UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10 – Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

OR

FOR THE TRANSITION PERIOD FROM                    TO                     

COMMISSION FILE NUMBER: 0-29440

SCM MICROSYSTEMS, INC.

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. þ Yes       o No

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

At May 4, 2005, 15,542,260 shares of common stock were outstanding.

Table of Contents

PART 1: 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.

2

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

See notes to consolidated financial statements.

3

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

See notes to condensed consolidated financial statements.

4

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005

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, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. 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, 2004.

Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment. SFAS No. 123R is a revision of SFAS No. 123 and supersedes Accounting Principles Board (“APB”) Opinion 25. SFAS No. 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

     The Company has not yet quantified the effects of the adoption of SFAS No. 123R, but it is expected that the new standard may result in significant stock-based compensation expense. The actual effects of adopting SFAS No. 123R will be dependent on numerous factors including, but not limited to, the valuation model chosen by the Company to value stock-based awards; the assumed award forfeiture rate; the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS No. 123R.

     As a result of the Securities and Exchange Commission’s (“SEC”) decision to delay its effective date, SFAS No. 123R will be effective for the Company’s fiscal year beginning January 1, 2006. SFAS No. 123R requires the use of the Modified Prospective Application Method. Under this method SFAS No. 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. In addition, companies may use the Modified Retrospective Application Method. This method may be applied to all prior years for which the original SFAS No. 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS No. 123.

     In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion 29. SFAS No. 153 eliminates certain differences between existing accounting standards. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June, 15, 2005. The Company does not expect adoption of this standard to have a material impact on its future results of operations and financial position.

     In November 2004, FASB issued SFAS No. 151, Inventory Costs. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that these items be recognized as current period charges. In addition, SFAS No. 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is evaluating the impact of the adoption of the new standard on its future results of operations and financial position.

5

     In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF No. 03-01”). EITF No. 03-01 provides guidance on recording other-than-temporary impairments of cost method investments and disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. For investments accounted for under SFAS No. 115, the disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated balance sheet or statement of operations.

Reclassifications

     Certain reclassifications have been made to the 2004 financial statement presentation to conform to the 2005 presentation.

2. Stock Based Compensation

     Pending the effective date of SFAS No. 123R, the Company accounts for its employee stock option plan in accordance with the provisions of 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.

     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):

6

3. Discontinued Operations

     During 2003, the Company completed two transactions to sell its retail Digital Media and Video business. On July 25, 2003, the Company completed the sale of its digital video business to Pinnacle Systems and on August 1, 2003, the Company completed the sale of its retail digital media reader business to Zio Corporation. As a result of these sales, the Company has accounted for the retail Digital Media and Video business as a discontinued operation.

     The operating results for the discontinued operations of the retail Digital Media and Video business for the three months ended March 31, 2005 and during the same period for 2004 are as follows (in thousands):

4. Short-Term Investments

     The fair value of short-term investments at March 31, 2005 and December 31, 2004 was as follows (in thousands):

     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. For the three months ended March 31, 2005 and 2004, no impairment of the investments was identified based on the evaluations performed.

7

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. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, only SCM’s intangible assets relating to core technology and customer relations are subject to amortization. Amortization expense related to intangible assets was $0.2 million for the first three months of 2005 and $0.3 million for the same period of 2004.

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

7. Lines of Credit

     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 $3.6 million respectively) with base interest rates of 4.8% and 7.3% respectively. Both of the facilities are unsecured and due upon demand. There were no amounts outstanding under any of these credit facilities as of March 31, 2005.

8. Restructuring and Other Charges

     Continuing Operations

     In the first three months of 2005 and 2004, SCM incurred net restructuring and other charges related to continuing operations of approximately $0.2 million and $0.1 million, respectively.

8

     Accrued liabilities related to restructuring actions and other activities during the first three months of 2005 and during the year ended December 31, 2004 consist of the following (in thousands):

     For the three months ended March 2005, restructuring and other charges primarily related to changes in estimates for European tax related matters and lease commitments which were partially offset by changes in estimates related to severance costs in connection with cost reduction actions taken by management in 2004. These cost reduction actions are substantially complete and the Company does not expect to incur further significant charges in 2005 related to these actions. As of March 31, 2005, the remaining balance of accrued other costs primarily relates to European tax matters.

     Discontinued Operations

     In the first three months of 2005 and 2004, SCM incurred net restructuring and other charges related to discontinued operations of approximately $11,000 and $0.3 million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the first three months of 2005 and during the year ended December 31, 2004 consist of the following (in thousands):

     Exit costs for the three months ended March 31, 2005 primarily related to changes in estimates of lease obligations and legal fees. The Company has substantially exited its retail Digital Media and Video business and does not expect to incur further significant charges during 2005, except for legal costs relating to the Company’s defense to the complaint filed by DVDCre8. (See Note 12.)

