ACTIVCARD CORP - 10-Q Quarterly Report

(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. YES x NO ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES x NO ¨

The number of shares of the Registrant’s Common Stock outstanding on April 30, 2004 was 42,205,761.

See accompanying notes to unaudited condensed consolidated financial statements.

ActivCard Corp. (“ActivCard” or the “Company”) develops and markets secure digital identity and authentications systems and products for secure remote access, single sign-on and digital identity card solutions. The Company’s solutions provide customers with the ability to authenticate a user to a network through a variety of personal devices as well as the ability to manage credentials remotely post-issuance. The Company markets its solutions to governments, enterprises and financial institutions directly and indirectly through resellers, distributors, original equipment manufacturers and system integrators.

The accompanying consolidated financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosure normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America has been condensed or omitted pursuant to such rules and regulations. In the opinion of management, these condensed consolidated financial statements include all normal recurring adjustments necessary for the fair presentation of the Company’s consolidated financial position at March 31, 2004, consolidated results of operations for the three months ended March 31, 2004 and 2003, and consolidated statements of cash flows for the three months ended March 31, 2004 and 2003. The consolidated results of operations for the three months ended March 31, 2004 are not necessarily indicative of the consolidated operating results for the Company’s full fiscal year ending December 31, 2004 or any future periods.

These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in ActivCard Corp.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

Reclassifications – Certain reclassifications have been made to the 2003 financial statement presentation to conform to the 2004 presentation. These reclassifications had no effect on reported net loss or shareholders’ equity.

Revenues are derived primarily from the sale of software licenses, hardware and service agreements. The Company applies the provisions of Statement of Position 97-2 and related guidance. Revenues from software license agreements are generally recognized upon shipment, provided that evidence of an arrangement exists, the fee is fixed or determinable, no significant obligations remain and collection of the corresponding receivable is probable. In software arrangements that include hardware products, rights to multiple software products, maintenance and/or other services, the Company allocates the total arrangement fee among each deliverable, based on vendor-specific objective evidence of fair value of each element if vendor-specific objective evidence of each element exists. The Company determines vendor specific evidence of fair value of an element based on the price charged when the same element is sold separately. For an element not yet sold separately, vendor specific evidence of fair value of an element is established by management having the relevant authority as long as it is probable that the price, once established, will not change before separate introduction of the element in the marketplace. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, the Company recognizes revenue for the delivered elements based on the residual value method. For arrangements containing multiple elements wherein vendor specific objective evidence of fair value does not exist for all undelivered elements, revenue for the delivered and undelivered elements is deferred until vendor specific objective evidence of fair value exists or all elements have been delivered. The Company does not include acceptance clauses for its shrink-wrapped software products such as ActivCard Gold or Trinity client software. Acceptance clauses usually give the customer the right to accept or reject the software after the Company has delivered the product. However, the Company has provided certain customers with acceptance clauses for customized or significantly modified software products developed under product development agreements, and on occasion, for hardware products and client/server software products as well. In instances where an acceptance clause exists, the Company does not recognize revenue until the product is formally accepted by the customer in writing or the defined acceptance period has expired.

Revenue from the sale of hardware is recognized upon shipment of the product, provided that no significant obligation remains and collection of the receivable is considered probable.

Post-contract customer support is recognized on a straight-line basis over the term of the contract.

Service revenues include revenues from training, installation, or consulting. The Company enters into agreements with customers that require significant production, modification or customization of software in addition to the provision of services. Where the services are essential to the functionality of the software element of the arrangement, separate accounting for the services is not permitted and contract accounting is applied to both the software and service elements. In these cases, revenue is recognized as the work is performed pursuant to the related contracts and the achievement of related milestones in accordance with the percentage of completion method based on input measures.

Service revenues are recognized separately from the software element when the services are performed if vendor specific objective evidence of fair value exists to allocate the revenue to the various elements in a multi-element arrangement, the services are not essential to the functionality of any other element of the arrangement and the total price of the contract would vary with the inclusion or exclusion of the services.

The Company normally sells its products to customers with payment terms that are less than 60 days.

In certain specific and limited circumstances, the Company provides product return and price protection rights to certain distributors and resellers. The Company generally recognizes revenue from product sales upon shipment to resellers, distributors and other indirect channels, net of estimated returns or estimated future price changes. The Company’s policy is to not ship product to a reseller or distributor unless the reseller or distributor has a history of selling the Company’s products and the end user is known or has been qualified by the Company. The Company has established a reasonable basis through historical experience for estimating future returns and price changes. Actual returns have not been material to date. Price protection rights typically expire after 30 days and have not been material to date.

Amounts billed in excess of revenue recognized are recorded as deferred revenue in the accompanying consolidated balance sheets. Unbilled work-in-process is recorded as a receivable in the accompanying consolidated balance sheets.

In October 1995, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123, “Accounting for Stock Based compensation”, which recommends that the compensation cost for stock-based plans be measured using a fair value based method. The Company calculates the compensation cost for its stock option plans in compliance with the provisions of APB Opinion No. 25, which provides that no compensation costs be recorded if the exercise price of the options granted is equal to the fair market value of the Company’s stock as at the date of grant.

In accordance with APB Opinion No. 25, the Company allocates to deferred stock compensation, the fair value of restricted stock when granted to employees of acquired companies if they remain as employees of the Company subsequent to the acquisition date. The Company amortizes the deferred stock compensation to expense using the straight-line method over the vesting period, which is three years.

Pro forma information regarding net loss and loss per share is required by SFAS 123 as modified, and has been determined as if the Company had accounted for its employee stock options and warrants under the fair value method of SFAS 123. For purposes of pro forma disclosures, the estimated fair value of the options granted is amortized to expense over the options’ vesting period. The Company’s pro forma information follows (in thousands except for net loss per share information):

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” and a revised interpretation of FIN 46, (FIN 46R), in December 2003. FIN 46 provides guidance on: 1) the identification of entities for which control is achieved through means other than through voting rights, known as “variable interest entities” (VIEs); and 2) which business enterprise is the primary beneficiary and when it should consolidate a VIE. This new requirement for consolidation applies to entities: 1) where the equity investors (if any) do not have a controlling financial interest; or 2) whose equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. FIN 46R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. For VIEs created after January 31, 2003, FIN 46R is effective immediately. The adoption of FIN 46R in the first quarter of 2004 did not have a material impact on the Company’s results of operations or financial position.

In May 2003, the EITF reached a consensus on Issue No. 03-5 “Applicability of AICPA Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software.” The FASB ratified this consensus in August 2003. The EITF affirmed that SOP 97-2 applies to non-software deliverables, such as hardware and services, in an arrangement if the software is essential to the functionality of the non-software deliverables. The adoption of EITF Issue No. 03-5 in the fourth quarter of 2003 did not have a material impact on the Company’s results of operations or financial position.

In November 2003, the EITF reached a consensus on certain disclosure provisions under Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The disclosure provisions indicate that certain quantitative and qualitative disclosures are required for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS Nos. 115 and 124 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The EITF has not reached a consensus on the proposed models for evaluating impairment of equity securities and debt securities. The consensus on the required quantitative and qualitative disclosures is effective for fiscal years ending after December 15, 2003. The adoption of the disclosure provisions of this Issue during the fourth quarter of 2003 did not have a material impact on the Company’s results of operations or financial position.

