UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

OR

FOR THE TRANSITION PERIOD FROM_________TO _________

COMMISSION FILE NUMBER: 0-22689

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 May 3, 2004, 15,407,830 shares of common stock were outstanding.

Table of Contents

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)

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(Unaudited)

See notes to consolidated financial statements.

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

See notes to condensed consolidated financial statements.

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SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004

1. Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. 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, 2003.

Recent Accounting Pronouncements

     On March 31, 2004, the Financial Accounting Standards Board (“FASB”) issued its Exposure Draft, Share-Based Payment, which is a proposed amendment to Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. Generally, the approach in the Exposure Draft is similar to the approach described in SFAS No. 123. However, the Exposure Draft would require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. The FASB expects to issue a final standard late in 2004 that would be effective for the Company’s 2005 fiscal year. The pro forma impact of the adoption of SFAS No 123 on the Company’s historical financial statements is included in the footnotes to the financial statements. The Company expects to continue to grant stock-based compensation to employees and the impact of the adoption of the new standard, when and if issued, may have a material impact on its future results of operations.

     In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 104, Revenue Recognition (SAB No. 104), which codifies, revises and rescinds certain sections of SAB 101, Revenue Recognition in Financial Statements in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The changes noted in SAB 104 did not have a material effect on our consolidated results of operations, financial position or cash flows.

     The FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN No. 46), in January 2003, and a revised interpretation of FIN No. 46 (FIN No. 46R) in December 2003. FIN No. 46 requires that certain variable interest entities (“VIEs”) 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 have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. SCM has no contractual relationship or other business relationship with a VIE and therefore the adoption did not have an effect on its consolidated results of operations or financial position.

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Reclassifications

     Certain reclassifications have been made to the 2003 financial statement presentation to conform to the 2004 presentation.

2. Stock Based Compensation

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

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

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

3. Discontinued Operations

     In conjunction with a strategy to focus on its core Security business, in 2003 the Company’s Board of Directors authorized two transactions to sell SCM’s retail 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”) for $21.5 million. Pinnacle issued to SCM 1,866,851 shares of Pinnacle

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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 registered the shares with the SEC and SCM sold the stock over a period of several months. The proceeds received from the sale of the Pinnacle shares were less than $21.5 million and Pinnacle compensated SCM in cash to reach the $21.5 million level. Pursuant to an agreement signed on October 31, 2003, Pinnacle paid SCM an additional $2.0 million in cash including but not limited to the aforementioned adjustments.

     On August 1, 2003, the Company completed the sale of its retail digital media reader business to Zio Corporation, which purchased and distributed existing inventories of digital media readers and also assumed 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 March 31, 2004, Zio had purchased $2.5 million of reader inventory.

     As a result of these sales, the Company has accounted for the retail 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. For comparability, certain 2003 amounts have been reclassified, where appropriate, to conform to the financial statement presentation used in 2004.

     The operating results for the discontinued operations of the retail Digital Media and Video business for the three months ended March 31, 2004 and during the same period for 2003 are as follows (in thousands):

4. Short-Term Investments

     The fair value of short-term investments at March 31, 2004 and December 31, 2003 was as follows (in thousands):

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

5. Inventories

     Inventories consist of (in thousands):

6. Intangible Assets

     Intangible assets consist of the following (in thousands):

     SCM evaluates long-lived assets under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. During 2003, in connection with the sale of its Digital Media and Video retail business, SCM recorded an impairment of intangible assets consisting mainly of core technology and customer relations of $0.3 million. In accordance with SFAS No. 142, only SCM’s intangible assets relating to core technology, customer relations and non-compete agreements are subject to amortization.

     Amortization expense related to intangible assets was $0.3 million for the first three months of 2004 and $0.3 million for the same period of 2003.

     Estimated future amortization of intangible assets is as follows (in thousands):

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7. Lines of Credit

     The Company has a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million Euro (approximately $0.9 million as of March 31, 2004). The German line has no expiration date and bears interest at 6.0%. Borrowings under this line of credit are unsecured. The Company has an unsecured line of credit in France of 0.1 million Euro (approximately $0.1 million as of March 31, 2004) which bears interest at 3.05% and has no expiration date. In addition, the Company has two separate overdraft facilities for its manufacturing facility of 4.0 million and 5.9 million Singapore Dollars (approximately $2.4 million and $3.5 million, respectively) with base interest rates of 4.8% and 7.0%, respectively. All of the facilities are unsecured and due upon demand. There were no amounts outstanding under any of these credit facilities as of March 31, 2004.

