-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Gqqvg82nyVtvtg5xShDcLWi93mO6PEylBhaoIkOEH6YiUGphGso+ASsbe07y9K3R rS3rZGnOY1x8ELW8VqQwjw== 0000891618-99-005160.txt : 19991115 0000891618-99-005160.hdr.sgml : 19991115 ACCESSION NUMBER: 0000891618-99-005160 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SCM MICROSYSTEMS INC CENTRAL INDEX KEY: 0001036044 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER PERIPHERAL EQUIPMENT, NEC [3577] IRS NUMBER: 770444317 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-22689 FILM NUMBER: 99750987 BUSINESS ADDRESS: STREET 1: 160 KNOWLES DRIVE CITY: LOS GATOS STATE: CA ZIP: 95030 BUSINESS PHONE: 4083704888 MAIL ADDRESS: STREET 1: 160 KNOWLES DRIVE CITY: LOS GATOS STATE: CA ZIP: 95030 10-Q 1 FORM 10-Q FOR PERIOD ENDED SEPTEMBER 30, 1999 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- FORM 10 - Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM_________TO _________ COMMISSION FILE NUMBER: 0-22689 ---------------- SCM MICROSYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0444317 STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER) 160 KNOWLES DRIVE, LOS GATOS, CA 95032 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE) (408) 370-4888 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) N/A (FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT) ---------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No At November 2, 1999, 14,114,735 shares of common stock were outstanding. ================================================================================ 1 2 ITEM I. FINANCIAL STATEMENTS SCM MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands, except per share data)
QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- --------------------- 1999 1998 1999 1998 -------- -------- -------- -------- Revenues ....................................... $ 36,401 $ 19,402 $ 87,145 $ 49,903 Cost of revenues ............................... 23,048 11,987 57,176 31,413 Cost of revenues - product line redundancies ... -- -- 1,122 -- -------- -------- -------- -------- Gross Margin ......................... 13,353 7,415 28,847 18,490 -------- -------- -------- -------- Operating expenses: Research and development ................ 2,494 1,603 6,365 4,464 Sales and marketing ..................... 3,816 2,365 9,410 6,173 General and administrative .............. 2,892 2,408 7,460 5,723 In-process research and development ..... -- -- 900 3,101 Other acquisition and integration charges -- -- 1,168 581 Other one time charges .................. -- -- 1,950 -- -------- -------- -------- -------- Total operating expenses ............. 9,202 6,376 27,253 20,042 -------- -------- -------- -------- Income (loss) from operations ........ 4,151 1,039 1,594 (1,552) Interest and other, net ....................... 1,307 2,036 4,695 4,382 -------- -------- -------- -------- Income before taxes .................. 5,458 3,075 6,289 2,830 Provision for income taxes ..................... 1,634 1,099 3,311 1,945 -------- -------- -------- -------- Net income ............................ $ 3,824 $ 1,976 $ 2,978 $ 885 ======== ======== ======== ======== Net income per share: Basic .................................... $ 0.27 $ 0.14 $ 0.21 $ 0.07 Diluted .................................. $ 0.26 $ 0.14 $ 0.20 $ 0.06 Shares used in computing net income per share: Basic .................................... 14,078 13,705 14,068 12,954 Diluted .................................. 14,690 14,434 15,203 13,726 Comprehensive income: Net income ..................................... $ 3,824 $ 1,976 $ 2,978 $ 885 Changes in cumulative foreign currency translation account ......................... 1,069 439 (1,055) 374 -------- -------- -------- -------- Total comprehensive income ............. $ 4,893 $ 2,415 $ 1,923 $ 1,259 ======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements. 2 3 SCM MICROSYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ ASSETS Current assets: Cash, cash equivalents and short-term investments . $ 123,109 $ 129,918 Accounts receivable, net .......................... 29,373 25,535 Inventories ....................................... 12,361 12,159 Prepaids and other current assets ................. 5,231 3,879 --------- --------- Total current assets ......................... 170,074 171,491 Property and equipment, net ............................. 6,618 4,063 Goodwill ................................................ 8,652 4,847 Other assets ............................................ 4,761 2,919 --------- --------- Total assets ................................. $ 190,105 $ 183,320 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable .................................. $ 13,083 $ 15,046 Accrued expenses .................................. 9,502 4,941 Notes and loans payable ........................... 1,517 -- Income taxes payable .............................. 3,996 4,554 --------- --------- Total current liabilities ..................... 28,098 24,541 Stockholders' equity: Capital stock ..................................... 14 14 Additional paid-in capital ........................ 170,163 168,897 Accumulated deficit ............................... (8,220) (11,198) Deferred stock compensation ....................... (33) (72) Other cumulative comprehensive income ............. 83 1,138 --------- --------- Total stockholders' equity ................... 162,007 158,779 --------- --------- $ 190,105 $ 183,320 ========= =========
See accompanying notes to condensed consolidated financial statements. 3 4 SCM MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
NINE MONTH PERIODS ENDED SEPTEMBER 30, ----------------------- 1999 1998 -------- -------- Cash flows from operating activities: Net income ................................................ $ 2,978 $ 885 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization ......................... 1,765 1,511 Charge off of in-process research and development ..... 900 3,101 Write-off of investments .............................. 803 -- Write-off of accounts receivable balance .............. 1,950 -- Other ................................................. 36 42 Changes in operating assets and liabilities: Accounts receivable ................................. (3,778) (7,055) Inventories ......................................... 176 (4,080) Prepaid and other current assets .................... (1,098) (532) Accounts payable .................................... (3,637) 1,216 Accrued expenses .................................... 2,904 842 Income taxes payable ................................ (603) 1,572 -------- -------- Net cash provided by (used in) operating activities 2,396 (2,498) Cash flows from investing activities: Capital expenditures ...................................... (4,158) (1,512) Purchase of long-term investments ......................... (4,596) -- Businesses acquired, net of cash received ................. (1,334) (9,875) Proceeds from maturities of short-term investments ........ 57,062 26,612 Purchases of short-term investments ....................... (43,605) (94,383) -------- -------- Net cash provided by (used in) investing activities 3,369 (79,158) Cash flows from financing activities: Principal payments on long-term debt ...................... (30) (266) Proceeds from issuance of equity, net ..................... 1,265 89,665 -------- -------- Net cash provided by financing activities ......... 1,235 89,399 Effect of exchange rates on cash and cash equivalents ........ (357) 90 -------- -------- Net increase in cash and cash equivalents .................... 6,643 7,833 Cash and cash equivalents at beginning of period ............. 47,177 25,737 -------- -------- Cash and cash equivalents at end of period ................... $ 53,820 $ 33,570 ======== ======== Supplemental disclosures of cash flow information: Cash paid for income taxes ................................ $ 4,566 $ -- ======== ======== Cash paid for interest expense ............................ $ 238 $ 59 ======== ======== Non-cash investing and financing activities: Fair value of assets less liabilities assumed in business combinations ................................... $ 4,128 $ 5,976 ======== ======== Tax benefits from employee stock transactions ............. $ 435 $ 765 ======== ========