In 2002, the Company commenced restructuring its business to enhance operational efficiency and reduce expenses. This plan included a reduction in workforce, a reduction in excess facilities and other direct costs. The charge for excess facilities was comprised primarily of future minimum lease payments payable over a nine-year period ending February 2011, net of estimated sublease income of $626. Sublease income was estimated assuming current market lease rates and after estimated vacancy periods. Charges for the reduction in workforce consisted of severance, outplacement and other termination costs.

In 2003, the Company took further measures to restructure its business and reduce its operating costs by implementing a reduction in workforce that resulted in the termination of 17 employees. Of the terminated employees, 9 were employed in sales and marketing, 7 were employed in research and development and 1 was employed in manufacturing and logistics. Charges for the reduction in workforce consisted of severance, outplacement and other termination costs.

In March 2004, the Company initiated a restructuring plan to reduce operating costs, streamline and consolidate operations and reallocate resources to selling and marketing functions. This plan includes a reduction in workforce that will result in the termination of approximately 100 employees, closure of five facilities, and termination of certain non-strategic projects. In the three months ended March 31, 2004, the Company began executing the restructuring plan by terminating a non-strategic project and 44 employees. Of the terminated employees, 8 were employed in sales and marketing, 29 in research and development, 2 in manufacturing and logistics, and 5 in general and administrative functions. Charges incurred to terminate the non-strategic project consisted of contractually obligated payments required under an existing agreement. Charges for the reduction in workforce consisted of severance, outplacement and other termination costs.

Components of restructuring and business realignment accruals, which are presented on the condensed consolidated balance sheet and in the condensed consolidated statements of operations for the year ended December 31, 2003 and the three months ended March 31, 2004 were as follows:

Remaining cash expenditures to complete the facility exit activities will be made over the seven-year period ending February 2011. The Company expects to make remaining cash payments to complete the workforce reduction by February 28, 2005.

In July 2003, the Company acquired a 38% interest in ASPACE Solutions Limited (“Aspace”), a developer of secure multi-channel data management systems based in London, England. The Company purchased 38,140 common shares of Aspace from existing shareholders for £954 (£25 per share) or $1,552. In connection with the acquisition of common shares, the Company also provided Aspace with a two-year, senior convertible loan in the amount of £2,500 or $4,067, which bears interest at a rate of 6% per annum. If all or part of the senior convertible loan is outstanding on the two-year anniversary date or if the senior convertible loan covenants are breached, the Company has the right to convert the loan balance any time thereafter, into common shares of Aspace at a price of £25 per share.

In December 2003, the Company provided Aspace with an additional two-year loan facility in the amount of £1,000 or $1,727, which bears interest at a rate of 6% per annum and is repayable on November 30, 2005. In connection with the additional loan, the Company received shares and warrants convertible into 21,245 newly issued shares of Aspace at a price of £0.01 per share. The Company exercised its warrant conversion rights in December 2003 increasing its ownership to 59,385 common shares or 49% of the outstanding common shares of Aspace. Aspace currently has 121,245 shares outstanding. In the event that the senior convertible loan, excluding accrued interest, is converted into common shares, an additional 100,000 new common shares of Aspace would be issued to the Company thereby increasing its ownership to approximately 72% of the voting control.

Aspace has incurred losses to date and ActivCard management anticipates continuing losses from Aspace over the balance of the current fiscal year. The authoritative accounting guidance requires that the Company record 100% of the net losses incurred by Aspace despite holding less than a controlling interest because the investments of other shareholders have been fully applied to previous losses.

The Company is an investor in Aspace and currently has no joint selling and marketing or research and development activities with Aspace. The Company has concluded that it’s not required to consolidate Aspace because it’s not the primary beneficiary. The Company’s maximum exposure to loss as a result of its involvement with Aspace is limited to the carrying value of its investment. Aspace currently has 48 employees located in London. For the three months ended March 31, 2004, the Company recorded $1,572 for losses incurred by Aspace.

On February 15, 2002, the Company executed its plan to dispose of the hosting operations of Authentic8 International Inc., a wholly owned subsidiary. On February 12, 2003, the Company entered into an agreement with a third-party for the disposition of the assets and certain liabilities of the hosting operations of Authentic8. The results of operations of the hosting activities to March 14, 2003, the effective date of the agreement with the third-party, have been included in the loss from discontinued operations in the consolidated statement of operations for the three months ended March 31, 2003.

Results of the discontinued operations related to the disposal of the hosting operations of the former Authentic8 are as follows:

The following is a reconciliation of the numerator and denominator used to determine basic and diluted loss per share:

No amounts have been presented for diluted earnings per share for the periods where the effect of including the weighted average number of common shares available under share options and warrants after applying the treasury stock method is anti-dilutive. Weighted average common share equivalents excluded in the three months ended March 31, 2004 and 2003 were 450,081 and 995,710, respectively.

The contractual maturities of available-for-sale debt securities as of March 31, 2004 were as follows:

During the three months ended March 31, 2003, the Company had purchases of approximately $1,976 from SCM Microsystems, Inc. (“SCM”), a manufacturer of smart card readers. As of December 31, 2003, there were no amounts owing to SCM. Although SCM is not a single-source supplier to the Company of specific products, the companies shared the services of Steven Humphreys. Mr. Humphreys was the Chairman and Chief Executive Officer of ActivCard until September 30, 2003 and is the non-executive Chairman of SCM’s Board of Directors. Mr. Humphreys was not compensated for the transactions between the two companies.

The Company has one operating segment: Digital Identity Solutions. Accordingly, the Company is disclosing segmented information by geographic area only. Transfers between geographic areas are eliminated in the consolidated financial statements. The following is a summary of operations by geographic region for the three months ended March 31, 2004 and 2003 and as of March 31, 2004 and December 31, 2003:

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 within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included in this Quarterly Report on Form 10-Q, other than statements that are purely historical, are forward-looking statements. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions also identify forward-looking statements. Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. Forward-looking statements in this Quarterly Report on Form 10-Q include, without limitation, statements regarding operating results, product development, marketing initiatives, business plans and anticipated trends. The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties further discussed under “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risks Factors” and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission on March 15, 2004. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q.

The following discussion of our financial condition and results of operations should be read in conjunction with our Condensed Consolidated Financial Statements and related notes included in “Item 1. Financial Statements” in this Quarterly Report on Form 10-Q.

Our objective is to be a leading provider of secure digital identity and authentication systems and products for secure remote access, single sign-on and digital identity card solutions. Our scalable systems and strong authentication solutions are trusted by organizations – from enterprise to governments around the world. We develop, market and support digital identity systems that enable our customers to issue, use and maintain digital identities in a secure, manageable and reliable manner. We market our solutions to government, financial institutions, network service providers and enterprise customers directly through our own sales organization and indirectly through system integrators, resellers and original equipment manufacturers. Unless otherwise indicated, references to “ActivCard”, “we”, “us” and “our” refer to the consolidated group of ActivCard companies.

We have focused our development efforts on smart card related products, primarily in the form of software applications embedded on the smart card and client/server software to support multi-function capabilities including card issuance, provisioning and management of digital identities. In the three months ended March 31, 2004 and 2003, 27% and 49% of revenues were derived from our core smart card related software products, primarily from ActivCard Gold, ActivPack authentication server and license fees from product development agreements for the ActivCard Identity Management System and ActivCard Java Card Applets, respectively.

The discussion and analysis of our consolidated financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of our condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expense during the reporting period. Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003 describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, sales warranties and allowance for doubtful accounts, long-lived assets, goodwill and intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, the actual results could differ from those estimates.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Significant management judgments and estimates must be made and used in connection with the revenue recognized in any reporting period.