8. Restructuring and Other Charges

     Continuing Operations

     In the first three months of 2004 and 2003, SCM incurred net restructuring and other charges related to continuing operations of approximately $0.1 million and $0.3 million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the first three months of 2004 and during the year ended December 31, 2003 consist of the following (in thousands):

     Restructuring costs for the three months ended March 31, 2003 consisted of approximately $0.1 million for severance costs related to the closure and relocation of certain SCM facilities. These charges were in accordance with SFAS 146 and represent the total amount incurred in the restructuring action. The severance costs related to the reduction in force of 11 employees. Eight of these employees were from Operations, two from Research and Development and one from General and Administrative functions. Ten were from Asia and one from Europe.

     For the three months ended March 2004, other charges consisted of approximately $0.1 million of legal settlements and related legal costs. For the three months ended March 2003, other charges consisted primarily of $0.2 million of legal, accounting and professional fees relating to the announced separation of the Digital Media and Video division.

     Discontinued Operations

     In the first three months of 2004 and 2003, SCM incurred net restructuring and other charges related to discontinued operations of approximately $0.3 million and $25,000, respectively.

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     Accrued liabilities related to restructuring actions and other activities during the first three months of 2004 and during the year ended December 31, 2003 consist of the following (in thousands):

     Exit costs related to discontinued operations for the three months ended March 31, 2004 primarily consist of $0.3 million of legal costs as well as $24,000 related to lease commitments and $22,000 of asset write-downs. 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 retail Digital Media and Video business. The Company has substantially exited the retail Digital Media and Video business and does not expect to incur further significant charges during 2004, except for legal costs relating to the Company’s defense to the complaint filed by DVDCre8. (See Note 13.)

     Restructuring costs of $25,000 related to discontinued operations apply for the first quarter of fiscal 2003 and primarily consisted of asset write-downs.

9. Stock Repurchase Program

     In October 2002, the Company’s Board of Directors approved a stock repurchase program in which up to $5.0 million may be used to purchase shares of the Company’s common stock on the open market in the United States or Germany from time to time over two years, depending on market conditions, share prices and other factors. No shares were repurchased during the first three months of 2004. As of March 31, 2004, the Company had repurchased a total of 618,400 shares under this program for approximately $2.8 million.

10. Segment Reporting, Geographic Information and Major Customers

     The Company 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 the Company for making operating decisions and assessing financial performance. The Company’s chief operating decision maker is considered to be its executive staff, consisting of the Chief Executive Officer and Chief Financial Officer.

     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 segments: Digital TV, PC Security and Flash Media Interface. The executive staff reviews financial information and business performance along these three business segments. The Company evaluates the performance of its segments at the revenue and gross margin level. The Company’s reporting systems do not track or allocate operating expenses or assets by segment. The Company does not include intercompany transfers between segments for management purposes.

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     Summary information by segment for the three months ended March 31, 2004 and during the same period for 2003 is as follows (in thousands):

     Additional information regarding revenue by geographic region is as follows (in thousands):

     Two customers exceeded 10% of total net revenue for the three months ended March 31, 2004 and three customers exceeded 10% of net revenue for the three months ended March 31, 2003. Two customers represented greater than 10% of accounts receivable as March 31, 2004 and three customers represented greater than 10% of accounts receivable as of December 31, 2003.

     Long-lived assets by geographic location as of March 31, 2004 and December 31, 2003, are as follows (in thousands):

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11. Commitments

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

     Purchases for inventories are highly dependent upon forecasts of the customers’ demand. Due to the uncertainty in demand from its customers, the Company may have to change, reschedule, or cancel purchases or purchase orders from its suppliers. These changes may lead to vendor cancellation charges on these purchases or contractual commitments. As of March 31, 2004, the purchase and contractual commitments were $8.3 million.

     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 the Company 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 the Company’s estimates, adjustments to recognize additional cost of sales may be required in future periods.

     Components of the reserve for warranty costs for the three months ended March 31, 2004 and 2003 were as follows (in thousands):

12. Related Party Transactions

     During the three months ended March 31, 2004 and 2003, SCM has recognized revenue of approximately $0.3 million and $0.2 million respectively, from sales to Conax AS, a company engaged in the development and provision of smart-card based systems. As of March 31, 2004 and December 31, 2003, accounts receivable amounts due from Conax were $0.2 million and $0.2 million, respectively. Oystein Larsen serves as Chief Representative and General Manager, China of Conax and is a board director of SCM Microsystems. Mr. Larsen is not directly compensated for revenue transactions between the two companies

     During the three months ended March 31, 2004 SCM recognized revenue of approximately $0.1 million from sales to Pexagon, a company based in Connecticut. No revenue was recognized during the three months ended March 31, 2003. The Company had an accounts receivable due from Pexagon of $0.1 million as of March 31, 2004 and $2.9 million as of December 31, 2003. Brian Campbell, a former vice president of the Company is the majority shareholder of Pexagon. SCM and Pexagon continue to have an ongoing trading relationship.