See accompanying notes to condensed consolidated financial statements. 4 5 SCM MICROSYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles 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 generally accepted accounting principles 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 and nine-month periods ended September 30, 1999 are not necessarily indicative of the results that may be expected for the year ending December 31, 1999. For further information, refer to the financial statements and footnotes thereto included in the Company's December 31, 1998 annual report on Form 10-K. 2. NET INCOME PER SHARE Basic and diluted net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share does not include the effect of 612,286 and 928,028 shares issuable under stock options and warrants as of September 30, 1999 and 1998, respectively, with weighted average exercise prices of $22.86 and $17.45, respectively, because their inclusion would be antidilutive. 3. RECENT ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. Under SFAS No. 133, entities are required to carry all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, the reason for holding it. This statement will be effective for all annual and interim periods beginning after June 15, 2000 and management does not believe the adoption of SFAS No. 133 will have a material effect on the consolidated financial position of the Company. 4. BUSINESS COMBINATIONS Shuttle On November 4, 1998, the Company issued approximately 828,000 shares of its common stock to the shareholders of Shuttle Technology Group Ltd. ("Shuttle"), a privately-held company based in England, in exchange for all of the outstanding share capital of Shuttle ("the Shuttle merger"). The Shuttle merger has been accounted for as a pooling of interests and, accordingly, the Company's consolidated financial statements have been restated for all periods prior to the merger to include the results of operations, financial position and cash flows of Shuttle. No significant adjustments were required to conform the accounting policies of the Company and Shuttle. In connection with the merger with Shuttle, in the fourth quarter of 1998, the Company recorded nonrecurring charges totaling $9,683,000, all of which was settled by the end of the second quarter of 1999. As separate companies, total revenues and net income for the individual entities for the three and nine-month periods ended September 30, 1998 were as follows (in thousands):
Three months ended Nine months ended September 30, 1998 September 30, 1998 ------------------ ------------------ Total revenue: SCM .............. $ 14,234 $ 32,642 Shuttle .......... 5,168 17,261 -------- -------- $ 19,402 $ 49,903 ======== ======== Net income (loss): SCM .............. $ 2,787 $ (1,182) Shuttle .......... (811) 2,067 -------- -------- $ 1,976 $ 885 ======== ========
5 6 Dazzle On June 30, 1999, the Company acquired a 51% interest in Dazzle Multimedia, Inc. ("Dazzle"), a privately held company based in Fremont, California, in a transaction that was accounted for under the purchase method of accounting. Prior to the acquisition, the Company had an investment in Dazzle totaling approximately $6.6 million consisting primarily of a $2.5 million convertible loan, and accounts receivable of $3.6 million from Dazzle resulting from sales to Dazzle by ICS during 1998 and 1999 prior to the acquisition date. The 51% interest was acquired by the Company directly from Dazzle in exchange for the conversion of the convertible loan and $2.0 million of the receivables discussed above, and upon the exercise by the Company of a common stock warrant of $ 0.1 million issued by Dazzle in connection with the convertible loan financing transaction. Based on the Company's management's preliminary valuation of Dazzle at the time of closing the transaction, which included a weighting of projected future discounted cash flows and market comparables, the net investment of $6.1 million (total investment of $6.6 million less fair value of net tangible assets acquired of $0.5 million, excluding cash) for a 51% stake in Dazzle, was reduced by $0.6 million to reflect a fair value of $5.5 million. The $0.6 million impairment charge is included in general and administrative expenses in the second quarter of 1999. The Company received an independent valuation in the third quarter of 1999, which validated the preliminary valuation. A summary of the allocation of the purchase price is as follows (in thousands): In-process research and development ..................... $ 900 Cash .................................................... 963 Accounts receivable ..................................... 3,245 Other assets ............................................ 1,307 Notes payable ........................................... (1,418) Accounts payable ........................................ (1,437) Accrued expenses ........................................ (2,211) Core technology ......................................... 2,550 Trade name .............................................. 400 Assembled workforce ..................................... 200 Goodwill ................................................ 1,492 ------- Total ................................................ $ 5,991 =======
At the time of the acquisition, the estimated aggregate fair value of Dazzle's research and development efforts that had not reached technological feasibility as of the acquisition date and had no alternative future uses was estimated by the Company's management to be $900,000, and was expensed at the acquisition date. Goodwill for the acquisition approximated $1.5 million and represented the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired less liabilities assumed. The estimated life of the goodwill is five years. The following summary, prepared on a pro forma basis, combines the Company's consolidated results of operations with Dazzle's result of operations for the three and nine-months ended September 30, 1999 and 1998, as if Dazzle had been acquired as of the beginning of the period presented. The table includes the impact of certain adjustments including the elimination of the special charge for acquired in-process research and development, elimination of intercompany profit and additional amortization relating to intangible assets acquired (in thousands, except per share data):
Three months ended Nine months ended September 30, September 30, --------------------- --------------------- 1999 1998 1999 1998 -------- -------- -------- -------- Revenues ............................. $ 36,401 $ 20,948 $ 93,203 $ 54,771 Net income ........................... $ 3,824 $ (273) $ 1,447 $ 2,932 Net income per share: Basic ........................... $ 0.27 $ (0.02) $ 0.10 $ 0.23 Diluted ......................... $ 0.26 $ (0.02) $ 0.10 $ 0.21 Shares used in per share computations: Basic ........................... 14,078 13,705 14,068 12,954 Diluted ......................... 14,690 13,705 15,203 13,726
6 7 5. RESTRUCTURING In the second quarter of 1999, the Company accrued restructuring charges of $568,000 consisting of headcount related restructuring costs of $328,000 and legal and other costs of $240,000. $519,000 of the accrual remained unused as of the end of the third quarter of 1999. 6. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS Prior to 1999, the executive staff reviewed financial information presented on a geographic basis for purposes of making operating decisions and assessing financial performance. Beginning January 1, 1999, the executive staff realigned the Company's organization along three product segments: Digital TV, Digital Media, and PC and network security. Effective with this realignment, the executive staff began reviewing financial information and business performance along these three product segments. The Company evaluates the performance of its segments based on the operating profit for each segment, excluding any special charges such as in-process research and development, restructuring and asset impairment charges and merger-related costs. The Company does not include intercompany transfers between segments for management reporting purposes. Summary information by segment for the three and nine-months ended September 30, 1999 and 1998, is as follows (in thousands):