9

9. Segment Reporting, Geographic Information and Major Customers

     SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information 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, Chief Financial Officer, Chief Operating Officer and Executive Vice President, Sales.

     SCM provides 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.

     Summary information by segment for the three months ended March 31, 2005 and during the same period for 2004 is as follows (in thousands):

10

     Geographic net revenue is based on selling location. Information regarding net revenue by geographic region is as follows (in thousands):

     Customers comprising 10% or greater of the Company’s net revenue are summarized as follows:

     Customers representing 10% or greater of the Company’s accounts receivable are summarized as follows:

11

     Long-lived assets by geographic location as of March 31, 2005 and December 31, 2004, are as follows (in thousands):

10. Commitments

     The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These lease agreements expire at various dates during the next twelve 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, 2005, purchase and contractual commitments were $4.0 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, 2005 and 2004 were as follows (in thousands):

11. Related Party Transaction

     During the three months ended March 31, 2004, SCM recognized revenue of approximately $0.3 million from sales to Conax AS, a company engaged in the development and provision of smart-card based systems. As of December 31, 2004, no accounts receivable amounts were due from Conax. Oystein Larsen, a board member of SCM Microsystems, served as Executive Vice President Business Development and New Business of Conax through December 31, 2004. Mr. Larsen was not directly compensated for revenue transactions between the two companies.

12

12. 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 April 2005, Cybercard Corporation (“Cybercard”), a Canadian corporation, filed a patent infringement claim against the Company in the Southern District of Illinois (Case No. 05-CV-274-MJR). The claim alleged infringement of U.S. Patent No. 5,497,411, entitled “Telecommunications Card – Access System,” by the Company’s CHIPDRIVE® Smartcard Office product. In the same lawsuit, Cybercard sued six other defendants. No specific damages have been specified in the claim. To date, no sales of the allegedly infringing product have been made in the United States. The Company is investigating the claim, which it expects to vigorously defend, if necessary, or otherwise resolve, as appropriate, of any allegations of infringement.

     In September 2003, we 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 (“Dazzle”). The complaint alleges that in connection with our sale of certain assets of our former Dazzle video products business to Pinnacle, Dazzle breached the Software License Agreement between the Plaintiff and Dazzle. The complaint further alleges that we 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. In December of 2003, Dazzle filed a Cross-Complaint against the Plaintiff seeking $600,000 in damages for alleged breach of the Software License Agreement between the Plaintiff and Dazzle. In June of 2004, Plaintiff filed a First Amended Complaint asserting additional claims against Pinnacle. In July of 2004 and January of 2005, the parties participated in settlement discussions before a private mediator which were unsuccessful. In March of 2005, Plaintiff filed a Second Amended Complaint, which dropped contract claims and a claim for injunctive relief against Pinnacle, as well as the misappropriation of trade secrets claim against all defendants, and added new allegations against Dazzle and SCM Microsystems, including a claim for damages in excess of $5.8 million. No trial date has been set, and the parties are currently engaged in discovery. Pursuant to the Asset Purchase Agreement between SCM and Pinnacle, we and Pinnacle are seeking indemnification from each other, respectively, for all or part of the damages and the expenses incurred to defend the Plaintiff’s claims. We believe the claims by DVDCre8 are without merit and intend to vigorously defend the action, but we cannot predict the final outcome of this lawsuit, nor accurately estimate the amount of time and resources that we may need to devote to defending ourselves against it. If we were to be unsuccessful in our defense of this lawsuit, and if the Plaintiff were to be able to establish substantial damages, we could be forced to pay an amount, currently unknown, which could have an adverse effect on our business. In addition, although we believe that we are 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 we will be successful on the indemnification claim or recover all or a portion of any damages assessed or expenses incurred, and we may even be forced to pay Pinnacle an amount, currently unknown, which could have an adverse effect on our business.

13

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 for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. For example, statements, other than statements of historical facts regarding our strategy, future operations, financial position, projected results, estimated revenues or losses, projected costs, prospects, plans, market trends, competition and objectives of management constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “will,” “believe,” “could,” “should,” “would,” “may,” “anticipate,” “intend,” “plan,” “estimate,” “expect,” “project” or the negative of these terms or other similar expressions. Although we believe that our expectations reflected in or suggested by the forward-looking statements that we make in this Quarterly Report on Form 10-Q are reasonable, we cannot guarantee future results, performance or achievements. You should not place undue reliance on these forward-looking statements. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our expectations change, whether as a result of new information, future events or otherwise. We also caution you that such forward-looking statements are subject to risks, uncertainties and other factors, not all of which are known to us or within our control, and that actual events or results may differ materially from those indicated by these forward-looking statements. 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 Results” and elsewhere in this Quarterly Report.