     In 2003, the Company completed the sale of its retail 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. During the three months ended March 31, 2004 and for the same period in 2003, SCM recognized no revenue from sales to Zio Corporation. As of March 31, 2004, the company had an accounts receivable due from Zio Corporation of $46,000. As of December 31, 2003, the amount due from Zio Corporation was $1.4 million.

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13. Legal Proceedings

     From time to time the Company could be subject to claims arising in the ordinary course of business or could be a defendant in lawsuits. While the outcome of such claims or other proceedings can not be predicted with certainty, management expects that any such liabilities, to the extent not provided for by insurance or otherwise, will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

     In September 2003, the Company and Pinnacle Systems, Inc. (“Pinnacle”) 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 the sale of certain assets of the Company’s former Dazzle video products business to Pinnacle, the Company and Pinnacle tortiously interfered with DVDCre8’s commercial relationships, engaged in acts to restrain competition in the DVD software market, misappropriated DVDCre8’s trade secrets, and engaged in unfair competition. Pursuant to the Asset Purchase Agreement between the Company and Pinnacle, the Company and Pinnacle are seeking indemnification from each other, respectively, for all or part of the damages and the expenses incurred to defend such claims. The Company believes the claims by DVDCre8 are without merit and intends to vigorously defend the action, but management cannot predict the final outcome of this lawsuit, nor accurately estimate the amount of time and resources that may be required to defend against it. Specific damages amounts have not been specified, nor assessed at this early stage of the litigation, so the potential damages claims cannot be estimated. Accordingly, if the Company were to be unsuccessful in its defense of this lawsuit or the indemnification claim, and if the plaintiffs were able to establish substantial damages, the Company could be forced to pay an amount, currently unknown, which could have an adverse effect on its business. In addition, although management believes that the Company is entitled to indemnification in whole or in part for any damages and costs of defense and that Pinnacle’s claim for indemnification is without merit, there can be no assurance that the Company will recover all or a portion of any damages assessed or expenses incurred.

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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 some of the important factors that could cause our actual results to differ materially from our expectations under the heading “Factors That May Affect Future Operating Results” in this Quarterly Report on Form 10-Q. 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 on Form 10-Q. 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 12, 2004.

Overview

     SCM Microsystems designs, develops and sells hardware, software and silicon solutions 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 digital access products into three markets segments: Digital TV, PC Security and Flash Media Interface.

•		For the Digital TV market, we offer conditional access modules that provide secure decryption for digital pay-TV broadcasts.
•		For the PC Security market, we offer smart card reader technology that enables secure access to PCs, networks and physical facilities.
•		For the Flash Media Interface market, we offer digital media readers and ASICs that are used to transfer digital content to and from various flash media.

     We sell our products primarily to original equipment providers, or OEMs, who typically either bundle our products with their own solutions, or repackage our products for resale to their customers. Our OEM customers include: digital TV operators and conditional access providers for our conditional access modules; government contractors, systems integrators, large enterprises, computer manufacturers, and banks and other financial institutions for our smart card readers; and computer and camera manufacturers for our digital media readers. 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.

     Until the middle of 2003, our operations included a retail Digital Media and Video business that accounted for approximately half of our sales. We sold this business in the third quarter of 2003, so that we are now solely focused on our core OEM Security business. As a result of this sale and divestiture, beginning in the second quarter of fiscal 2003, we have accounted for the retail 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.

     In our continuing Security operations, we have experienced a significant drop in revenues in the period from January 2003 through March 2004, which has resulted in continued operational losses in our business in recent quarters. This decline in our revenues is primarily related to our Digital TV product sales, which have been adversely affected by new competition since the middle of 2003, as well as ongoing weakness in the overall digital television market. Sales of our PC Security products have also been adversely affected by the slow pace of new smart card programs which drive demand for our readers. Sales of our Flash Media Interface products have remained relatively constant from period to period.

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Critical Accounting Policies and Estimates

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

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

•		We recognize product revenue upon shipment 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. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. Nonrecurring engineering revenue is recognized using the percentage of completion method.
•		We maintain 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.
•		We write down inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Based on such judgments, we wrote down approximately $0.4 million in the first three months of 2004.
•		In assessing the recoverability of our other intangibles, we 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.
•		The carrying value of our net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. Management evaluates the realizability of the deferred tax assets quarterly. 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 retail 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 our deferred tax assets.
•		We accrue 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 Statement of Financial Accounting Standards (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. Prior to 2003, 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.