Quarter ended Nine months ended September 30, September 30, -------------------- --------------------- 1999 1998 1999 1998 -------- -------- -------- -------- Digital TV: Revenues ............... $ 12,072 $ 4,062 $ 29,770 $ 14,743 Gross margin ........... 4,842 1,614 10,874 6,329 Segment operating profit 1,507 631 3,270 3,174 Segment assets ......... 17,754 12,874 17,754 12,874 Long-lived assets ...... 5,316 2,675 5,316 2,675 Digital Media: Revenues ............... $ 18,589 $ 8,345 $ 44,854 $ 21,392 Gross margin ........... 6,078 2,534 12,600 6,787 Segment operating profit 2,100 (838) 449 (1,604) Segment assets ......... 36,982 32,790 36,982 32,790 Long-lived assets ...... 11,043 6,813 11,043 6,813 PC and Network Security: Revenues ............... $ 5,740 $ 6,995 $ 12,521 $ 13,768 Gross margin ........... 2,433 3,267 5,373 5,374 Segment operating profit 544 1,246 (55) 560 Segment assets ......... 12,260 22,234 12,260 22,234 Long-lived assets ...... 3,672 4,619 3,672 4,619
7 8 A reconciliation of the Company's segment assets and segment operating profit (loss) as of September 30, 1999 and December 31, 1998 and for the three and nine months ended September 30, 1999 and 1998 follows (in thousands):
As of As of September 30, December 31, 1999 1998 ------------- ------------ Segment assets - Digital TV ............................... $ 17,754 $ 10,606 Segment assets - Digital Media ............................ 36,982 30,701 Segment assets - PC and Network Security .................. 12,260 12,095 -------- -------- Total segment assets .................................. 66,996 53,402 Corporate cash, cash equivalents and short-term investments 123,109 129,918 -------- -------- Total assets ....................................... $190,105 $183,320 ======== ========
Three months ended Nine months ended September 30, September 30, ------------------ ------------------- 1999 1998 1999 1998 ------- ------- ------- ------- Segment operating profit - Digital TV ................... $ 1,507 $ 631 $ 3,270 $ 3,174 Segment operating profit (loss) - Digital Media ......... 2,100 (838) 449 (1,604) Segment operating profit (loss) - PC and Network security 544 1,246 (55) 560 ------- ------- ------- ------- Total segment operating profit .................... 4,151 1,039 3,664 2,130 Special charges recorded at corporate level ............. -- -- (2,070) (3,682) ------- ------- ------- ------- Total income (loss) from operations ............... $ 4,151 $ 1,039 $ 1,594 $(1,552) ======= ======= ======= =======
Additional information regarding revenues by geographic region for the three and nine-months ended September 30, 1999 and 1998 follows (in thousands):
Three months Nine months ended ended September30, September 30, --------------------- --------------------- 1999 1998 1999 1998 ------- ------- ------- ------- United States .......... $19,657 $ 7,804 $40,146 $19,404 Europe ................. 10,920 7,142 34,296 22,585 Asia-Pacific ........... 5,824 4,456 12,703 7,914 ------- ------- ------- ------- $36,401 $19,402 $87,145 $49,903 ======= ======= ======= =======
There was no single customer that accounted for 10% or more of total net sales during the three and nine-months ended September 30, 1999 and 1998. 8 9 ] ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. SCM's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in this section as well as those discussed under the caption "Factors That May Affect Future Operating Results" and elsewhere in this document. OVERVIEW SCM Microsystems ("the Company") designs, develops and sells products used to control access to computers, networks and digital television broadcasts, conduct secure electronic commerce, and exchange digital information from devices such as digital cameras and audio recorders. The Company's target customers are manufacturers in the computer, telecommunications and digital television industries. The Company sells and licenses our products through a direct sales and marketing organization, primarily to original equipment manufacturers (OEMs), and also through distributors, value-added resellers and system integrators worldwide. BUSINESS COMBINATIONS On November 4, 1998, the Company issued approximately 828,000 shares of its common stock to the shareholders of Shuttle Technology Group Ltd. ("Shuttle"), a privately-held company based in England, in exchange for all of the outstanding share capital of Shuttle ("the Shuttle merger"). The Shuttle merger has been accounted for as a pooling of interests and, accordingly, the Company's consolidated financial statements have been restated for all periods prior to the merger to include the results of operations, financial position and cash flows of Shuttle. No significant adjustments were required to conform the accounting policies of the Company and Shuttle. On June 30, 1999, the Company acquired a 51% interest in Dazzle Multimedia, Inc. ("Dazzle"), a privately held company based in Fremont, California, in a transaction that was accounted for under the purchase method of accounting. Prior to the acquisition, the Company had an investment in Dazzle totaling approximately $6.6 million consisting primarily of a $2.5 million convertible loan, and accounts receivable of $3.6 million from Dazzle resulting from sales to Dazzle by ICS during 1998 and 1999 prior to the acquisition date. The 51% interest was acquired by the Company directly from Dazzle in exchange for the conversion of the convertible loan and $2.0 million of the receivables discussed above, and upon the exercise by the Company of a common stock warrant of $ 0.1 million issued by Dazzle in connection with the convertible loan financing transaction. Based on the Company's management's preliminary valuation of Dazzle at the time of closing the transaction, which included a weighting of projected future discounted cash flows and market comparables, the net investment of $6.1 million (total investment of $6.6 million less fair value of net tangible assets acquired of $0.5 million, excluding cash) for a 51% stake in Dazzle, was reduced by $0.6 million to reflect a fair value of $5.5 million. The $0.6 million impairment charge is included in general and administrative expenses in the second quarter of 1999. The Company received an independent valuation in the third quarter of 1999, which validated the preliminary valuation. At the time of the acquisition, the estimated aggregate fair value of Dazzle's research and development efforts that had not reached technological feasibility as of the acquisition date and had no alternative future uses was $900,000, and was expensed at the acquisition date. Goodwill for the acquisition approximated $1.5 million and represented the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired less liabilities assumed. The estimated life of the goodwill is five years. RESULTS OF OPERATIONS Net Revenues. Net revenues reflect the invoiced amount for goods shipped less estimated returns. Revenue is recognized upon product shipment. Net revenues for the quarter ended September 30, 1999 were $36.4 million compared to $19.4 million in 1998, an increase of 88%. For the first nine months of 1999, net revenues were $87.1 million compared to $49.9 million in the first nine months of 1998, an increase of 75%. The increase in revenues in the first nine months of 1999 was due primarily to an increase in shipments of the Company's digital media and connectivity products of $23.5 million and an increase in shipments of Digital TV products and services of $15.0 million which included shipments of Dazzle product to its end customers in the third quarter of 1999, offset by a 9 10 $1.2 million decrease in PC and Network security revenue. The increase in the third quarter of 1999 was due primarily to an increase in shipments of the Company's digital media and connectivity products of $10.2 million, an increase in shipments of Digital TV products and services of $8.0 million which included shipments of Dazzle products to its end customers and offset by a decrease in shipments of PC and Network security products of $1.3 million. The increases in 1999 also included revenues from the Company's acquisition of Intermart and ICS which were acquired at the end of the second quarter of 1998. Gross Margin. Gross margin for the third quarter of 1999 was $13.4 million, or 37% of total net revenues, compared to $7.4 million or 38% for the third quarter of 1998. Gross margin for the first nine months of 1999 was $28.8 million or 33% of total net revenues, compared to $18.5 million or 37% in the first nine months of 1998. The increase in gross margin in absolute dollars for the third quarter and the first nine months of 1999, was primarily due to the increase in shipments of digital media and connectivity products and an increase in shipments of Digital TV products and services, including development test tools, software and engineering services, all of which carry gross margin levels higher than the Company's other products. The decrease in gross margin as a percentage of total net revenues in the first nine months of 1999 was due to a $1.1 million charge resulting from a write down of excess inventory in the Company's digital media division and costs associated with the ramp up of production of certain digital media products in the second quarter of 1999. The write down of inventory resulted from a review of the Company's products in the digital media division, which was conducted following a slow down in sales of certain products. These declining sales were attributed to an overlap in the Company's product lines. The Company believes that its gross margin in absolute dollars during 1999 will continue to be above the levels experienced in 1998. The Company's gross margin has been and will continue to be affected by a variety of factors, including competition, product configuration and mix, the availability of new products, product enhancements, software and services and the cost and availability of components. Accordingly, gross margin percentages are expected to fluctuate from period to period. Research and Development. Research and development expenses consist primarily of employee compensation and prototype expenses. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, the Company has not capitalized any software development costs. For the third quarter of 1999, research and development expenses were $2.5 million, compared with $1.6 million in the third quarter of 1998, an increase of 56%. As a percentage of total net revenues, research and development expenses were 7% in the third quarter of 1999 compared to 8% in the third quarter of 1998. For the first nine months of 1999, research and development expenses were $6.4 million compared to $4.5 million in the comparable period of 1998, an increase of 43%. As a percentage of total net revenues, research and development expenses were 7% in the first nine months of 1999 compared to 9% in the comparable period of 1998. The increases in absolute dollar amounts for the third quarter and the first nine months of 1999 were primarily due to increased engineering headcount and related product development costs at the Company's development centers in France and India and research and development expenses of Intermart and ICS, companies acquired in May and June 1998, respectively, as well as Dazzle acquired in June of 1999. The Company believes that the absolute amount of research and development expenses during 1999 will be higher than in 1998 due to a higher number of personnel involved in the Company's new product development and customer projects, but that such expenses will fluctuate as a percentage of total net revenues. Sales and Marketing. Sales and marketing expenses consist primarily of employee compensation and trade show and other marketing costs. Sales and marketing expenses for the third quarter of 1999, were $3.8 million, or 10% of revenues, compared with $2.4 million in the third quarter of 1998, or 12% of revenues, an increase of 61%. For the first nine months of 1999, sales and marketing expenses were $9.4 million compared with $6.2 million in the comparable period of 1998. As a percentage of total net revenues, sales and marketing expenses were 11% and 12% in the first nine months of 1999 and 1998, respectively. These increases in absolute amounts in 1999 were primarily due to sales and marketing costs of the companies acquired by the Company in 1998 and 1999, including personnel, trade show and collateral material costs. Sales and marketing expenses in 1999 are expected to increase in absolute amounts as the Company continues to expand its sales and business development efforts on a worldwide basis. General and Administrative and Other Operating Expenses. General and administrative expenses consist primarily of compensation expenses for employees performing the Company's administrative functions. In the third quarter of 1999, general and administrative expenses were $2.9 million, an increase of 20% compared with $2.4 million in the third quarter of 1998, representing 8% and 12% of total net revenues in the third quarter of 1999 and 1998, respectively. For the nine month period, general and administrative expenses were $7.5 million in 1999, an increase of 30% compared with $5.7 million in 1998, representing 9% and 11% of total net revenues in the first nine months of 1999 and 1998, respectively. These increases in absolute amounts in 1999 were primarily due to 10 11 increases in administrative headcount to support higher levels of business activities and administrative costs of the companies acquired in 1998 and 1999. The Company believes general and administrative expenses in 1999 will continue to increase in absolute dollar amount for the last aforementioned reasons, but will fluctuate as a percentage of total net revenues. In the second quarter of 1999, the Company expensed $0.9 million of in- process research and development related to the Dazzle acquisition. In the second quarter of 1998, $3.1 million was recorded for in-process research and development related to the Company's 1998 acquisitions. Other acquisition and integration charges recorded in the second quarter of 1999 represented a one time charge to its allowance for doubtful accounts totaling $2.0 million to fully reserve for a customer who filed for bankruptcy in that quarter. The Company also recorded a $600,000 write down of its Dazzle investment and accrued operational restructuring charges of $568,000 consisting of headcount related restructuring costs of $328,000 and legal and other costs of $240,000 in the second quarter of 1999. Interest Income and Other, Net. Interest income and other, net, consists primarily of interest earned on invested cash, offset by interest paid or accrued on outstanding debt. In the third quarter of 1999, interest income and other, net, was $1.3 million, compared to $2.0 million in the third quarter of 1998. In the first nine months of 1999, interest income and other, net, was $4.7 million, compared to $4.4 million in the comparable period of 1998. In the third quarter of 1999, interest income and other, net, included foreign currency loss of $168,000, compared to a foreign currency gain of $198,000 in the third quarter of 1998. In April 1998, the Company completed a secondary offering of 3.45 million shares of its common stock (2.0 million shares sold by selling stockholders and 1.45 million shares sold by the Company), which generated net proceeds to the Company of approximately $83 million. Higher average investable cash balances in 1999 as a result of this stock offering and significantly less debt service requirements resulted in the increase in interest income and other, net, in the first nine months of 1999 over the first nine months of 1998. Income Taxes. The provision for income taxes was $1.6 million in the third quarter of 1999 resulting principally from tax liabilities associated with foreign operations of the Company and minimum state income taxes. As of December 31, 1998, the Company had net operating loss carryforwards of approximately $2.2 million and $0.9 million for United States federal and California income tax purposes, respectively, and approximately $600,000 of net operating loss carryforwards available to offset taxable income in Japan. LIQUIDITY AND CAPITAL