the participation of our Chief Executive Officer and Chief Financial Officer, SCM’s management evaluated the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-14) as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). Based on that evaluation, these officers have concluded that as of the Evaluation Date, SCM’s disclosure controls and procedures were adequate and designed to ensure that material information relating to us and our consolidated subsidiaries would be made known to them by others within those entities.

Changes in internal controls

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

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PART II: OTHER INFORMATION

Item 1. Legal Proceedings

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

Not applicable.

Item 5. Other Information

Not applicable.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.


Exhibit
Number		Description of Document

10.27		Post-Closing Agreement, dated as of October 31, 2003, between SCM Microsystems, Inc., SCM Multimedia, Inc., and Pinnacle Systems, Inc.

10.28		Agreement with Andrew Warner

31.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		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.

(b) Reports on Form 8-K

A current report on the Form 8-K was furnished pursuant to the Securities and Exchange Act of 1934, as amended, on October 29, 2003, reporting under Items 7 and 12 the announcement that on October 29, 2003, SCM Microsystems issued a press release regarding its financial results for the three and nine months ended September 30, 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: November 14, 2003

		/s/ STEVEN L. MOORE

		Steven L. Moore
		Chief Financial Officer and Secretary
		(Principal Financial and Accounting Officer)

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EXHIBIT INDEX


Exhibit No.		Description

10.27		Post-Closing Agreement, dated as of October 31, 2003, between SCM Microsystems, Inc., SCM Multimedia, Inc., and Pinnacle Systems, Inc.

10.28		Agreement with Andrew Warner

31.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		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. Maintenance revenue is deferred and amortized over the period of the maintenance contract.

	•		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 our 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. Based on such judgments, we wrote down approximately $2.0 million of inventory in 2002 and $0.8 million of inventory in the first nine months of 2003.

	•		From time to time, SCM holds minority interests in companies with 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. We record 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. We realized impairment charges of approximately $1.2 million related to our investments in 2002, and $0.5 million in the first nine months of 2003.

	•		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 $6.6 million of asset impairment based on conclusions that the goodwill and intangible assets from past acquisitions were impaired.

	•		The carrying value of 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. We evaluate 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. The divestiture of our consumer Digital Media and Video business to Pinnacle Systems and Zio Corporation as well as future changes to the operating structure of our new strategic focus on our Security business may limit our ability to utilize current deferred tax assets.

	•		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, Accounting for Costs Associated with Exit or Disposal Activities, 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 may be tied to our customers’ budgetary cycles, project plans or equipment roll-out schedules;

	•		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, our disposition of the consumer Digital Media and Video business, litigation and write-down of investments or inventory.

	•		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;

	•		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 and timing of planned smart card projects 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.

	•		We have agreed to indemnify Pinnacle for breaches of representations, warranties and covenants we made to Pinnacle in the agreement and for losses Pinnacle incurs related to liabilities we retained and other related matters.

	•		If Pinnacle’s stock price or trading volume declines significantly and Pinnacle otherwise experiences financial difficulties, we may have difficulty disposing of the shares of Pinnacle stock that we own, and Pinnacle may have difficulty complying with its obligation to pay us the shortfall that results.

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

	•		technical features;

	•		ease of use;

	•		quality and reliability;

	•		level of security; and

	•		price.

	•		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.

	(b)		Reports on Form 8-K

			A current report on the Form 8-K was furnished pursuant to the Securities and Exchange Act of 1934, as amended, on October 29, 2003, reporting under Items 7 and 12 the announcement that on October 29, 2003, SCM Microsystems issued a press release regarding its financial results for the three and nine months ended September 30, 2003.