     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 the headings “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 for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 31, 2005.

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

     We sell our products primarily to original equipment manufacturers, 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: government contractors, systems integrators, large enterprises, computer manufacturers, as well as banks and other financial institutions for our smart card readers; digital TV operators and broadcasters and conditional access providers for our conditional access modules; and computer and photographic equipment 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 operations, we have experienced a significant drop in revenues in the period from January 2003 through March 2005, 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 competition since the middle of 2003, as

14

well as ongoing weakness in the overall digital television market. Sales of our PC Security products remained relatively constant in 2004 compared with 2003, and sales for the first three months of 2005 are in line with recent previous quarters. We believe that growth in sales of our PC Security products has been curtailed by the slow pace of new smart card programs which drive demand for our readers. Sales of our Flash Media Interface products remained relatively constant in 2004 compared with 2003, but declined in the first three months of 2005 when we discontinued sales of certain digital media products. In all three of our primary product segments, sales are dependent on a small number of customers, which can result in fluctuations in sales levels from one quarter to another.

     We have adopted a strategy to address our declining revenue that is based on introducing new Digital TV and PC Security products to offset the rate of decline of our legacy Digital TV product sales and to address new market opportunities. To date, this strategy has been only partially successful. Delays in the certification process for our digital TV security modules in South Korea have limited shipment of our modules to customers and we have not yet recognized revenue from the Korean digital TV market, which remains an important focus for us. We have also experienced delays in the development of new products designed to take advantage of new market opportunities, including our mobile smart card readers, physical access control terminals and dual reader conditional access modules.

     We have taken measures to reduce operating expenses over the last several quarters, including reducing headcount, reducing the use of outside contract personnel and limiting certain expenses such as travel. While we have been successful in reducing expenses overall, expense reductions have been partially offset by the devaluation of the U.S. dollar related to foreign currencies. More than half of our expenses are denominated in local currency other than the U.S. dollar, such as the euro, Singapore dollar, Indian rupee and Japanese yen. In addition to the unfavorable effect of foreign currency exchange, in recent periods we have also increased spending on audit and other services related to compliance with the Sarbanes-Oxley Act of 2002.

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. 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 had net inventory writedowns of approximately $0.7 million and $0.4 million in the first three months of 2005 and 2004, respectively.
	•	We record an investment impairment charge when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investment that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. In each of the first three months of 2005 and 2004, we recognized no impairment charges related to investments.

15

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

Recent Accounting Pronouncements

     In December 2004, FASB issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R is a revision of SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

     We have not yet quantified the effects of the adoption of SFAS No. 123R, but it is expected that the new standard may result in significant stock-based compensation expense. The actual effects of adopting SFAS No. 123R will be dependent on numerous factors including, but not limited to, the valuation model that we choose to value stock-based awards; the assumed award forfeiture rate; the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS No. 123R.

     As a result of the SEC’s decision to delay the effective date of SFAS No. 123R, SFAS No. 123R will be effective for our fiscal year beginning January 1, 2006. SFAS 123R requires the use of the Modified Prospective Application Method. Under this method SFAS No. 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. In addition, companies may use the Modified Retrospective Application Method. This method may be applied to all prior years for which the original SFAS No. 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS No. 123.

     In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion 29. SFAS No. 153 eliminates certain differences between existing accounting standards. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June, 15, 2005. The Company does not expect adoption of this standard to have a material impact on its future results of operations and financial position.

16

     In November 2004, FASB issued SFAS No. 151, Inventory Costs. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that these items be recognized as current period charges. In addition, SFAS No. 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is evaluating the impact of the adoption of the new standard on its future results of operations and financial position.

     In March 2004, the EITF reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF No. 03-01”). EITF No. 03-01 provides guidance on recording other-than-temporary impairments of cost method investments and disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. For investments accounted for under SFAS No. 115, the disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated balance sheet or statement of operations.

17

Results of Operations

     Net Revenue. Summary information by product segment for the three month periods ended March 31, 2005 and 2004 is as follows (in thousands):

     Net revenue for the three months ended March 31, 2005 was $10.8 million, compared to $13.2 million for the same period in 2004, a decrease of 19%. 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 $1.8 million, or 31% in the first quarter of 2005, versus the same period of 2004. Sales of our Flash Media Interface products also decreased by $1.3 million, or 43% in the first quarter of 2005 compared with the prior year period. Sales of our PC Security products increased by $0.7 million, or 15% in the first quarter of 2005 versus the same period of 2004.