For all sales, we use a binding contract, purchase order or other form of documented agreement to evidence an arrangement with a customer. We do not include acceptance clauses for our shrink-wrapped software products such as ActivCard Gold. Acceptance clauses usually give the customer the right to accept or reject the software after we have shipped the product. However, we have provided certain customers with acceptance clauses for customized or significantly modified software products developed under product development agreements and, on occasion, for hardware products and client/server software products as well. In instances where an acceptance clause exists, we do not recognize revenues until the product is formally accepted by the customer in writing or the defined acceptance period has expired.

Revenues are derived primarily from the sale of software licenses, hardware and service agreements. We apply the provisions of Statement of Position 97-2 and related guidance. Revenues from software license agreements are generally recognized upon shipment, provided that evidence of an arrangement exists, the fee is fixed or determinable, no significant obligations remain and collection of the corresponding receivable is probable. In software arrangements that include hardware products, rights to multiple software products, maintenance and/or other services, we allocate the total arrangement fee among each deliverable, based on vendor-specific objective evidence of fair value of each element if vendor-specific objective evidence of each element exists. We determine vendor specific evidence of fair value of an element based on the price charged when the same element is sold separately. For an element not yet sold separately, vendor specific evidence of fair value of an element is established by management having the relevant authority as long as it is probable that the price, once established, will not change before separate introduction of the element in the marketplace. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize revenue for the delivered elements based on the residual value method. For arrangements containing multiple elements wherein vendor specific objective evidence of fair value does not exist for all undelivered elements, revenue for the delivered and undelivered elements is deferred until vendor specific objective evidence of fair value exists or all elements have been delivered.

Revenue from the sale of hardware is recognized upon shipment of the product, provided that no significant obligation remains and collection of the receivable is considered probable.

Post-contract customer support is recognized on a straight-line basis over the term of the contract.

Service revenues include revenues from training, installation, or consulting. We enter into agreements with customers that require significant production, modification or customization of software in addition to the provision of services. Where the services are essential to the functionality of the software element of the arrangement, separate accounting for the services is not permitted and contract accounting is applied to both the software and service elements. In these cases, revenue is recognized as the work is performed pursuant to the related contracts and the achievement of related milestones in accordance with the percentage of completion method based on input measures.

We normally sell our products to customers with payment terms that are less than 60 days.

In certain specific and limited circumstances, we provide product return and price protection rights to certain distributors and resellers. We generally recognize revenue from product sales upon shipment to resellers, distributors and other indirect channels, net of estimated returns or estimated future price changes. Our policy is to not ship product to a reseller or distributor unless the reseller or distributor has a history of selling our products and the end user is known or has been qualified by us. We have established a reasonable basis through historical experience for estimating future returns and price changes. Actual returns have not been material to date. Price protection rights typically expire after 30 days and have not been material to date.

Expenses associated with potential warranty claims are accrued at the time of sale, based on warranty terms and prior experience. The Company provides for the costs of warranty in excess of warranty coverage provided by the product assembly contractors. The Company’s standard warranty period is ninety days for software products and one year for hardware products.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to pay outstanding amounts. The provision is based on factors that include account aging, historical bad debt experience, customer creditworthiness and other known factors.

Inventories are stated at the lower of cost or market, cost being determined on a first-in, first-out method. Write-downs for slow-moving and obsolete inventories are provided based on historical experience and current product demand.

In June 2003, we commenced a follow-on registered exchange offer to acquire the minority interest in ActivCard S.A. not owned by ActivCard Corp. The follow-on exchange offer closed in July 2003 with ActivCard Corp. issuing 1,808,075 shares of its common stock to acquire approximately an additional 4.6% of the outstanding securities of ActivCard S.A. We allocated the purchase price to the assets acquired and liabilities assumed at the date of purchase based on their fair values. In order to determine fair values, we had to make assumptions regarding estimated future cash flows and make estimates based on other factors. In certain cases, an allocation was made to acquired in process research and development which was charged to operations, as the research and development did not have alternative future uses as of the date of the acquisition. The allocation of purchase price among long-lived assets, which are depreciated, in-process research and development, which is expensed at the time of acquisition and goodwill, which is not amortized but evaluated periodically for impairment, has a significant impact on both current and future operating results.

We review the valuation of goodwill in accordance with SFAS No. 142 “Goodwill and Other Intangible Assets.” Under the provisions of SFAS No. 142, goodwill is required to be tested for impairment annually in lieu of being amortized. The annual impairment test date is December 1. Furthermore, goodwill is required to be tested for impairment on an interim basis if an event or circumstance indicates that it is more likely than not that an impairment loss has been incurred. An impairment loss shall be recognized to the extent that the carrying amount of goodwill exceeds its implied fair value. In assessing the recoverability of our goodwill and 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 against these assets in the reporting period in which the impairment is determined.

We review the valuation of long-lived assets, including property and equipment, under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We are required to assess the recoverability of long-lived assets on an interim basis whenever events and circumstances indicate that the carrying value may not be recoverable. This evaluation includes an analysis of estimated expected future undiscounted net cash flows to be generated by the assets over their estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over their estimated useful lives, we record an impairment charge in the amount by which the carrying value of the assets exceeds their fair value. Fair value for identifiable long-lived assets is generally determined based on discounted cash flows.

On February 15, 2002, as a result of changes in strategic plans, we executed a plan to dispose of the hosting operations of Authentic8 International. As a result of the changed circumstances, the estimates and assumptions for future cash flows from the hosting operation declined indicating that an impairment in the value of the related assets existed. Accordingly, we recorded a charge to earnings in the amount of $15.6 million in 2002, which included an impairment of the carrying value of goodwill and other intangibles of $15.0 million. We disposed of the hosting operations in February 2003.

In December 2002 and 2003, we performed impairment tests on the carrying value of goodwill and determined that no impairment existed.

At March 31, 2004, we had $17.0 million of goodwill and other intangible assets, which accounted for 7% of our total assets. In the future, if any additional impairment is determined to exist, the resulting charge could be significant and could have a material adverse effect on our consolidated financial position and results of operations.

We recorded charges of $1.2 million and $0.9 million in the three months ended March 31, 2004 and 2003, respectively, related to restructuring plans, which consisted primarily of reductions-in-work force. We expect to incur additional restructuring costs in 2004 as we continue to implement our restructuring initiatives. Accounting pronouncements in effect for restructuring activities initiated after December 31, 2002 require us to record a liability and charge to earnings when the liability is incurred rather than when we formally committed to the restructuring plan, as previously required. These new provisions require us to measure the liability at fair value.

In 2002, we were required to make significant estimates related to the subletting of facilities in Fremont, California and Melbourne, Australia. Estimates related to sublease income are based on assumptions regarding expected vacancy periods required to locate and contract with suitable sublessees and current sublease market rates. In December 2003 and 2002, we revised our estimate of expected sublease income and recorded additional charges to earnings of $111 thousand and $620 thousand, respectively. If the assumptions for these estimates change in the future due to changes in the market, the ultimate restructuring expenses for these facilities could vary by material amounts. Our policies, as supported by current authoritative guidance, require us to continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. As management continues to evaluate the business, there may be additional charges for new restructuring activities, as well as changes in estimates to amounts previously recorded.

The following table sets forth the selected items from our condensed consolidated statements of operations expressed as a percentage of total revenues for the periods presented:

The decrease in hardware and software revenues of 31% and 68%, respectively, in the first three months of 2004 compared to the first three months of 2003 reflected decreased demand for smart card readers and our ActivCard Gold client software products for maturing smart card based digital identification deployments by U.S. Department of Defense agencies.