RESOURCES LIQUIDITY AND CAPITAL RESOURCES Prior to the Company's initial public stock offering, the Company had financed its operations principally through private placements of debt and equity securities and, to a lesser extent, borrowings under bank lines of credit. In October 1997, the Company completed the sale of 3.8 million shares of Common Stock in an initial public offering ("IPO"), resulting in net proceeds of $43.7 million. In April 1998, the Company completed a secondary offering of 3.45 million shares of its Common Stock at a price to the public of $61.00 per share. Of the total number of shares sold, 2.0 million shares were sold by shareholders and 1.45 million shares were sold by the Company. The net proceeds to the Company from the secondary offering were $83.1 million. During the first nine months of 1999, cash and cash equivalents increased by $6.6 million due to $2.4 million provided by operations, $3.7 million provided by investing activities and $1.2 million provided by financing activities from issuance of equity. Cash provided by investing activities were primarily from proceeds from short-term investments of $57.1 million decreased by purchases of short-term investments of $43.6 million, purchase of long-term investments of $4.6 million, business acquired net of cash received of $1.3 million and capital expenditures of $4.2 million. Cash provided by financing activities were primarily from the exercise of options of $1.3 million. The Company has revolving lines of credit with two banks in Germany providing total borrowings of up to 1.5 million DM each (approximately $1.6 million in total at September 30, 1999). Both lines of credit have no fixed expiration date. The German lines of credit bear interest at rates ranging from 7.0% to 8.75% per annum. Borrowings under the German lines of credit are unsecured. The Company also has a $3.0 million U.S. line of credit which is secured by all assets of the Company, bears interest at the bank's prime rate (7.75% as of September 30, 1999), and expires in June 2001. At September 30, 1999, no amounts were outstanding under any of the 11 12 Company's lines of credit. The notes and loans payable consist mainly of $1.4 million of convertible notes issued by Dazzle, convertible into Series B Preferred Stock of Dazzle at any time prior to maturity, at the election of the note holder. The notes mature on June 30th, 2000. The Company currently expects that its current capital resources and available borrowings should be sufficient to meet its operating and capital requirements through at least the end of 2000. The Company may, however, seek additional debt or equity financing prior to that time. There can be no assurance that additional capital will be available to the Company on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment. WE HAVE INCURRED OPERATING LOSSES AND MAY NOT REMAIN PROFITABLE. Although SCM was profitable for the quarters ended September 30, 1999 and March 31, 1999 and for the year ended December 31, 1997, the Company incurred net operating losses on an annual basis from our inception in 1993 through the year ended December 31, 1996, as well as in 1998 and incurred an operating loss in the quarter ended June 30, 1999. As of September 30, 1999, SCM had an accumulated deficit of $8.2 million. In view of our loss history, we cannot assure you that SCM will be able to achieve or sustain profitability on an annual or quarterly basis in the future. THERE ARE MANY FACTORS, INCLUDING SOME BEYOND OUR CONTROL, THAT MAY CAUSE FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS. Our quarterly operating results depend on a number of factors that are difficult to forecast. If our future quarterly operating results fall below the expectations of securities analysts or investors, the trading price of our common stock will likely drop. Our quarterly operating results have fluctuated in the past and may continue to fluctuate in the future as a result of many factors, including: - size, timing, cancellation or rescheduling of significant orders; - new product announcements or introductions by us or our competitors; - our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all; - our success in expanding our sales and marketing organization and programs; - technological changes in the market for our products; - our level of expenditures on research and development; and - general economic trends. In addition, because a high percentage of our operating expenses are fixed, a small variation in revenue can cause significant variations in our operating results from quarter to quarter. The Company's operating results may vary significantly in future periods and our historical results may not be a reliable indicator of our future performance 12 13 SEASONAL TRENDS IN SALES OF OUR PRODUCTS MAY AFFECT OUR QUARTERLY OPERATING RESULTS. Our business and operating results reflect seasonal trends. We have typically experienced lower net sales and operating income in the first quarter and second quarter and higher net sales in the third quarter and fourth quarter of each calendar year. The Company believes that the seasonal trends in our business and operating results are primarily due to two factors. The first is related to the budgeting cycle of the U.S. government, which is heavily weighted to the second half of the calendar year. Because OEMs incorporate our data security products into PCs and workstations that are then sold to the US government, the government's budget cycle influences the dynamics of our business as well. The second factor is the retail selling cycles of our OEM customers in our Digital Media and Digital TV businesses. The Company sells readers for digital cameras and Internet music players in the U.S. and digital video broadcasting products in Europe. Because OEMs typically bundle our devices into their consumer products, and because the market for consumer products is stronger in the second half of the year, our business is impacted as well. The Company expects that our sales to consumer-oriented OEMs will increase, and the seasonal trends that effect our business and operating results will continue. ANY DELAYS IN OUR NORMALLY LENGTHY SALES CYCLE COULD RESULT IN SIGNIFICANT FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS. When we obtain a new OEM customer, our initial sales to that customer usually take six to nine months. During this sales cycle, we may expend substantial financial resources and our management's time and effort with no assurance that a sale will ultimately result. The length of a new OEM customer's sales cycle depends on a number of factors that we may not be able to control. These factors include the customer's product and technical requirements and the level of competition we face for that customer's business. Any delays in the sales cycle for new customers could have a material adverse effect on our business and operating results. OUR TARGET MARKETS MAY NOT ACCEPT OUR PRODUCTS. SCM's future growth and operating results will depend on whether our products are commercially successful. As described below, each of our product families address needs in different emerging markets. We may not succeed in these emerging markets. In addition, as these markets develop, industry standards may be established. Our products may not comply with the industry standards ultimately adopted in these emerging markets. We sell security and connectivity products across three target markets: Digital Media, PC/Network Security and Digital TV. In the Digital Media market, our reader and connectivity products provide easy to use, high-speed connections between digital platforms, such as PCs and digital cameras, and electronic media, such as copywrite-protected music from the Internet. If the benefits of rapid transfer of digital photographs or music are not perceived as sufficient, then demand for products such as ours may not grow. In the PC/Networking Security market, smart card-based security applications are beginning to be adopted by computer makers and software providers. Smart card token-based security applications provide protection from unauthorized access to digital information. Our SwapBox and SwapSmart product families are designed to provide