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Results of Operations

     Net Revenue. Summary information by product segment for the three month periods ended March 31, 2004 and 2003 is as follows (in thousands):

     Net revenue for the three months ended March 31, 2004 was $13.2 million, compared to $18.7 million for the same period in 2003, a decrease of 29%. This decrease in revenues was primarily related to the market for our Digital TV products, where we continue to experience increased competition and weaker demand for our conditional access modules (further discussed in “Factors that May Affect Operating Results – Our Markets are highly competitive, and our customers may purchase products from our competitors.”). Digital TV sales declined by $4.4 million, or 43% in the first quarter of 2004, versus the same period of 2003. Sales of our PC Security products also decreased by $1.4 million, or 25% in the first quarter of 2004 versus the same period of 2003, due to lower levels of smart card sales for U.S. government programs. Sales of our Flash Media Interface products rose by $0.3 million, or 13% in the first quarter of 2004 compared with the prior year period.

     In our Digital TV product line, sales decreased from $10.3 million in the first three months of 2003 to $5.9 million in the first three months of 2004. The majority of our Digital TV sales come from shipments of conditional access modules, which are used in conjunction with set-top boxes or integrated digital televisions to decrypt digital pay-television broadcasts. To date, sales primarily have been to small European operators or broadcasters or to distributors and conditional access suppliers serving these operators and broadcasters. Throughout 2003, many of the larger television operators in Europe experienced lower subscription rates and accordingly had financial difficulties. Because of the size and industry influence of the larger operators, we believe their difficulties have weakened demand from our customer base, the smaller operators, as well. Beginning in the third quarter of 2003 and continuing through the first quarter of 2004, we also were significantly impacted by new competition from suppliers that have emulated the conditional access decryption software for pay-TV content and have ported it to conditional access modules which may be used to provide unauthorized access to that content. We are pursuing, and in some cases have already obtained, legal injunctions against these suppliers. Despite developing and bringing to market a new product, released in the fourth quarter of 2003, to better compete against this competitive threat, we were unable to improve significantly on our position relative to these unauthorized modules in the first three months of 2004. We expect that it will take several months to regain the market share we have lost.

     In our PC Security product line, sales decreased from $5.8 million in the first three months of 2003 to $4.4 million in the first three months of 2004. This product line consists of smart card readers and related chip technology that is purchased principally for use by corporations, banks or governments to protect computer networks against unauthorized access. The market for external smart card readers is shifting away from U.S. government secure identification programs, where we have historically had strong sales, and towards European banking and financial projects, which are just beginning. In both the U.S. and Europe, currently

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there are very few smart card based-security programs requiring high volumes of cards and readers. Our business therefore has been limited to smaller programs and pilots of larger programs that we anticipate will be initiated in the second half of 2004.

     Revenues from our Flash Media Interface product line remained relatively constant in the first three months of 2004 compared with the first quarter of 2003, with sales of $3.0 million in the first quarter of 2004 versus $2.6 million in the first quarter of 2003. Flash Media Interface revenues consist of sales of digital media readers and related ASIC technology used to provide an interface for flash memory cards in computer printers and digital photography kiosks, which are used to download and print digital photos.

     Gross Profit. Gross profit for the three months ended March 31, 2004 was $5.4 million, or 41% of total net revenue, compared to $8.2 million, or 44% in the same period of 2003. During the first three months of 2004 our margins were adversely affected by an inventory write down of approximately $0.6 million related primarily to pre-loaded security modules within our Digital TV product line. Our gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to continue to fluctuate from period to period.

     Research and Development. Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are related to hardware and chip development, as well as software development. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, we have not capitalized any software development costs. For the first three months of 2004, research and development expenses were $2.8 million, or 21% of revenue, compared with $2.4 million, or 13% of revenue in the first three months of 2003. Research and development expenses rose in the first three months of 2004 primarily due to the fact that figures for the comparable 2003 period included only approximately 35% of expenses for our Indian research and development center. This center’s costs had previously been associated with product development for our retail Digital Media and Video business. When we sold the retail Digital Media and Video business in mid 2003, we retained the engineering resources in India and phased into our Security business the costs of this organization throughout 2003, with full expenses recognized in continuing operations from approximately October 2003 onwards. For the first three months of 2004, 100% of the costs associated with our Indian research and development center have now been included. We expect our research and development expenses to vary based on future project demands.