     In our Digital TV product line, sales decreased from $5.9 million in the first three months of 2004 to $4.0 million in the first three months of 2005. 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. Beginning in the third quarter of 2003 and continuing through the first quarter of 2005, our Digital TV products sales have been significantly adversely impacted by competition from suppliers that have emulated the conditional access decryption software for pay-TV content on conditional access modules that may be used to provide unauthorized access to that content. We have pursued, and in some cases have obtained, legal injunctions against these suppliers. However, we do not expect to be able to regain the market share we have lost.

     In our PC Security product line, sales increased from $4.4 million in the first three months of 2004 to $5.0 million in the first three months of 2005. This product line consists of smart card readers and related chip technology that are utilized principally in security programs where smart cards are used to identify and authenticate people in order to control access to computers, computer networks and buildings or other facilities. Throughout 2004 and in the first three months of 2005 our readers were purchased for the U.S. Department of Defense’s Common Access Card personal identification program, various on-line banking programs in Europe, employee badging and identification and other smart card-based security programs. Market research firms, the U.S. and other governments and our customers have indicated to us that they expect a significant increase in the volume of secure access projects requiring readers such as ours over the next few years. However, during 2004 and through the first three

18

months of 2005, there has been no significant increase in the number of smart card readers being deployed in these projects. The timing of any new projects that may increase demand for smart card readers remains unpredictable.

     Revenues from our Flash Media Interface product line decreased from $3.0 million in the first three months of 2004 to $1.7 million in the first three months of 2005. The decrease was primarily due to the cessation of sales of certain products within this business. In addition, sales were also adversely impacted by delays in orders of an existing product prior to our release of a newly developed product. We expect to recognize revenues from this new product beginning in the second quarter of 2005. Flash Media Interface revenues consist of sales of digital media readers 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, 2005 was $3.6 million, or 34% of revenue, compared to $5.4 million, or 41% of revenue in the same period of 2004. During the first three months of 2005, gross profit was adversely affected by a net inventory writedown of approximately $0.7 million, which resulted from provisions for additional inventory reserves of approximately $0.8 million related to our transition to lead-free products and from the writedown of approximately $0.4 million related to Digital TV inventory, partially offset by sales of Flash Media and Digital TV products that previously had been written down, with positive effects to cost of sales of $0.3 million and $0.2 million, respectively. During the first three months of 2004, our gross profit was adversely affected by an inventory writedown of approximately $0.6 million related primarily to pre-loaded security modules within our Digital TV product line, which we determined we could not sell. Our gross profit has been and will continue to be affected by a variety of factors, including, without limitation, 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 primarily related to hardware and chip development. For the first three months of 2005, research and development expenses were $2.5 million, or 23% of revenue, compared with $2.8 million, or 21% of revenue, in the first three months of 2004. Research and development expenses decreased in the first three months of 2005 primarily due to lower headcount, contract service and travel expenses, largely offset by the devaluation of the U.S. dollar compared with foreign currencies in which all of our research and development expenses are paid. 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 2005 were $2.4 million, or 23% of revenue, compared with $3.3 million in the first three months of 2004, or 25% of revenue. The decrease of $0.9 million in expenses between the first three months of 2005 and 2004 was primarily due to reductions in headcount and in trade show expenditures, partially offset by the devaluation of the U.S. dollar compared with foreign currencies in which the majority of our sales and marketing expenses are paid. We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

19

     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 2005, general and administrative expenses were $2.5 million, or 23% of revenue, compared with $2.8 million, or 21% of revenue, in the first three months of 2004. This decrease of $0.4 million in expenses was primarily due to reductions in headcount, partially offset by increased spending on audit and other services related to compliance with the Sarbanes-Oxley Act of 2002, and by the devaluation of the U.S. dollar compared with foreign currencies in which the majority of our general and administration expenses are paid. 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 three months of 2005 was $0.2 million, compared with $0.3 million in the first three months of 2004.

     Restructuring and Other Charges. We recorded restructuring and other charges of $0.2 million in the first three months of 2005, primarily related to changes in estimates for European tax related matters. For the three months ended March 31, 2004, other charges consisted of approximately $0.1 million of legal settlements and related legal costs.

     Interest and Other Income, Net. Interest and other income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt, other income and expenses, and foreign currency gains or losses. Interest income, net was $0.3 million in the first three months of 2005 and $0.1 million in the first three months of 2004. Foreign currency transaction gains and other income was $0.9 million in the first three months of 2005, compared with $0.3 million in the first three months of 2004. Gains in the first three months of 2005 and 2004 were primarily a result of exchange rate movements between the U.S. dollar and the euro. The gains in 2005 resulted primarily from the revaluation of dollar holdings in an entity where the euro is the functional currency while the gains in 2004 resulted primarily from the revaluation of U.S. denominated intercompany balances to the functional currency of the subsidiary.