smart card-based security for PCs. However, the market for network and electronic commerce security applications is still emerging and the smart card may not become the industry standard and hence other token architectures may be selected for these applications. In the Digital TV market, our digital video broadcasting (DVB) product family provides a means of controlling access to digital television broadcasts. Our SwapAccess DVB-CAM product implements the DVB-CI (European) and NRSS-B (U.S.) standards. To date, our DVB-CAM product has been implemented in a relatively limited number of DVB set-top boxes in Europe. However, the European standard for DVB conditional access applications is still emerging. Although we believe that the DVB-CI standard will eventually become the European standard for DVB conditional access applications, this standard may not be adopted and the European DVB market may fail to further develop. In addition, the market for DVB products in the United States has only recently begun to develop and may not grow. Also, the substantial base of analog set-top boxes already installed in the United States may cause the market for DVB products in general, and our SwapAccess products in particular, to grow more slowly than expected or not at all. 13 14 If the market for the products described above or any of our other products fail to develop or develop more slowly than expected, or 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. WE DEPEND ON OUR CONTINUED SALES TO ORIGINAL EQUIPMENT MANUFACTURERS. Most of our products are intended for use as components subsystems or value-added devices in systems manufactured and sold by third party OEMs. In order to convince an OEM to incorporate our products into its systems, we must demonstrate that our products provide significant commercial advantages over our competitors' products. We may fail to successfully demonstrate these advantages or our products may cease to provide any advantages. Even if we are able to demonstrate that our products are superior, OEMs may still choose not to incorporate our products into their systems. OEMs may also change their business strategies and manufacturing practices, which could cause them to purchase fewer units of our products, find other sources for products we currently manufacture or manufacture these products internally. Our OEM customers may also seek price concessions from us. Failure of OEMs to incorporate our products into their systems, the failure of such OEMs' systems to achieve market acceptance or any other event causing a decline in our sales to OEMs would have a material adverse effect on our business and operating results. Our products are targeted at OEM consumer electronics, computer, telecommunication and digital TV component and system manufacturers. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. In the third quarter of 1999, sales to our top 10 customers (all of which were OEMs) accounted for 41% of total net sales. No customer accounted for 10% or more of the Company's revenue in the third quarter and first nine months of 1999. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business, could harm our business and operating results. OUR SALES TO GOVERNMENT CONTRACTORS ARE SUBJECT TO UNCERTAINTIES AND MAY DECREASE. Approximately 10%, 12%, 17%, and 28% of our net revenues for first nine months of 1999 and for the years ended 1998, 1997, and 1996 , respectively, were derived from sales of our SwapBox product for use by the U.S. government. These sales were made under contracts between SCM and major OEMs that sell PCs to the United States Department of Defense, or DOD. We believe that indirect sales to the DOD are subject to a number of significant uncertainties, including timing and availability of funding, unpredictable changes in the timing and quantity of government orders and the generally competitive nature of government contracting. Furthermore, the DOD has been reducing total expenditures over the past few years in several areas. Accordingly, funding for the purchase of our products may be reduced in the future. In addition, we may not be able to modify existing products or develop new products that will continue to meet the specifications of OEM suppliers to the DOD. A significant loss of indirect sales to the U.S. government would have a material adverse effect on our business and operating results. OUR SALES TO DISTRIBUTORS ARE SUBJECT TO UNCERTAINTIES AND MAY FLUCTUATE. Sales of some of our Digital Media and PC/Network Security products are made to distributors, some of whom are smaller companies with limited working capital for marketing and promotion efforts and whose cash flow is dependent on payment from their customers. We believe that delays in shipments by and payments to our distribution customers by their customers may have a material adverse effect on our business and operating results. WE RELY ON OUR STRATEGIC RELATIONSHIPS TO GENERATE REVENUE. SCM collaborates with a number of corporations and is a member of key industry consortia. Our future success will depend significantly on the success of our current arrangements and our ability to establish additional arrangements. We have formed strategic relationships, including technology sharing agreements, with a number of key industry players such as Intel, Microsoft and SanDisk. We evaluate, on an ongoing basis, potential strategic 14 15 alliances and intend to continue to pursue such relationships. These arrangements may not result in commercially successful products. OUR MARKETS ARE HIGHLY COMPETITIVE. The market for our products is intensely competitive and characterized by rapidly changing technology. We believe that competition in this market is likely to intensify as a result of increasing demand for digital data security, access control and connectivity products. We currently experience competition from a number of sources, including: - ActionTec, Greystone and Litronic in PC Card adapters; - SmartDisk Corporation, Gemplus, Utimaco and Towitoko Electronics in smart card readers and Philips in universal smart card reader silicon interfacing; and - Gemplus in DVB-CAM modules. We also experience indirect competition from some of our customers which sell alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these competitors and new competitors, such as Motorola, that develop digital information security products. In addition, the market for digital data security, access control and connectivity products may ultimately include technological solutions other than ours. 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, it is possible that 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. Any of these factors could have a material adverse effect on our business and operating results. We believe that the principal competitive factors affecting the market for digital data security and connectivity products include: - the extent to which products comply with existing industry standards; - technical features; - ease of use; - quality and reliability; - level of security; - strength of distribution channels; and - price. We may not be able to successfully compete as to these or other factors and the competitive pressures may cause our business and operating results to suffer. 