     Selling and Marketing. Selling and marketing expenses consist primarily of employee compensation as well as tradeshow participation and other marketing costs. Selling and marketing expenses in the first three months of 2004 were $3.3 million, or 25% of revenue, compared with $2.9 million in the first three months of 2003, or 16% of revenue. The increase of $0.4 million in expenses between the first three months of 2003 and 2004 was primarily driven by increased spending related to trade show activity in Europe during the first quarter of 2004. We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

     General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing our administrative functions, professional fees arising from legal, auditing and other consulting services and charges for allowances for doubtful accounts receivable. In the first three months of 2004, general and administrative expenses were $2.8 million, or 21% of revenue, compared with $2.7 million, or 15% of revenue in the first three months of 2003. We expect that our general and administrative costs will remain high as a percentage of revenue relative to other companies our size, as our global operations make it necessary to maintain our current business infrastructure.

     Amortization of Goodwill and Intangibles. Amortization of intangibles in the first quarter of 2004 and 2003 was $0.3 million in each quarter.

     Restructuring and Other Charges. We recorded restructuring and other charges of $0.1 million in the first three months of 2004 and $0.3 million in the first three months of 2003. Charges in the first three months of 2004 related to a legal settlement and associated legal costs. Restructuring charges in the first three months of 2003 primarily consisted of severance charges of $0.1 million related to the closure and relocation of certain SCM facilities. Other charges for the same period consisted of $0.2 million of legal, accounting and professional fees relating to the announced separation of the Digital Media and Video division.

     Interest Income, Net. Interest income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt. Interest income, net was $0.1 million in the first three months of 2004 and 2003.

     Foreign Currency Transaction Gains and Other Income. Foreign currency transaction gains and other income was $0.2 million in the first three months of 2004, compared with foreign currency gains and other income of $0.6 million in the first three months of 2003. Gains in the first quarter of 2004 were primarily a result of favorable exchange rate movements between the U.S. Dollar and the Euro. Gains in the same period of 2003 were also due to the U.S. Dollar to Euro exchange movements as well as

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favorable movements in the exchange rate of the U.S. Dollar compared to the Singapore Dollar. The gains in both years resulted primarily from the revaluation of receivables (especially U.S. dollar denominated receivables) to the functional currency of the subsidiary.

     Income Taxes. In the first three months of 2004, we recorded a provision for income taxes of $0.1 million, compared to a provision of $0.1 million in the first three months of 2003. The provision for income taxes in both periods resulted from taxes payable in foreign jurisdictions which are not offset by operating loss carryforwards.

     Discontinued Operations. During 2003, we completed two transactions to sell our retail 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 retail digital media reader business to Zio Corporation. Net revenue for the retail Digital Media and Video business in the first three months of 2004 and 2003 was $16,000 and $12.3 million, respectively. Operating loss for the same periods was $29,000 and $3.8 million, respectively.

     During the three months ended March 31, 2004, net gain on the disposal of the retail Digital Media and Video business was approximately $0.1 million and primarily resulted from changes in estimates related to the sale transaction.

     Liquidity and Capital Resources

     As of March 31, 2004 our working capital, which we have defined as current assets less current liabilities, was $48.4 million compared to $50.8 million as of December 31, 2003, a decrease of approximately $2.4 million. The reduction in working capital for the first three months of 2004 primarily reflects a decrease in accounts receivable of $2.0 million, an increase in inventory of $3.3 million, the net impact of a refund of withholding taxes in Europe of $4.9 million and decreases in current liabilities.

     Cash and cash equivalents and short-term investments were $56.2 million as of March 31, 2004, an increase of approximately $1.2 million compared to the balance of $55.0 million as of December 31, 2003.

     During the first three months of 2004, cash provided by operating activities was $1.4 million and reflects a loss from continuing operations of $3.6 million, offset by the impact of cash provided from the return of withholding taxes of $4.9 million, being partially offset by cash used in other operating activities, including an increase in net inventory of $2.9 million. Significant commitments that will require the use of cash in future periods include obligations under operating leases, inventory purchase commitments and other contractual agreements. Total future lease obligations as of March 31, 2004 were $11.1 million, of which $2.6 million will be paid over the next 12 months. Inventory purchase commitments and other contractual obligations as of March 31, 2004 were $7.8 million and $0.5 million respectively.

     In the coming months, we expect to continue to use cash to fund operations, and we currently expect that our current capital resources and available borrowings should be sufficient to meet our operating and capital requirements for 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 us on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

     Cash used in investing activities was primarily for net purchases of short-term investments of $0.5 million and $0.1 million of capital expenditures. Cash provided by financing activities was primarily from the issuance of common stock related to our Employee Stock Option program of $0.3 million.