The increase in maintenance and support revenues of 9% in the three months ended March 31, 2004 compared to the same period one year ago was the result of growth in the installed base of our ActivCard Gold client software primarily at U.S. Department of Defense agencies.

Revenues by geographic region, expressed as a percentage of total revenues, are as follows:

Revenues by customer segment, expressed as a percentage of total revenues, are as follows:

The decrease in revenues in North America of 29% and the Government segment of 36% in the three months ended March 31, 2004, compared to the same period in 2003, was the result of decreased unit sales of our ActivCard Gold client software products and related smart card readers for maturing smart card based digital identification deployments by the U.S. Department of Defense agencies.

The increase in revenues in Europe of 31% and the Financial segment of 20% in the three months ended March 31, 2004, compared to the three months ended March 31, 2003, was the result of increased demand for our token-based products from European financial institutions.

Gross margin totaled $4.3 million and $7.9 million in the three months ended March 31, 2004 and 2003, respectively.

Hardware gross margin, expressed as a percentage of hardware sales, increased 21% in the three months ended March 31, 2004 compared to the three months ended March 31, 2003, primarily as a result of a decreased proportion of hardware sales derived from lower margin smart card readers and an increased proportion from higher margin token-based products. Software gross margin, expressed as a percentage of software sales, decreased 20% in the first quarter of 2004 compared to the first quarter of 2003, primarily due to increased engineering labor costs for custom software development related to deployments by the U.S. Department of Defense. Maintenance and support gross margin, expressed as a percentage of maintenance and support revenues, declined 10% in the three months ended March 31, 2004 compared to the same period one year ago as a result of increased costs of software support activities for our large government deployments.

Research and development expenses decreased 4% in the first quarter of 2004 compared to the first quarter of 2003 primarily as a result of increased utilization of engineering resources to complete custom software development related to deployments by the U.S. Department of Defense.

In the three months ended March 31, 2004, selling and marketing expenses increased 17% compared to the three months ended March 31, 2003. Approximately one-half of the increase in selling and marketing expenses was a result of increased marketing-related activities such as tradeshow attendance, advertising and promotions. The balance of the increase in selling and marketing expenses related primarily to the development of a North American indirect sales organization to leverage indirect sales channels such resellers, distributors and systems integrators.

General and administrative expenses decreased 2% in the first quarter of 2004 compared to the first quarter of 2003 as a result of a decrease in professional fees incurred to defend our intellectual property and implement new regulatory reporting and compliance regulations.

The amortization of acquired intangible assets decreased 25% in the three months ended March 31, 2004 compared to same period one year ago primarily as a result of impairment write-downs of $758 thousand in the second quarter of 2003 to adjust the carrying value of acquired intangible assets to their estimated fair value as of the reporting date. The amortization of acquired intangible assets consisted of the amortization of developed and core technology and trade names and trademarks associated with the acquisitions of Ankari, Safe Data and the ActivCard S.A. minority interest.

In March 2003, we took measures to restructure our business and reduce our operating costs by implementing a reduction in workforce that resulted in the termination of 17 employees. Of the terminated employees, 9 were employed in sales and marketing, 7 were employed in research and development and 1 was employed in manufacturing and logistics. Charges for the reduction in workforce in the three months ended March 31, 2003 were $947 thousand for the termination of 14 employees and consisted of severance, outplacement and other termination costs.

In March 2004, we initiated a restructuring plan to reduce operating costs, streamline and consolidate operations and reallocate resources to selling and marketing functions. This plan includes a reduction in workforce that will result in the termination of approximately 100 employees, closure of five facilities housing selling and research and development activities, product development efforts to converge certain our products, and termination of certain non-strategic projects. In the three months ended March 31, 2004, we began executing the restructuring plan incurring charges of $1.2 million to terminate two non-strategic projects and 44 employees. Of the terminated employees, 8 were employed in sales and marketing, 29 in research and development, 2 in manufacturing and logistics, and 5 in general and administrative functions. Charges incurred to terminate non-strategic projects consisted of contractually obligated payments required under existing agreements. Charges for the reduction in workforce consisted of severance, outplacement and other termination costs.

Remaining cash expenditures of $4.3 million to complete the facility exit activities will be made over the seven-year period ending February 2011. We expect to make remaining cash payments of $602 thousand to complete the work force reduction by February 28, 2005.

In the three months ended March 31, 2003, we incurred charges of $945 thousand related to the change in domicile of the publicly listed company in the ActivCard group from the Republic of France to the United States, which was completed in February 2003. The charges consisted primarily of share cancellation expenses and professional fees associated with the regulatory filings prepared in connection with the exchange offer and filed with the SEC and the Belgian Banking and Finance Commission. Total charges incurred to complete the change in domicile were $2.0 million.

Interest income in the first quarter of 2004 was lower than the comparable period of the prior year due primarily to the effects of lower interest rates in effect during the three months ended March 31, 2004 compared to the rates in effect during the three months ended March 31, 2003.

For the three months ended March 31, 2004 and 2003, foreign exchange gains and losses were attributable primarily to the volatility of the U.S. dollar against the local functional currencies of ActivCard legal entities and resulted from revaluation of the assets and liabilities denominated in currencies other than the functional currency. The average exchange rate of the Euro relative to the U.S. dollar was 1.25 for the three months ended March 31, 2004 and 1.07 for the three months ended March 31, 2003.

Income tax expense in the three months ended March 31, 2004 and 2003 consisted of minimum annual franchise taxes in certain jurisdictions.

Minority interest of $49 thousand in the first quarter of 2003 represents approximately 5.2% of the consolidated net loss of ActivCard S.A. from February 3, 2003 to March 31, 2003. Minority interest of $35 thousand in the first quarter of 2004 represents approximately 0.6% of the consolidated net loss of ActivCard S.A. during that period. In February 2003, we completed the change in domicile of the publicly listed company in the ActivCard group, formerly ActivCard S.A., from the Republic of France to the United States. In July 2003, we completed a follow-on exchange offer in which we acquired approximately an additional 4.6% of the outstanding securities of ActivCard S.A. The minority interest in ActivCard S.A. is approximately 0.6% representing outstanding common shares and American Depositary Shares of ActivCard S.A. that were not exchanged as of March 31, 2004.

Equity in the net loss of Aspace Solutions Limited (“Aspace”) of $1.6 million during the three months ended March 31, 2004 represents 100% of the net loss incurred by Aspace during that period. Aspace has incurred losses to date and we anticipate continuing losses from Aspace over the balance of the current fiscal year. Although we own 49% of Aspace’s outstanding common shares, the authoritative accounting guidance requires that we record 100% of the net losses incurred by Aspace despite holding less than a controlling interest because the investments of other shareholders have been fully applied to previous losses.

On February 15, 2002, we executed a plan to dispose of the hosting operations of Authentic8. On February 12, 2003, we entered into an agreement with a third-party for the disposition of the assets and certain liabilities of the hosting operations of Authentic8. The results of operations of the hosting activities to March 14, 2003, the effective date of the agreement with the third-party, have been included in the loss from discontinued operations in the consolidated statement of operations for the three months ended March 31, 2003.