15 16 WE HAVE EXPERIENCED SIGNIFICANT GROWTH IN OUR BUSINESS IN RECENT PERIODS AND WE MAY NOT BE ABLE TO MANAGE THIS GROWTH OR ANY FUTURE GROWTH. Our business has grown substantially in recent periods, with net revenues increasing from $10.9 million in 1994 to $85.0 million in 1998, and revenues of $87.1 million in the first nine months of 1999. We have expanded our focus from the PC Security market to include Digital TV and more recently Digital Media. Managing business in each of these markets requires skilled management, significant attention and substantial resources. To address our need to for additional resources and because of acquisitions, we have increased in size from 67 employees at December 31, 1995 to 358 as of September 30, 1999. The growth of our business places a significant strain on our management and operations. If we are successful in achieving our growth plans, our growth is likely to continue to place a significant burden on our operating and financial systems and increased responsibility for senior management and other personnel. Existing management or any new members of management may not be able to improve existing systems and controls or implement new systems and controls in response to anticipated growth. Our failure to do so could have a material adverse effect on our business and operating results. OUR GLOBAL LOCATIONS MUST WORK TOGETHER EFFECTIVELY. SCM's U.S. headquarters are located in Los Gatos, California, European headquarters are located in Pfaffenhofen, Germany, and research and development facilities are located in Erfurt, Germany, La Ciotat, France, Wokingham, England, Pondicherry, India and Madras, India. In Asia, we are located in Singapore, Taiwan and Tokyo, Japan. Operating in diverse geographic locations imposes a number of risks and burdens on us, including the need to manage employees and contractors from diverse cultural backgrounds and who speak different languages, and difficulties associated with operating in a number of time zones. Although these difficulties can be reduced through the use of electronic mail and teleconferencing, unforeseen difficulties or logistical barriers in operating in diverse locations may occur. Operating in widespread geographic locations requires us to implement and operate complex information and operational systems. Although we believe that our systems are adequate, in the future we may have to implement new systems. Implementation of new information systems, in particular, may be costly. Any failure or delay in implementing needed systems, procedures and controls on a timely basis or in expanding current systems in an efficient manner could have a material adverse effect on our business and operating results. WE MAY BE EXPOSED TO RISKS OF INTELLECTUAL PROPERTY INFRINGEMENT. SCM's success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights. Our software, documentation and other written materials are protected under trade secret and copyright laws, which afford only limited protection. SCM generally enters into confidentiality and non-disclosure agreements with our employees and with key vendors and suppliers. For example, our SwapBox and SwapSmart trademarks are registered in the United States. We continuously evaluate the registration of additional trademarks as appropriate. We currently have seven United States patents issued and three German patents issued. We also have nineteen patent applications pending worldwide. In addition, we have exclusive licenses under four other United States patents, and licenses for two United States patents associated with our products. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable, and that any issued patent will fail to provide us with any competitive advantages. There has been a great deal of litigation in the technology industry regarding intellectual property rights. Litigation may be necessary to protect our proprietary technology. SCM has from time to time received claims that it is infringing upon third parties' intellectual property rights and future disputes with third parties may not be resolved on terms acceptable to us. As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, cause product shipment delays, or require us to redesign our products or require us to enter into royalty or licensing agreements. Any of these events could have a material adverse effect on our business and operating results. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors 16 17 will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. OUR BUSINESS COULD SUFFER IF WE OR OUR CONTRACT MANUFACTURERS CANNOT MEET PRODUCTION REQUIREMENTS. Most of our products are manufactured outside the United States because we believe that global sourcing enables us to achieve greater economies of scale, improve gross margins and maintain uniform quality standards for our products. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative sources would materially and adversely affect our business and operating results. In an effort to reduce our manufacturing costs, SCM has shifted volume production of many of our product components to our wholly owned subsidiary in Singapore, SCM Microsystems (Asia) Pte. Ltd., formerly Intellicard. In addition, we utilize contract manufacturers in China, Taiwan and Europe. Foreign manufacturing poses a number of risks, including transportation delays and interruptions, difficulties in staffing, currency fluctuations, potentially adverse tax consequences and unexpected changes in regulatory requirements, tariffs and other trade barriers, and political and economic instability. If we or any of our contract manufacturers cannot meet our production requirements, we may have to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. Despite efforts to do so, we may not be able to identify or qualify new contract manufacturers in a timely manner and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements. WE HAVE A LIMITED NUMBER OF SUPPLIERS OF KEY COMPONENTS. We rely upon a limited number of suppliers of several key components of our products. For example, SCM purchases mechanical components for use in our smart card reader product exclusively from Stocko, a German-based supplier. Our reliance on only one supplier could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of these components could delay shipments of our products, which could have a material adverse effect on our business and operating results. These delays could also damage relationships with current and prospective customers. THE MARKETS FOR OUR PRODUCTS MAY UNDERGO RAPID TECHNOLOGICAL CHANGE AND OUR FUTURE SUCCESS WILL DEPEND ON OUR ABILITY TO MEET THE SOPHISTICATED NEEDS OF OUR CUSTOMERS. The markets for our products are characterized by rapidly changing technology. Our customers' needs change and new products are introduced frequently. Product life cycles are short and industry standards are still evolving. These rapid changes in technology could render our existing products obsolete and unmarketable. Therefore, our future success will depend upon our ability to successfully develop and introduce new and enhanced products that meet our customers' increasing expectations and incorporate the latest technology. Product development is risky because it is difficult to foresee developments in technology, coordinate technical personnel and identify and eliminate design flaws. Any significant delay in releasing new products could have a material adverse effect on the ultimate success of our products and could reduce sales of predecessor products. We may not be able to introduce new products on a timely basis. In addition, new products introduced by us may fail to achieve a significant degree of market acceptance or, once accepted, may fail to sustain viability in the market for any significant period. These factors could have a material adverse effect on our business and operating results. MANY OF OUR CUSTOMERS ARE LOCATED IN OTHER COUNTRIES WHICH EXPOSES OUR BUSINESS TO RISKS RELATED TO INTERNATIONAL SALES AND CURRENCY FLUCTUATIONS. SCM was originally a German corporation and continues to conduct a substantial portion of its business in Europe. Approximately 54%, 62%, 51%, and 50% of our revenues for the first nine months of 1999 and the years ended 1998, 1997, and 1996, 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 17 18 will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, including: - tariffs and other trade barriers; - difficulties in staffing and managing disparate branch operations; - currency exchange risks; - exchange controls; and - potential adverse tax consequences. These factors may have a material adverse effect on our business and operating results. We conduct operations and sell products in several different countries. Over the last two years, we have acquired companies in Japan, Singapore, Great Britain and India. Therefore, our operating results may be impacted by the fluctuating exchange rates of foreign currencies, especially the German mark, the Japanese yen, the Singapore dollar, the British pound and the Indian rupee, in relation to the U.S. dollar. We do not currently engage in hedging activities with respect to our foreign currency