     SCM has a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million Euro (approximately $0.9 million as of March 31, 2004). The German line has no expiration date and bears interest at 6.0%. Borrowings under this line of credit are unsecured. We have an unsecured line of credit in France of 0.1 million Euro (approximately $0.1 million as of March 31, 2004) which bears interest at 3.05% and has no expiration date. In addition, we have two separate overdraft facilities for our manufacturing facility of 4.0 million and 5.9 million Singapore Dollars (approximately $2.4 million and $3.5 million as of March 31, 2004, respectively) with base interest rates of 4.8% and 7.0%, respectively. All of the facilities are unsecured and due upon demand. There were no amounts outstanding under any of these credit facilities as of March 31, 2004.

     In October 2002, we adopted a stock repurchase program in which up to $5.0 million may be used to purchase shares of the our common stock on the open market in the United States or Germany from time to time over two years, depending on market conditions, share prices and other factors. As of March 31, 2004, we had repurchased a total of 618,400 shares under this program for approximately $2.8 million. Cash provided by future operating activities, as well as available cash and cash equivalents, are the expected sources of funding for the share repurchase program.

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FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

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

We have incurred operating losses and may not achieve profitability.

     We have a history of losses with an accumulated deficit of $165.2 million as of March 31, 2004. We may continue to incur losses in the future and may be unable to achieve or maintain profitability.

Our quarterly operating results will likely fluctuate.

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

•		business and economic conditions overall and in our markets,
•		the timing and amount of orders we receive from our customers that may be tied to budgetary cycles, product 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;
•		competition;
•		new product announcements or introductions;
•		our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all;
•		our ability to successfully market and sell products into new geographic or customer market segments;
•		the sales volume, product configuration and mix of products that we sell;
•		technological changes in the market for our products;
•		reductions in the average selling prices that we are able to charge due to competition or other factors;
•		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, organizational restructuring, litigation and write-off of investments.

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

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

     We do not typically maintain a significant level of backlog. As a result, revenue in any quarter depends on contracts entered into or orders booked and shipped in that quarter. Historically, many of our 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

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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, 2003 and the first three months of 2004. Decreased or lower than expected sales are likely to have an adverse effect on our stock price. Also, reduced or canceled orders for our products could lead to decreased sales in a particular period and, because many of our products are custom made for particular customers, could also cause us to write off inventory. In some cases, customers could delay payment or be unable to pay for orders made to us, causing us to increase our allowance for doubtful accounts or to write off certain receivables. In addition, if we anticipate that demand for our products will not increase, we may decide to reduce our operating expense base in order to maintain or reach profitability. Decreased sales, expense base decreases or any write-offs, or any combination of these, could have a materially adverse 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 Nasdaq market conditions, could negatively impact our stock price.

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

     The stock market has recently experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. During the 12-month period from April 29, 2003 to April 28, 2004, the reported sale prices for our common stock on the Nasdaq market ranged between $3.72 and $9.30 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 competitors;
•		litigation developments; and
•		general market downturns.

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

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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, two customers accounted for approximately 29% of our total net revenue in the twelve months ended December 31, 2003. This trend continued in the first three months of 2004 with three customers accounting for 32% of total net revenues. The divestiture of our retail 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.

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, our revenue and gross profit margins could decline or fail to grow. We cannot predict the future growth rate, if any, or size or composition of the market for any of 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 include, but are not limited to, 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 adoption and/or continuation of industry or government regulations or policies requiring the use of products such as our conditional access modules or smart card readers;
•		the timing of adoption of smart cards by the U.S. government, European banks and other enterprises for large scale security programs beyond those in place today;
•		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; and
•		the ability of high capacity flash memory cards to drive demand for digital media readers, such as ours, that enable rapid transfer of large amounts of data, particularly digital photographs.

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

     We are currently developing or have recently released products that are expected to generate approximately half our planned revenue in 2004. If we cannot complete development of these products, if development is delayed, or if there are performance issues with these products that initially limit their efficacy, we could lose business to competition or lose the opportunity to introduce new technology to the market, and our sales could suffer significantly. For example, in the fourth quarter of 2003, our sales fell below the level of estimates previously made by management because we were not able to recognize revenue from shipments made during the quarter of a new digital TV module that did not fulfill the customer’s expectations. Although we believe we have substantially resolved our technical issues with the product, sales levels did not meet our expectations in the first quarter of 2004. In addition, we are currently developing new smart card readers designed to provide secure physical access to buildings. If we are unable to deliver samples of these readers in time to participate in pilot projects, we may not be selected to participate in any U.S. government secure access programs. 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.

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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 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 heavily on our strategic relationships.