Results of the discontinued operations related to the disposal of the hosting operations of the former Authentic8 are as follows:

As of March 31, 2004 we had cash and equivalents and short-term investments of $222.0 million, a decrease of $6.7 million from $228.7 million at December 31, 2003. In the first quarter of 2004, we consumed $6.6 million of cash from continuing operations, primarily due to a loss from continuing operations in the period of $9.1 million reduced by equity in the net loss of Aspace of $1.6 million. We consumed $4.6 million of cash from continuing operations in the first quarter of 2003 primarily from a net loss from continuing operations of $4.3 million.

Accounts receivable, net of allowances, decreased to $3.0 million as of March 31, 2004 from $3.4 million as of December 31, 2003. Days sales outstanding, which is a measure of the average collection period of trade accounts receivable, improved to 37 days at March 31, 2004 from 45 days at December 31, 2003. The decline in days sales outstanding was the result of improved linearity of monthly shipments in the first quarter of 2004 compared to the fourth quarter of 2003 resulting in proportionately lower shipments in the last month of the quarter. The credit terms extended to our customers are typically less than 60 days, which has not changed during these periods. We anticipate that days sales outstanding will return to our historical trend of approximately 70 days, which we believe is consistent with other companies in our industry.

Investing activities during the three months ended March 31, 2004 consisted primarily of investments in short-term securities and capital expenditures. Proceeds from sales and maturities of short-term investments, net of purchases of short-term investments, totaled $18.8 million in the first quarter of 2004. Capital expenditures of $0.6 million and $0.4 million in

the three months ended March 31, 2004 and 2003, respectively, consisted of leasehold improvements, furniture and fixtures, computers and equipment. During 2003, we made investments in and loans to Aspace totaling $8.2 million. Although we have no contractual obligation to do so, we may provide additional financing to Aspace in the future.

Financing activities of $0.4 million and $1.6 million for the three months ended March 31, 2004 and 2003, respectively, consisted primarily of proceeds from the issuance of common shares resulting from the exercise of warrants and stock options.

At March 31, 2004 we had $3.7 million of long-term restructuring accruals. Long-term restructuring accruals represent remaining cash expenditures to complete the facility exit activities and will be paid over the seven-year period ending February 2011. At March 31, 2004 and 2003 we had $1.1 million of other long-term liabilities representing deferred rent obligations on leased facilities.

Our future capital requirements, the timing and amount of expenditures, and the adequacy of funds available to us will depend on our success in developing and selling new and existing products. Based on our current plans, we believe that existing cash balances and cash flows generated by operations will be adequate to satisfy our capital requirements for at least the next twelve months.

The following risk factors should be read in conjunction with the risk factors set forth in our most recent Annual Report on Form 10-K, as filed with the SEC.

We have a history of losses and we may experience losses in the foreseeable future.

We have not achieved profitability on an operating basis and we may continue to incur operating losses in the foreseeable future. In the three months ended March 31, 2004 and 2003, we incurred losses from continuing operations of $9.1 million and $4.3 million, respectively. As of March 31, 2004, our accumulated deficit was $148.5 million, which represents our net losses since we began our operations. Even with our sizable cash balances, we may not become profitable or be able to significantly increase our revenue.

We will need to achieve significant incremental revenue growth and contain costs to achieve profitability. Even if we do achieve profitability, we may be unable to sustain profitability on a quarterly or annual basis in the future. It is possible that our revenues will grow more slowly than we anticipate or that operating expenses will exceed our expectations.

Our cost-reduction initiatives may not result in the anticipated savings or more efficient operations and may harm our long-term viability.

We are currently executing a plan to enhance and improve sales and marketing activities, rationalize research and development projects and general and administrative functions and consolidate geographic locations. In connection with this plan, we incurred charges of $1.2 million in the three months ended March 31, 2004 for a reduction in work force and to terminate a non-strategic project. We expect to incur substantial costs for additional employee terminations and facility closures during the balance of 2004 to complete this plan. In the years ended December 31, 2003 and 2002, we incurred restructuring charges of $1.5 million and $8.6 million, respectively, in connection with restructuring plans to streamline operations, improve efficiency and reduce costs. These restructuring efforts are disruptive to operations and may not generate the anticipated savings in operational costs.

Additionally, our current restructuring plan may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce. Although we believe that it is necessary to reduce the size and cost of our operations to improve our financial results, a reduction in our operations may make it more difficult to develop and market new products and to compete successfully with other companies in our industry. In addition, many of the employees who were terminated possessed specific knowledge or expertise that may prove to have been important to our operations. In that case, their absence may create significant difficulties. This personnel reduction may also subject us to the risk of litigation, which may adversely impact our ability to conduct our operations and may cause us to incur significant expense.

We have experienced significant turnover in management and this may make it more difficult for the Company to execute on its business plan.

In February 2004, we announced the departure of our chief executive officer, who had joined us in October 2003. Since that time, we have eliminated or consolidated the positions of several other senior-level officers and employees in connection with our restructuring initiatives. The remaining members of our management team have assumed many of the duties of these positions. Additionally, recent turnover in our management team may make it more difficult for us to attract and retain skilled employees in the future.

We have recorded significant write-downs in recent periods for impairment of assets and may have similar write-downs in future periods.

We recorded an impairment write-down of $758 thousand in the second quarter of 2003 and $5.1 million in the fourth quarter of 2002 to adjust the carrying value of acquired intangible assets to their estimated fair value. The impaired assets consisted of developed and core technology, agreements, contracts, and trade names and trademarks. Additionally, we terminated certain non-core activities in 2003, including our biometric hardware product line, hosting of PKI digital certificate issuance and overlapping product offerings. As a result of these decisions, we recorded charges to earnings of $4.2 million in 2003, which included impairment in value of software licenses included in property and equipment of $1.7 million.

We may terminate additional non-core activities in future periods or determine that our investment in Aspace Solutions Limited, other intangible assets or goodwill have been impaired. Any additional impairment charges that result could be significant and could have a material adverse effect on our consolidated financial position and results of operations. At March 31, 2004, we had $17.0 million of goodwill and other intangible assets, which accounted for 7% of our total assets.

We have a 49% voting control interest in Aspace Solutions Ltd. To date, Aspace’s product is unproven in the marketplace, achieving only modest revenues. Further, Aspace has a history of losses and may not have adequate capital to grow its business. We have no contractual obligation to continue to fund Aspace, although we may do so in the future. Should Aspace fail to execute on its business plan, our operating results and financial condition could be negatively affected.

Despite our only owning 49% of the voting control of Aspace, current authoritative accounting guidelines require us to record 100% of Aspace’s losses in our results of operations. Should Aspace continue to experience losses, we will be required to continue to record those losses, up to the total amount of our investment, which would negatively affect our operating results and financial condition.

We derive revenue from only a limited number of products and we do not have a diversified product base.

Substantially all of our revenues are derived from the sale of our digital identity systems and products. We anticipate that substantially all of the growth in our revenue, if any, will also be derived from these sources. If for any reason our sale of these products is impeded, and we have not diversified our product offerings, our business and results from operations could be harmed. We do not expect to diversify our product offerings in the foreseeable future and are reducing our product offerings as part of our restructuring initiatives so that we focus on just our core products. By limiting our product offerings in the future, we will likely increase the risks associated with not having a diversified product base.

Our customer base is highly concentrated and the loss of any one of these customers could adversely affect our business.

Historically, we have experienced a concentration of revenues through certain of our channel partners to customers. In the three months ended March 31, 2004 and 2003, there was a high concentration of revenues through a number of system integrators to the U.S. Department of Defense. Many of our contracts with our significant channel partners are short-term. If any of these channel partners did not renew their contract upon expiration, or if there was a substantial reduction in sales to any of our significant customers, it could adversely affect our business and operating results.