     Income Taxes. In the first three months of 2005, we recorded a benefit for income taxes of $0.1 million, compared to a provision of $0.1 million in the first three months of 2004. The benefit for income taxes in the first three months of 2005 primarily resulted from a refund related to a European subsidiary and the provision for income taxes in the first three months of 2004 primarily 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 2005 and 2004 was $0 and $16,000, respectively. Operating loss for the same periods was $0.1 million and $29,000, respectively.

     During the three months ended March 31, 2005 and 2004, net gain on the disposal of the retail Digital Media and Video business was approximately $55,000 and $0.1 million, respectively and primarily resulted from asset recoveries and changes in estimates related to the sale transaction.

     Liquidity and Capital Resources

     As of March 31, 2005 our working capital, which we have defined as current assets less current liabilities, was $35.8 million, compared to $39.2 million as of December 31, 2004, a decrease of approximately $3.3 million. The reduction in working capital for the first three months of 2005 primarily reflects decreases in cash and cash equivalents and short-term investments of $2.1

20

million, accounts receivable of $1.8 million and inventory of $1.9 million, offset by decreases in current liabilities of $2.3 million and an increase in other current assets of $0.2 million.

     Cash and cash equivalents and short-term investments were $44.0 million as of March 31, 2005, a decrease of approximately $2.1 million compared to the balance of $46.2 million as of December 31, 2004.

     The following summarizes our cash flows for the three months ended March 31, 2005 (in thousands):

     During the first three months of 2005, cash used in operating activities was $0.3 million and reflects a loss from continuing operations of $2.9 million, net of non-cash related expenses. The primary working capital source of cash was a reduction in accounts receivable of $1.6 million and decreases in inventory levels of $1.8 million due to lower purchases made during the quarter. These positive items were primarily impacted by decreases in accounts payable and accrued expenses of approximately $1.5 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. As of March 31, 2005, total future lease obligations, net of sublease income, were $9.7 million, of which $2.5 million will be paid over the next 12 months. Inventory purchase commitments and other contractual obligations as of March 31, 2005 were $3.6 million and $0.4 million, respectively.

     In the coming months, we expect to continue to use cash to fund operations and we expect that our current capital resources and available borrowings will 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 $4.8 million. Cash provided by financing activities was primarily from the issuance of common stock related to our Employee Stock Option program.

     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 $3.6 million as of March 31, 2005, respectively) with base interest rates of 4.8% and 7.3%, 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, 2005.

21

FACTORS THAT MAY AFFECT FUTURE RESULTS

     Our business and results of operations are subject to numerous risks, uncertainties and other factors that you should be aware of, some of which are described below. The risks, uncertainties and other factors described below are not the only ones facing our company. Additional risks, uncertainties and other factors not presently known to us or that we currently deem immaterial may also impair our business operations.

     If any of the following actually occur, our business, financial condition, results of operations, cash flows or product market share could be materially adversely affected and the trading price of our common stock could decline substantially.

We have incurred operating losses and may not achieve profitability.

     We have a history of losses with an accumulated deficit of $183.2 million as of March 31, 2005. 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; 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.

It is 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 believe they are able to negotiate lower prices and more

22

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.

Our strategy to grow revenue and become profitable depends on our ability to identify and secure new customers and market opportunities at a faster rate than the rate of decline in our sales from legacy customers and products.

     Over the last several quarters, sales of our legacy Digital TV products have declined significantly, primarily due to competition for our traditional customer base. We have experienced no growth in sales of our PC Security products, due to the slow pace of large digital security projects which could utilize our products. We have adopted a strategy to address our declining revenue that is based on introducing new Digital TV and PC Security products to offset the rate of decline of our legacy Digital TV product sales and to address new market opportunities. To date, this strategy has been only partially successful. Delays in the certification process for our digital TV security modules in South Korean have limited shipment of our modules to customers and we have not yet recognized any revenue from the South Korean digital TV market, which remains an important focus for us. We have also experienced delays in the development of new products designed to take advantage of new market opportunities, including our mobile smart card readers, physical access control terminals and dual reader conditional access modules. Once available, our physical access control product for the U.S. government faces substantial competition, and there is no guarantee that we will be successful in securing a significant portion of this market opportunity. If we are not able to complete, sell and ship new products into the new markets we have identified, we may not be able to counter our revenue decline and our losses could increase.