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

Our future success will depend on our and our partners’ 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, and in some cases, price. Our customers’ needs change, new technologies are introduced into the market, and industry standards are still evolving. As a result, product life cycles are short, and frequently we must develop new products quickly in order to remain competitive in light of new market requirements. 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, we are currently developing a line of smart card readers designed to provide secure physical access to U.S. government buildings and other facilities. The U.S. government has announced its intention to build upon its smart card authentication programs, such as Common Access Card, to enhance the physical security of its operations. As a major supplier of smart card readers to the Common Access Card program, one of the U.S. government’s first smart card-based security programs, we believe that we are well positioned to win this new physical access reader business. However, our physical access products are still under development. We may not be able to deliver the readers to the U.S. government’s requirements in a timely manner, or at all. If we are able to provide adequate products in a timely manner, we may lose the business to one of several competitors who are also attempting to address this market opportunity.

     In some cases, we depend upon partners who provide one or more components of the overall solution for a customer in conjunction with our products. If our partners do not adapt their products and technologies to new market or distribution requirements, or if their products do not work well, then we may not be able to sell our products into certain markets.

     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. For example, authentication tokens other than smart cards, such as USB tokens, could become a preferred solution for secure network or business access, or contactless smart cards, which do not require a reader such as ours, could be more widely used than current smart cards requiring a reader. If any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected.

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

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

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•		the extent to which products support existing industry standards and provide interoperability;
•		technical features;
•		quality and reliability;
•		our ability to develop new products quickly to satisfy new market and customer requirements;
•		ease of use;
•		strength of distribution channels; and
•		price.

     We believe that competition in our markets is likely to intensify as a result of increasing demand for digital access products. We currently experience competition from a number of sources, including:

•		Advanced Card Systems, Gemplus, O2Micro, OmniKey and Xiring in smart card readers, ASICs and universal smart card reader interfaces for PC and network access;
•		ePOINT, OnSpec and YE Data for digital media readers and ASICs; and
•		Neotion and Aston in conditional access modules for digital television broadcast decryption. In recent months, we also have experienced new competition from companies offering unauthorized, “emulated” conditional access software on modules which can be used to illegally access digital broadcasts.

     We anticipate competing with several companies in the secure physical access market, once our smart card reader products for this market begin shipping. These companies could include AMAG Technology, BridgePoint Systems, HID, Indala, Precise Biometrics and XTec.

     In our Digital TV business, we may be adversely affected by competition from companies that provide conditional access modules using unauthorized conditional access decryption systems. We may lose business to these competitors, and their presence causes us to implement more costly anti-piracy mechanisms on our own products to prevent their unauthorized use.

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

     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. For example, during 2003 our sales of smart card reader products for the U.S. government’s Common Access Card program decreased from 2002 levels, as this program neared completion. While the U.S. government has announced plans for several new smart card-based security projects, none had yet reached a stage of high volume card or reader deployment as of the end of the first fiscal quarter of 2004, and we were not able to increase our reader sales. In

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addition, government 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.

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

     Although our contractual obligations to accept returned products from our distributors and OEM customers are limited, if demand is less than anticipated these customers may ask that we accept returned products that they 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. In this regard, we incurred charges related to inventory write-downs in 2001, 2002 and 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.

     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. 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.

     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.

The complexity of our business model, given our relatively small size, creates significant burdens on our management and our internal business systems.

     Our business model includes the management of three separate product lines that address three disparate market opportunities, which are dispersed geographically. While there is some shared technology across products, each product line requires significant research and development effort to address the evolving needs of our customers and markets. Likewise, we must market and sell products from each product line separately, to disparate customers or, at best, disparate departments within a customer’s enterprise. To support our development and sales efforts, we maintain company offices and business operations in several locations around the world. Managing our various development, sales and administrative operations places a significant burden on our financial systems and our senior management and other personnel. In addition, it requires us to maintain operational spending at a level that is perhaps disproportionately great for a company of our current revenue size. If we maintain our business model and geographic structure and do not grow revenues, we will likely not reach profitability.

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

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

We face risks associated with our past and future acquisitions.

     A component of our business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. 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. 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 accounting charges in connection with an acquisition, which could adversely affect our operating results.

     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 sales.

     We were originally a German corporation, and we continue to conduct a substantial portion of our business in Europe. Approximately 75% and 76% of our revenues for the first three months of 2004 and full year ended December 31, 2003 respectively, were derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, all of which can impact our sales and/or our operational performance. These risks include:

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•		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.

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

     Products such as our conditional access modules and smart card readers may contain defects for many reasons, including defective design, defective material or software interoperability issues. 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, or our ability to recognize revenue for products shipped could be impacted. For example, in late January 2004 we learned that conditional access modules shipped to a customer during the fourth quarter of 2003 did not fulfill the customer’s expectations and that the customer was unwilling to pay for them until all issues were resolved. As a result, we decided not to recognize revenue for the shipments in the fourth quarter of 2003 and consequently issued a press release announcing that our revenue levels were below the range of estimates originally provided by management for the quarter. 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, because the majority of our customers rely on our digital 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 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 smart card-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 production requirements.