In the three months ended March 31, 2004 one customer accounted for 22% of revenues. In the three months ended March 31, 2003, three customers accounted for 65% of revenues. Our customers consist primarily of system integrators, resellers, distributors and OEMs. We ship product to the U.S. Department of Defense exclusively through system integrators. In the three months ended March 31, 2004 and the year ended December 31, 2003, we shipped product to many departments within the U.S. Department of Defense through system integrators such as Northrop Grumman. Our subcontract agreement with Northrop Grumman expires in August 2004. We cannot be certain the subcontract agreement with Northrop Grumman will be renewed or extended.

In the aggregate, the U.S. Department of Defense, as an end-user, accounted for approximately 17% and 59% of our consolidated revenues in the three months ended March 31, 2004 and 2003, respectively. One department within the U.S. Department of Defense accounted for 10% of consolidated revenues during three months ended March 31, 2004 and three departments within the U.S. Department of Defense each accounted for 10% of consolidated revenues during the three months ended March 31, 2003. We expect to continue to depend upon a small number of large customers for a substantial portion of our revenue.

We have a long and often complicated sales cycle for individual orders, which can result in significant revenue fluctuations from quarter to quarter.

The sales cycle for our products, which is the period of time between the identification of a potential customer and completion of the sale, is typically long and subject to a number of significant risks over which we have little control. As our operating expenses are based on anticipated revenue levels, a small fluctuation in the timing of sales can cause our operating results to vary significantly from period to period. If revenue falls significantly below anticipated levels, our business would be seriously harmed.

A typical sales cycle is often six to nine months in the case of an enterprise customer, and more than twelve months in the case of a network service provider customer or government entity.

Purchasing decisions for our products and systems may be subject to delay due to many factors that are not within our control, such as:

Furthermore, the implementation process is subject to delays resulting from network administrative concerns associated with incorporating new technologies into existing networks, deployment of a new network system or preservation of existing network infrastructure and data migration to the new system. Full deployment of our technology and products for such networks, servers or other host systems is usually scheduled to occur over a two-to-three-year period and the licensing of digital identity systems and products, including client and server software, smart cards, readers, tokens and the recognition of maintenance revenues would also occur over this period.

The market for our products is still developing and if the industry adopts standards or a platform different from our platform, then our competitive position would be negatively affected.

The market for digital identity products is still emerging and is also experiencing consolidation. The evolution of the market is in a constant state of flux that may result in the development of different network computing platforms and industry standards that are not compatible with our current products or technologies.

We believe that smart cards are an emerging platform for providing digital identity for network applications and services. Our business model is premised on the smart card becoming a common access platform for network computing in the future. Further, we have focused on developing our products for particular operating systems related to smart card deployment and use. Should platforms other than the smart card emerge as a preferred platform or should operating systems other than the specific systems we have focused on emerge as preferred operating systems, our current product offerings could be at a disadvantage to competitors who have been focusing on alternative platforms and operating systems. If this were to occur, our future growth and operating results could suffer.

In addition, the digital identity market lacks industry-wide standards. While we are actively engaged in discussions with industry peers to define what standards should be, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines.

Our international operations subject us to risks associated with operating in foreign markets, including fluctuations in currency exchange rates that could adversely affect our results from operations and financial condition. International sales are a substantial portion of our business. A severe economic decline in one of our major foreign markets could make it difficult for customers from those countries to pay us on a timely basis. Any such failure to pay, or deferral of payment, could adversely affect our results of operations and financial condition. In the three months ended March 31, 2004 and 2003, markets outside of North America accounted for 61% and 32% of consolidated revenues, respectively.

We face a number of risks inherent in doing business in international markets, including among others:

While we prepare our financial statements in U.S. dollars, we have historically incurred a substantial portion of our expenses in Euros and prior to the Euro, French francs. We expect that a significant portion of our expenses will continue to be incurred in Euros and, to a lesser extent, in other non-U.S. foreign currencies. Fluctuations in the value of the Euro and other currencies relative to the U.S. dollar have caused and will continue to cause dollar-translated amounts to vary from one period to another. Due to the constantly changing currency exposures and the substantial volatility of currency exchange rates, we cannot predict the effect of exchange rate fluctuations upon future operating results.

It is difficult to integrate acquired companies, products and technologies into our operations and our inability to do so could greatly lessen the value of any such acquisitions.

As a consequence of the some of the acquisitions we previously made, we have been required to take charges to earnings associated with the impairment of goodwill and other intangibles, write-downs of property and equipment and losses from discontinued operations. We may make additional strategic acquisitions of companies, products or technologies in the future in order to implement our business strategy. If we are unable to successfully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of such acquisitions and we may be required to take future charges to earnings. Additionally, as we experienced following our acquisition of Authentic8 International Inc. in 2001, disputes may arise regarding representations and warranties, indemnities, earn-outs and other provisions in acquisition agreements, which can lead to expensive and time-consuming litigation. For the foregoing reasons, acquisitions may subject us to unanticipated.

To date, we have primarily used cash to finance our business acquisitions. We may incur debt or issue equity securities to finance future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer due to acquisition-related expenses and the amortization of acquired intangible assets.

We rely on strategic relationships with other companies to develop and market our products. If we are unable to enter into any such relationships, or if we lose an existing relationship, our business could be harmed.

Our success depends on establishing and maintaining strategic relationships with other companies to develop, market and distribute our technology and products and, in some cases, to incorporate our technology into their products. Part of our business strategy has been to enter into strategic alliances and other cooperative arrangements with other companies in the industry. We are currently involved in cooperative efforts to incorporate our products into products of others, to jointly engage in research and development efforts and to jointly engage in marketing efforts and reseller arrangements. None of these relationships is exclusive, and some of our strategic partners also have cooperative relationships with certain of our competitors.

If we are unable to enter into cooperative arrangements in the future or if we lose any of our current strategic or cooperative relationships, our business could be harmed. We do not control the time and resources devoted to such activities by parties with whom we have relationships. In addition, we may not have the resources available to satisfy our commitments, which may adversely affect these relationships. These relationships may not continue, may not be commercially successful, or may require the expenditure of significant financial, personnel and administrative resources from time to time. Further, certain of our products and services compete with the products and services of our strategic partners. For example, Schlumberger distributes software for logical security applications using smart cards in addition to the smart card products that they license from our company. This competition may adversely affect our relationships with our strategic partners, which could adversely affect our business.

Increased costs associated with corporate governance compliance may significantly impact the results of our operations.

Changing laws, regulations and standards relating to corporate governance, public disclosure and compliance practices, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules, are creating uncertainty for companies such as ours in understanding and complying with these laws, regulations and standards. As a result of this uncertainty and other factors, devoting the necessary resources to comply with evolving corporate governance and public disclosure standards may result in increased general and administrative expenses and a diversion of management time and attention to compliance activities. We also expect these developments to increase our legal compliance and financial reporting costs. In addition, these developments may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain such a coverage. Moreover, we may not be able to comply with these new rules and regulations on a timely basis.

These developments could make it more difficult for us and retain qualified members of our board of directors, or qualified executive officers. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing and magnitude of additional costs we may incur as a result. To the extent these costs are significant, our general and administrative expenses are likely to increase.

Our operating results could suffer if we are subjected to a protracted intellectual property infringement claim or one with a significant damages award.