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

     Our common stock is listed both on the Prime Standard of the Frankfurt Stock Exchange and on the Nasdaq Stock Market and we currently experience a significant volume of our trading on the Prime Standard. Because of this, factors that would not otherwise affect a stock traded solely on the Nasdaq Stock Market may cause our stock price to fluctuate. For example, 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 significantly. The European economy and market conditions in general, or downturns on the Prime Standard specifically, regardless of the Nasdaq Stock Market conditions, could negatively impact our stock price. In addition, our inclusion or removal from European stock indices could impact our stock trading patterns and price. For example, in September 2004 our stock was removed from the European TecDAX index of technology companies. The performance of companies on the TecDAX is widely publicized in Europe and stocks in the TecDAX may experience volatility related to that publicity. As a result of our removal from the TecDAX, some investors decreased their positions in our stock and we experienced significantly higher trading volumes and a reduction in our stock price.

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

     Over the past few years, the Nasdaq Stock Market and the Prime Standard of the Frankfurt Exchange have experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. For example, during the 12-month period from April 30, 2004 to April 29, 2005, the closing prices for our common stock on the Nasdaq Stock Market ranged between $2.51 and $6.97 per share. Volatility in our stock price on either or both exchanges may result from a number of factors, including, among others:

	•	variations in our or our competitors’ financial and/or operational results;
	•	the fluctuation in market value of comparable companies in any of our markets;
	•	expected or announced relationships with other companies;
	•	comments and forecasts by securities analysts;
	•	trading patterns of our stock on the Nasdaq Stock Market or Prime Standard of the Frankfurt Stock Exchange;
	•	the inclusion or removal of our stock from market indices, such as groups of technology stocks or other indices;
	•	any loss of key management;
	•	announcements of technological innovations or new products by us or our competitors;
	•	litigation developments; and
	•	general market downturns.

23

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

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

     Our products are generally targeted at OEM customers in the consumer electronics, digital photography, computer and conditional access system industries, as well as digital television operators, broadcasters and distributors, the government sector and corporate enterprises. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total revenues. For example, three customers accounted for approximately 19% of our total net revenue in the twelve months ended December 31, 2004 and two customers accounted for approximately 24% of our total net revenue in the three months ended March 31, 2005. Any additional consolidation of our business lines could further increase our dependence on a limited number of customers. We expect that sales of our products to a relatively small 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 those due to product performance issues, 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 product markets.

     We sell our products primarily to emerging product markets that have not yet reached a stage of mass adoption or deployment. If demand for products in these markets does not develop further 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, is subject to high levels of uncertainty and risk and may be influenced by several factors, including, but not limited to, the following:

	•	general economic conditions;
	•	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 agree on industry specifications and to develop 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, for example digital photographs.

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 perceived defects or have reliability, quality or compatibility problems or perceived 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. In the event of a defect or other problem or a perceived defect or problem, we may have to invest significant capital, technical, managerial and other resources to investigate and correct the potential defect or problems and potentially divert these resources from other development efforts. If we are unable to provide a solution to the potential defect or problem that is acceptable to our customer, we may be required to incur substantial product recall, repair or replacement or even litigation costs. These costs could have a material adverse effect on our business and operating results.

24

     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 (or even a perceived defect) could result in legal or warranty claims against us for damages resulting from security breaches. If such claims are adversely decided against us, the potential liability could be substantial and have a material adverse effect on our business and operating results. Furthermore, the publicity associated with any such claim, whether or not decided against us, could adversely affect our reputation. 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. Any of the foregoing events could cause demand for our products to decline, which would cause our business and operating results to suffer.

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. If we were to determine that we could not utilize or sell this inventory, we may be required to write down its value. In order to minimize the negative financial impact of 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. Writing down inventory or reducing product prices could adversely impact 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 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. 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. Our reliance on foreign manufacturing poses a number of risks, including, but not limited to:

	•	difficulties in staffing;
	•	currency fluctuations;
	•	potentially adverse tax consequences;
	•	unexpected changes in regulatory requirements;
	•	tariffs and other trade barriers;
	•	political and economic instability;
	•	lack of control over the manufacturing process and ultimately over the quality of our products;
	•	late delivery of our products, whether because of limited access to our product components, transportation delays and interruptions, difficulties in staffing, or disruptions such as natural disasters;
	•	capacity limitations of our manufacturers, particularly in the context of new large contracts for our products, whether because our manufacturers lack the required capacity or are unwilling to produce the quantities we desire; and
	•	obsolescence of our hardware products at the end of the manufacturing cycle.

25

     If we or any of our contract manufacturers cannot meet our production requirements, we may be required 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 or at all or on reasonable terms and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements.