     Most of our products are manufactured outside the United States, either by us or by contract manufacturers, 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;

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

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

We have a limited number of suppliers of key components, and may experience difficulties in obtaining components for which there is significant demand.

     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 ASICs for our digital TV modules and we utilize the foundry services of Atmel and Samsung to produce ASICs for our smart cards readers. Our reliance on a limited number of suppliers could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. In addition, some of the basic components we use in our products, such as flash memory for our digital media readers, are in great demand. This can result in the components not being available to us timely or at all, particularly if larger companies have ordered more significant volumes of the components; or in higher prices being charged for the components. Disruption or termination of the supply of components or software used in our products could delay shipments of these 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.

     We have several trademarks registered in the United States, and we continuously evaluate the registration of additional trademarks as appropriate. We currently have patents issued in both the United States and Europe and have other patent applications pending worldwide. In addition, we have licenses for various other U.S. and European patents associated with our products. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable or that any issued patent will fail to provide us with any competitive advantages.

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

We face risks from litigation.

     We may face a variety of claims, which could include claims regarding infringement of the intellectual property rights of third parties, employment-related claims, and claims related to acquisitions, dispositions or restructurings. Any claims or litigation may be time-consuming and costly, cause product shipment delays, require us to redesign our products, or have other adverse effects on our business. Any of the foregoing could have a material adverse effect on our results of operations and could require us to pay significant monetary damages.

     We expect the likelihood of intellectual property infringement and misappropriation 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. As a result of infringement claims, we could be required to license intellectual property from a third party. These licenses may not be offered when we need them or on acceptable terms. If we do obtain licenses from third parties, we may be required to pay license

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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 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, we may be required to take a related non-recurring charge to earnings if we later determine that our intangible assets are impaired.

We are exposed to credit risk on our accounts receivable. This risk is heightened in times of economic weakness.

     We distribute our products both 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 the conflict with Iraq and potential terrorist attacks could have a material adverse effect on the U.S. and global economies.

     The ongoing involvement of U.S. military forces in Iraq coupled with the possibility of 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 or other consequences resulting from the current military action in Iraq could negatively impact consumer as well as business confidence, at least in the short term.

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

     We face a number of potential business interruption risks that are beyond our control. In past periods, the State of California experienced intermittent power shortages and interruption of service to some business customers. Additionally, we may experience natural disasters that could disrupt our business. For example, our corporate headquarters are located near a major earthquake fault. Power shortages, earthquakes or other disruptions could affect our ability to report timely financial statements.

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

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considered beneficial by some stockholders. Also, because these provisions may discourage a change of control, they could decrease the value of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     There has been no significant change in the Company’s exposure to market risk during the first three months of 2004. For discussion of the Company’s exposure to market risk, refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risk, contained in the Company’s Annual Report incorporated by reference in Form 10-K for the year ended December 31, 2003.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

     The Company’s Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15(d)-14(c)) as of March 31, 2004 (the “Evaluation Date”). Based on that evaluation, these officers have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and designed to ensure that material information relating to the Company and the Company’s consolidated subsidiaries would be made known to them by others within those entities.

Changes in Internal Control

     There were no significant changes in the Company’s internal controls over financial reporting during the first quarter of 2004 that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

     There have been no material developments in legal proceedings. For a description of previously reported legal proceedings, refer to Part I, Item 3, Legal Proceedings, of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Item 2. Changes in Securities and Use of Proceeds

     In October 2002, we adopted a stock repurchase program in which up to $5.0 million may be used to purchase shares of our common stock on the open market in the United States or Germany from time to time over two years, depending on market conditions, share prices and other factors. As of March 31, 2004, we had repurchased a total of 618,400 shares under this program for approximately $2.8 million.

     The following table presents the total number of shares purchased during the first three of 2004, the average price paid per share, the total number of shares purchases as part of a publicly announced repurchase plan, and the approximate dollar value of shares that may yet be purchased pursuant to the $5.0 million share repurchase program:

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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.

     (b) Reports on Form 8-K

A current report on Form 8-K was furnished pursuant to the Securities and Exchange Act of 1934, as amended, on February 19, 2004, reporting under Item 12 the announcement that on February 19, 2004, SCM Microsystems issued a press release regarding its financial results for the three and twelve months ended December 31, 2003.

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SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) 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.

	Registrant SCM MICROSYSTEMS, INC.
May 6, 2004	By:	/s/ Robert Schneider
		Robert Schneider
		Chief Executive Officer

May 6, 2004
	/s/ Steven L. Moore
	Steven L. Moore
	Chief Financial Officer and Secretary

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EXHIBIT INDEX