We may face claims of infringement on proprietary rights of others that could subject us to costly litigation and possible restriction on the use of such proprietary rights. There is a risk that our products infringe on the proprietary rights of third parties. While we do not believe that our products infringe on proprietary rights of third parties, infringement or invalidity claims may nevertheless be asserted or prosecuted against us and our products may be found to have infringed the rights of third parties. Such claims are costly to defend and could subject us to substantial litigation costs. If any claims or actions are asserted against us, we may be required to modify our products or may be forced to obtain a license for such intellectual property rights in a timely manner. We may not be able to modify our products or obtain a license on commercially reasonable terms, or at all.

The threat of new terrorist attacks and the continued weakness in the global economy may cause our company to fail to meet expectations, which could negatively impact the price of our stock.

Our operating results can vary significantly based upon the impact of changes in global and domestic economic and political conditions. Capital investment by businesses, particularly investments in new technology, has been experiencing substantial weakness. The threat of new terrorist attacks and the United States’ continued involvement in Iraq have contributed to continuing economic and political uncertainty that could result in a further decline in new technology investments. These uncertainties could cause customers to defer or reconsider purchasing our products or services if they experience a downturn in their business or if there is a further downturn in the general economy. Such events could have a material adverse effect on our business.

We believe that we are exposed to minimal market risks. We do not hold or issue derivatives, derivative commodity instruments or other financial instruments for trading purposes.

We are exposed to currency exchange fluctuations as we sell our products internationally. We manage the sensitivity of our international sales by denominating substantially all transactions in U.S. dollars.

In the three months ended March 31, 2004, approximately 75% of our revenues were invoiced in U.S. dollars. In the three months ended March 31, 2003, nearly all of our revenues were invoiced in U.S. dollars. Although we purchase many of our components in U.S. dollars, approximately half of our cost of revenues and operating expenses are denominated in other currencies.

In the first quarter of 2004 the net foreign exchange gain was $410 thousand. The fluctuation if the U.S. dollar against the local functional currencies in the first quarter of 2004 caused this net foreign exchange gain, which resulted primarily from revaluation of the assets and liabilities denominated in currencies other than the functional currency. In the first quarter of 2003, the net foreign exchange loss was $216 thousand.

We are exposed to interest rate risk as a result of our significant cash and equivalent holdings. The interest rate risk that we may be able to obtain on investment securities will depend on market conditions at that time and may differ from the rates we have secured in the past.

On March 31, 2004, we held $45.6 million of cash and equivalents and $176.4 million in short-term investments. Our cash and equivalents consist primarily of money-market funds and our short-term investments are primarily comprised of government and government agency securities. We currently have the ability and intention to hold our fixed investments until maturity, and therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. Due to the low current market yields and the relatively short-term nature of our investments, a hypothetical 10% increase in market rates would not be expected to have a material effect on the fair value of our portfolio.

The Company’s President (principal executive officer) and Chief Financial Officer (principal financial officer), carried out an evaluation of the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15(d)-15(e)), as of the end of the period covered by this report. Based on their evaluation, these officers have concluded that the Company’s disclosure controls and procedures were effective to ensure that material information required to be disclosed in the Company’s reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the periods specified in the Securities and Exchange Commission rules and forms.

There were no significant changes in the Company’s internal controls over financial reporting that occurred during the most recent quarter that has materially affected or is reasonably likely to materially affect the Company’s internal controls over financial reporting.

On February 3, 2004, the registrant furnished the SEC with a Current Report on Form 8-K to report the issuance of a press release announcing the registrant’s preliminary results of operations for the quarter and year ended December 31, 2003 and announcing the resignation of the registrant’s Chief Executive Officer.

On February 12, 2004, the registrant furnished the SEC with a Current Report on Form 8-K to report the issuance of a press release announcing the registrant’s results of operations for the quarter and year ended December 31, 2003.

Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Fremont, State of California on this 7th day of May 2004.


By:		/s/ Blair W. Geddes

		Blair W. Geddes Vice President and Chief Financial Officer


		Page
PART I: FINANCIAL INFORMATION		3

Item 1	Financial Statements	3
	Condensed Consolidated Statements of Operations	3
	Condensed Consolidated Balance Sheets	4
	Condensed Consolidated Statements of Cash Flows	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3	Quantitative and Qualitative Disclosures about Market Risk	28
Item 4	Controls and Procedures	29

PART II: OTHER INFORMATION		30

Item 1	Legal Proceedings	30
Item 2	Changes in Securities and Use of Proceeds	30
Item 3	Defaults Upon Senior Securities	30
Item 4	Submission of Matters to a Vote of Security Holders	30
Item 5	Other Information	30
Item 6	Exhibits and Reports on Form 8-K	30

SIGNATURES		30

EXHIBIT INDEX


	Three months ended March 31,
	2004			2003
Revenue
Hardware	$	3,797		$	5,485
Software		1,997			6,196
Maintenance and support		1,509			1,386

		7,303			13,067

Cost of revenue
Hardware		1,816			3,793
Software		731			1,079
Maintenance and support		478			300

		3,025			5,172

Gross margin		4,278			7,895

Operating expenses
Research and development		4,384			4,550
Sales and marketing		6,125			5,253
General and administrative		1,378			1,400
Amortization of acquired intangible assets		114			152
Restructuring and business realignment expenses		1,187			947
Re-incorporation expenses		—			945

Total operating expenses		13,188			13,247

Loss from operations		(8,910	)		(5,352	)
Interest income		1,016			1,245
Foreign exchange gain (loss)		410			(216	)

Loss from continuing operations before income taxes and minority interest		(7,484	)		(4,323	)
Income tax expense		(55	)		(62	)
Minority interest		35			49
Equity in net loss of Aspace Solutions Limited		(1,572	)		—

Loss from continuing operations		(9,076	)		(4,336	)
Loss from discontinued operations		—			(228	)

Net loss	$	(9,076	)	$	(4,564	)

Basic and diluted loss per common share:
From continuing operations	$	(0.22	)	$	(0.10	)
From discontinued operations		—		$	(0.01	)

	$	(0.22	)	$	(0.11	)

Shares used in the calculation of loss per common share:
Basic and diluted		42,144,295			40,614,240


	March 31, 2004			December 31, 2003
ASSETS
Current assets
Cash and equivalents	$	45,638		$	33,599
Short-term investments		176,386			195,135
Accounts receivable (net of allowance for doubtful accounts of $42 at March 31, 2004 and December 31, 2003)		3,037			3,364
Other receivables		2,048			2,372
Inventories		2,470			2,744
Other current assets		760			1,082

Total current assets		230,339			238,296
Restricted investments		566			551
Property and equipment		4,512			4,498
Investment in Aspace Solutions Limited		4,439			5,816
Goodwill		15,322			15,322
Other intangible assets		1,668			1,825
Other long-term assets		792			793

	$	257,638		$	267,101

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities	$	9,570		$	11,179
Current portion of restructuring and business realignment accruals		1,222			892
Income taxes payable		20			148
Deferred revenue		3,696			2,875

Total current liabilities		14,508			15,094

Long-term portion of restructuring and business realignment accruals		3,720			3,859
Other long-term liabilities		1,136			1,056

Total long-term liabilities		4,856			4,915

Minority interest		1,477			1,513

Commitments and contingencies

Shareholders’ equity
Preferred shares, $0.001 par value, none issued		—			—
Common shares, $0.001 par value, 42,206 and 42,115 shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively		42			42
Additional paid-in capital		398,344			397,962
Accumulated other comprehensive loss		(12,971	)		(12,816	)
Deferred stock compensation		(144	)		(211	)
Accumulated deficit		(148,474	)		(139,398	)