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

     The markets for our products are characterized by rapidly changing technology and the need to meet market requirements and 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 a product is deemed to be obsolete or unmarketable, then we might have to reduce revenue expectations or write off inventories for that product. For example, in the first quarter of 2005 we determined that we might no longer be able to sell certain of our Digital TV and PC Security products because they contain lead, which will be banned from use in electronic and electrical products in Europe beginning in July 2006 under the directive known as RoHS (Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment), which will come into force on 1 July, 2006. As a result, we wrote down Digital TV and PC Security product inventory in the first quarter. In addition, we must now submit new lead-free products to our customers, which may result in a vendor qualification process that could require us to compete for business that had previously been secured.

     Our future success will depend upon our ability to enhance our current products and to develop and introduce new products with clearly differentiated benefits that address the increasingly sophisticated needs of our customers and that keep pace with technological developments, new competitive product offerings and emerging industry standards. For example, we are beginning to bring to market a line of smart card readers designed to provide secure physical access to U.S. government buildings and other facilities. Industry specifications and market requirements for physical access are still evolving and competition for this market is already well established. We must be able to demonstrate that our products have features or functions that are clearly differentiated from existing or anticipated competitive offerings, or we may be unsuccessful in selling these products. 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 on a timely basis, or risk losing current and any future revenue from those products.

     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. 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.

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

	•	the extent to which products must support existing industry standards and provide interoperability;
	•	the extent to which standards are widely adopted and product interoperability is required within industry segments;
	•	the extent to which products are differentiated based on technical features, quality and reliability, ease of use, strength of distribution channels and price; and
	•	the ability of suppliers to develop new products quickly to satisfy new market and customer requirements.

     We currently experience competition from a number of companies in each of our target market segments and we believe that competition in our markets is likely to intensify as a result of increasing demand for secure digital access products. We may not be successful in competing against offerings from other companies, and could lose business as a result.

26

     In our Digital TV business, we are adversely affected by competition from companies that provide conditional access modules using unlicensed, emulated conditional access decryption systems. We have lost and will likely continue to lose business to these competitors and their presence causes us to implement more costly anti-piracy mechanisms on our own products to prevent their unlicensed 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.

Sales of smart card readers to the U.S. government could be impacted by uncertainty of timelines and budgetary allocations as well as by the delay of standards for information technology (IT) projects.

     Historically, we have sold a significant proportion of our smart card reader products to the U.S. government and we anticipate that some portion of our future revenues will also come from the U.S. government. The timing of U.S. government smart card projects is not always certain. For example, while the U.S. government has announced plans for several new smart card-based security projects, none have yet reached a stage of sustained high volume card or reader deployment, in part due to delays in reaching agreement on specifications for a new federally mandated set of identity credentials. In 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 government projects for any reason 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 with our customers. While we have experienced few product returns to date, returns may increase beyond present levels in the future. Once these products have been returned, we may be required to take additional inventory reserves to reflect the decreased market value of slow-selling returned inventory, even if the products are in good working order.

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

     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 our products, each product line requires significant research and development effort to address the evolving needs of our customers and markets. 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 has resulted in a level of operational spending that is disproportionately high compared to our current revenue levels. Based on our business model and geographic structure, if we do not grow revenues, we will likely not reach profitability.

     Operating in diverse geographic locations also 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;

27

	•	maintain sufficient internal financial controls in multiple geographic locations that may have different control environments;
	•	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.

     Any failure to effectively manage our operations globally could have a material adverse effect on our business and operating results.

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 results of operation.

     We were originally a German corporation and we continue to conduct a substantial portion of our business in Europe. Approximately 69% and 71% of our revenues for the twelve months ended December 31, 2004 and the three months ended March 31, 2005, 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 risks associated with foreign operations, any of which could impact our sales and/or our operational performance. These risks include, but are not limited to:

	•	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.

     In addition, 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.

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 were to leave and not be replaced, our business could be adversely affected.

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

We are subject to a lengthy sales cycle and additional delays could result in significant fluctuations in our quarterly operating results.

     Our initial sales cycle for a new customer usually takes a minimum of six to nine months. During this sales cycle, we may expend substantial financial and managerial resources with no assurance that a sale will ultimately result. The length of a new customer’s sales cycle depends on a number of factors, many of which 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 could delay or reduce our receipt of new revenue and could cause us to expend more resources to obtain new customer wins. If we are unsuccessful in managing sales cycles, our business could be adversely affected.

28

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. From time to time 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 that could have an adverse effect on our business operations. There is no assurance that we would be able to obtain equity or 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 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, which may expose us to certain risks including, without limitation, 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 could 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. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only

29

limited protection. 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 and from time to time we may be required to use litigation to protect our proprietary technology. This may result in our incurring substantial costs and there is no assurance that we would be successful in any such litigation.

     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 without authorization. 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. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. If we are unsuccessful in protecting our intellectual property or our products or technologies are duplicated by others, our business could be harmed.

Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

     We prepare our financial statements to conform with generally accepted accounting principles, or GAAP, in the United States. These accounting principles are subject to interpretation by the Financial Standards Accounting Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various other bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, under the recently issued Financial Accounting Standard Board Statement No. 123R, we will be required to apply certain expense recognition provisions beginning January 1, 2006 to share-based payments to employees using the fair value method. This new accounting policy and any other changes in accounting policies in the future may result in significant accounting charges.

We face costs and risks associated with compliance with Section 404 of the Sarbanes-Oxley Act.

     Under Section 404 of the Sarbanes-Oxley Act of 2002, on an annual basis our management is required to report on, and our independent auditors to are required attest to, the effectiveness of our internal controls over financial reporting. The process of maintaining and evaluating the effectiveness of these controls is expensive, time-consuming and requires significant attention from our management. While we believe that our internal controls are currently effective, we have found material weakness in the past and we cannot be certain that we will be able to 1) report that our controls are without material weakness in the future or 2) complete our evaluation of those controls in a timely fashion. Similarly, we cannot be certain that our auditors will consistently be able to attest that no material weakness in our controls exists.

     If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, including satisfaction of the requirements of Section 404 of the Sarbanes-Oxley Act, we may discover material weaknesses that we would then be required to disclose. We may not be able to accurately or timely report on our financial results, and we might be subject to investigation by regulatory authorities. As a result, the financial position of our business could be harmed; current and potential future shareholders could lose confidence in the Company and/or its reported financial results, which may cause a negative effect on the trading price of our common stock; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

     In addition, all internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to the preparation and presentation of financial statements. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

We face risks from litigation.

     From time to time, we may be subject to litigation, which could include claims regarding infringement of the intellectual property rights of third parties, product defects, 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, require us to accept return of product and write off inventory, 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.

30

     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. For example, in April 2005, Cybercard Corporation filed a claim against SCM and six other defendants alleging patent infringement by our CHIPDRIVE Smartcard Office product. As a result of infringement claims, we could be required to license intellectual property from a third party or redesign our products. Licenses may not be offered when we need them or on acceptable terms. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments or we may be required to license some of our intellectual property to others in return for such licenses. 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 also be unsuccessful in redesigning our products. Our suppliers and customers may be subject to infringement claims based on intellectual property included in our products. We have historically agreed to indemnify our suppliers and customers for patent infringement claims relating to our products. 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 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 seek to monitor and limit our exposure to credit risk on our trade and non-trade receivables, we may not be effective in limiting credit risk and avoiding losses. Additionally, if the global economy and regional economies deteriorate, one or more of our customers could experience a weakened financial condition and we could incur a material loss or losses as a result.

Factors beyond our control could disrupt our operations.

     We face a number of potential business interruption risks that are beyond our control. For example, 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 the acquisition of our Company, 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 or enter into a material transaction with 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.

     We have adopted a stockholder rights plan. The triggering and exercise of 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 SCM’s Board of Directors, except pursuant to an offer conditioned upon redemption of the rights. While the rights are not intended to prevent a takeover of SCM, they may have the effect of rendering more difficult or discouraging an acquisition of SCM that was deemed to be undesirable by our Board of Directors.

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

31

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 2005. 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, 2004.

Item 4. Controls and Procedures

     (a) Evaluation of Disclosure Controls and Procedures

     SCM carried out an evaluation as of March 31, 2005, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, SCM’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including our consolidated subsidiaries) required to be disclosed in our reports under the Securities Exchange Act of 1934.

     (b) Changes in Internal Controls

     During the three months ended March 31, 2005, in response to a material weakness in our internal controls identified by management in connection with our fiscal 2004 audit and related to the determination and reporting of the provision for income taxes and the related financial statements disclosures, we reviewed, revised and strengthened our procedures for the calculation of income tax provisions, including performing additional validation work and involving additional external advisors. Other than this, there have been no significant changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

     In April 2005, Cybercard Corporation (“Cybercard”), a Canadian corporation, filed a patent infringement claim against the Company in the Southern District of Illinois (Case No. 05-CV-274-MJR). The claim alleged infringement of U.S. Patent No. 5,497,411, entitled “Telecommunications Card – Access System,” by the Company’s CHIPDRIVE Smartcard Office product. In the same lawsuit, Cybercard sued six other defendants. No specific damages have been specified in the claim. To date, no sales of the allegedly infringing product have been made in the United States. The Company is investigating the claim which it expects to vigorously defend, if necessary, or otherwise resolve, as appropriate, of any allegations of infringement.

Item 6. Exhibits

32

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.

33

EXHIBIT INDEX