Total shareholders’ equity		236,797			245,579

	$	257,638		$	267,101


	Three months ended March 31,
	2004			2003
Operating activities
Loss from continuing operations	$	(9,076	)	$	(4,336	)
Adjustments to reconcile loss from continuing operations to net cash used in continuing operations:
Depreciation and amortization		577			827
Amortization of acquired intangible assets		114			152
Amortization of deferred stock compensation		61			298
Non-cash restructuring and business realignment expenses		—			520
Minority interest		(35	)		(49	)
Equity in net loss of Aspace Solutions Limited		1,572			—
Other non-cash items, net		38			208
Increase (decrease) in cash, net of the effects of business combinations, from:
Accounts receivable		304			(1,623	)
Other receivables		317			(678	)
Inventories		222			(695	)
Other current assets		(93	)		(78	)
Accounts payable and accrued liabilities		(1,495	)		1,651
Restructuring and business realignment accruals		191			(198	)
Deferred revenue		854			(640	)
Income taxes payable		(128	)		—

Net cash used in continuing operations		(6,577	)		(4,641	)
Net cash used in discontinued operations		—			(106	)

Net cash used in operating activities		(6,577	)		(4,747	)

Investing activities
Purchases of property and equipment		(625	)		(385	)
Purchases of short term investments		(55,061	)		(136,935	)
Proceeds from sales and maturities of short term investments		73,854			24,748
Other long-term assets		60			(29	)

Net cash provided by (used in) investing activities		18,228			(112,601	)

Financing activities
Proceeds from exercise of stock options		387			1,637
Increase in long-term liabilities		57			—
Repayment of long-term liabilities		—			(13	)

Net cash provided by financing activities		444			1,624

Effect of exchange rate changes on cash and equivalents		(56	)		473

Net increase (decrease) in cash and equivalents		12,039			(115,251	)
Cash and equivalents, beginning of period		33,599			158,880

Cash and equivalents, end of period	$	45,638		$	43,629


	Three months ended March 31,
	2004			2003
Net loss, as reported	$	(9,076	)	$	(4,564	)
Less: Stock-based employee compensation expenses included in reported net loss		61			298
Add: Total stock-based employee compensation expense determined under fair value based method for all awards		(204	)		(2,613	)

Pro forma net loss	$	(9,219	)	$	(6,879	)

Net loss per share, as reported
Basic and diluted	$	(0.22	)	$	(0.11	)
Pro forma net loss per share
Basic and diluted	$	(0.22	)	$	(0.17	)

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	2002 Restructuring						2003 Restructuring			2004 Restructuring
	Facility Exit Costs			Workforce Reduction			Workforce Reduction			Workforce Reduction			Projects Terminated			Total
Accrual balance at December 31, 2002	$	5,077		$	219		$	—		$	—		$	—			5,296
Provisions for restructuring and business realignment costs		111			—			1,347			—			—			1,458
Adjustments to accruals for changes in estimates		—			42			(3	)		—			—			39
Payments		(681	)		(261	)		(580	)		—			—			(1,522	)
Non-cash charges		—			—			(520	)		—			—			(520	)

Accrual balance at December 31, 2003		4,507			—			244			—			—			4,751
Provisions for restructuring and business realignment costs		—			—			—			1,147			40			1,187
Payments		(167	)		—			(244	)		(545	)		(40	)		(996	)

Accrual balance at March 31, 2004		4,340			—			—			602			—			4,942
Less current portion		620			—			—			602			—			1,222

Long term portion	$	3,720		$	—		$	—			—			—		$	3,720

Estimated remaining cash expenditures	$	4,340		$	—		$	—		$	602		$	—		$	4,942


	March 31, 2004			December 31, 2003
Loan advances and equity investments	$	8,405		$	8,210
Equity in net losses of Aspace		(3,966	)		(2,394	)

	$	4,439		$	5,816


	March 31, 2004
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
U.S. government and agency securities	$	175,868	$	586	$	68	$	176,386


	March 31, 2004
	Amortized Cost		Estimated Fair Value
Within one year	$	29,564	$	29,677
Between one year and three years		146,304		146,709

	$	175,868	$	176,386


	March 31, 2004		December 31, 2003
Components	$	984	$	660
Finished goods		1,486		2,084

	$	2,470	$	2,744


	Warranty Allowance
Sales warranty allowance balance at January 1, 2003	$	43
Warranty costs incurred		(73	)
Additions related to current period sales		198
Adjustments to accruals related to prior period sales		80

Sales warranty allowance balance at December 31, 2003		248
Warranty costs incurred		(38	)
Additions related to current period sales		9
Adjustments to accruals related to prior period sales		(6	)

Sales warranty allowance balance at March 31, 2004	$	213


	Europe			North America			Asia Pacific			Total
Three months ended March 31, 2004
Net revenues	$	4,235		$	2,839		$	229		$	7,303
Net loss		(3,502	)		(5,162	)		(412	)		(9,076	)

Three months ended March 31, 2003
Net revenues	$	3,455		$	8,914		$	698		$	13,067
Net loss		(2,779	)		(989	)		(796	)		(4,564	)

	Europe			North America			Asia Pacific			Total
March 31, 2004
Goodwill	$	1,795		$	13,420		$	107		$	15,322
Long lived assets		6,877			4,844			256			11,977
Total assets		17,832			237,695			2,111			257,638

December 31, 2003
Goodwill	$	1,795		$	13,420		$	107		$	15,322
Long lived assets		8,517			4,719			247			13,483
Total assets		19,364			245,452			2,285			267,101


	Three months ended March 31
	2004		2003
Percentage of revenue
Revenue	100.0	%	100.0	%
Cost of revenue	41.4		39.5

Gross profit	58.6		60.5

Operating expenses
Research and development	60.0		33.6
Sales and marketing	83.9		39.4
General and administrative	18.9		10.5
Other operating expenses	17.8		18.0

Total operating expenses	180.6		101.5

Loss from continuing operations	(122.0	)	(41.0	)
Non-operating income (expense)
Interest income	13.9		9.5
Foreign exchange gain (loss)	5.6		(1.7	)

Loss from continuing operations before income taxes and minority interest	(102.5	)	(33.2	)
Income tax expense	(0.8	)	(0.5	)
Minority interest	0.5		0.5
Equity in net loss of Aspace Solutions Limited	(21.5	)	—
Loss from discontinued operations	—		(1.7	)

Net loss	(124.3	)%	(34.9	)%


	Three months ended March 31,				% Change
	2004		2003
	(in thousands)
Hardware revenues	$	3,797	$	5,485	-31	%
Software revenues		1,997		6,196	-68	%
Maintenance and support revenues		1,509		1,386	+ 9	%

	$	7,303	$	13,067	-44	%


	Three months ended, March 31,				% Change
	2004		2003
Hardware gross margin as a percentage of hardware revenues	52	%	31	%	+21	%

Software gross margin as a percentage of software revenues	63	%	83	%	-20	%

Maintenance and support gross margin as a percentage of maintenance and support revenues	68	%	78	%	-10	%

Total gross margin	59	%	60	%	-1	%


Exhibit Number		Description
31.1		Certification Filed Pursuant to Section 302 of Sarbanes-Oxley Act of 2002

31.2		Certification Filed Pursuant to Section 302 of Sarbanes-Oxley Act of 2002

32.1		Certification Filed Pursuant to Section 906 of Sarbanes-Oxley Act of 2002

32.2		Certification Filed Pursuant to Section 906 of Sarbanes-Oxley Act of 2002