exposure. We continually monitor our exposure to currency fluctuations and may use financial hedging techniques when appropriate to minimize the effect of these fluctuations. Even so, exchange rate fluctuations may still have a material adverse effect on our business and operating results. In the future, we could be required to denominate our product sales in other currencies, which would make the management of currency fluctuations more difficult and expose us to greater currency risks. WE MAY FACE PRODUCT LIABILITY RISKS. Customers rely on our token-based security products to prevent unauthorized access to their digital information. A malfunction of or design defect in our products could result in legal or warranty claims. Although we place warranty disclaimers and liability limitation clauses in our sales agreements and maintain product liability insurance, we cannot assure you that these measures will be effective in limiting our liability. Liability for damages resulting from security breaches could be substantial and could have a material adverse effect on our business and operating results. In addition, a well-publicized security breach involving token-based and other security systems could adversely affect the market's perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. In that event, the demand for our products could decline, which would cause our business and operating results to suffer. WE FACE YEAR 2000 COMPLIANCE RISKS. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, during the current year, computer systems and software used by many companies may need to be upgraded to comply with such "Year 2000" requirements. The Year 2000 problem could affect computers, software and other equipment used, operated, or maintained by us, our business partners, our suppliers and our customers. We have formed a committee (the Committee) to oversee our computer system upgrade needs, including the specific assignment to deal with Year 2000 issues. The Committee is composed of various members of our staff. The Committee meets periodically and any findings are reviewed by our executive staff. We have reviewed all of our current product offerings and believe that our current products are Year 2000 compliant. The Committee's general plan of action included inventorying all essential internal equipment, contacting suppliers to ascertain their readiness for Year 2000 compliance, testing all critical systems, implementing a new Enterprise Resource Planning (ERP) system, and resolving all critical problems. With the exception of implementing a new ERP system, the Committee's general plan of action was completed by the end of the third quarter of 1999. The new ERP system is scheduled to be completed in the fourth quarter of 1999. We estimate the total Year 2000 costs to be between $100,000 and $150,000. In addition, we plan to implement a new ERP system to serve our worldwide information system, which we estimate will cost $1.3 million to $1.8 million. We have budgeted all Year 2000 costs independently of our information technology department. All costs will be paid from our operating funds. 18 19 SCM has completed a comprehensive inventory and evaluation of our systems, equipment and facilities. We have contacted all essential suppliers and determined that the suppliers' operations, products and services are Year 2000 compliant. We have completed a number of projects underway to replace or upgrade systems, equipment and facilities that were not Year 2000 compliant. We do not have a specific contingency plan should the replacement or upgrade of these systems fail. We are working to develop such a contingency plan. In addition, our sales could suffer if our customers divert resources from purchasing our products to resolving their own Year 2000 issues. We cannot be certain that the Year 2000 problem will not have a material adverse effect on our business and operating results. OUR KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS AND SUCH KEY PERSONNEL MAY NOT REMAIN WITH SCM IN THE FUTURE. We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel leave and are not adequately replaced, our business would be adversely affected. In particular, we depend on the continued service of Steven Humphreys, our Chairman of the Board, Robert Schneider, our Chief Executive Officer, and Bernd Meier, our President and Chief Operating Officer. SCM provides compensation incentives such as bonuses, benefits and option grants (which are typically subject to vesting over four years) to attract and retain qualified employees. In addition, our German subsidiary has entered into substantially similar employment agreements with each of Messrs. Schneider and Meier pursuant to which each serves as a Managing Director of the subsidiary. Each of the respective agreements has no set termination date, may be terminated by the subsidiary or the officer with nine months notice, and provides that the officer cannot work for one of our competitors during the one-year period following his termination. Non-compete agreements are, however, generally difficult to enforce. Therefore, these provisions may not provide us with significant protection. SCM entered into employment agreements with three employees of Shuttle, one of whom is covered by a key man life insurance policy. We do not maintain key man life insurance on any other employees. We believe that our future success will depend in large part on our continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and we may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future. OUR STOCK PRICE IS POTENTIALLY VOLATILE. The stock market has recently experienced significant price and volume fluctuations unrelated to the operating performance of particular companies. In addition, the market price of our common stock has been highly volatile and is likely to continue to be volatile. The future trading price for our common stock will depend on a number of factors, including: - variations in our financial results; - comments and forecasts by security analysts; - our ability to effectively manage our business; - any loss of key management; - announcements of technological innovations or new products by us or our competition; and - patents or other proprietary rights or patent litigation. 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 management's attention and resources. 19 20 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK FOREIGN CURRENCIES The Company transacts business in various foreign currencies, primarily in certain European countries, the United Kingdom, Singapore and Japan. Accordingly, the Company is subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to yen denominated sales in Japan and local currency denominated operating expenses in the U.K., Europe and Singapore, where the Company sells in both local currencies and U.S. dollars. The Company currently does not use financial instruments to hedge local currency activity at any of its foreign locations. Instead, the Company believes that a natural hedge exists, in that local currency revenues substantially offsets the local currency denominated operating expenses. The Company assesses the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis. FIXED INCOME INVESTMENTS The Company's exposure to market risk for changes in interest rates relates primarily to its investment portfolio. The Company does not use derivative financial instruments for speculative or trading purposes. The Company places its investments in instruments that meet high credit quality standards, as specified in the Company's investment policy. The policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio. The Company does not use derivative financial instruments in its investment portfolio to manage interest rate risk. The Company does, however, limit its exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for its fixed income portfolios. At the present time, the maximum duration of all portfolios is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria established in the Company's guidelines, the exposure to market and credit risk is not expected to be material. PART II: OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the third quarter of 1999. ITEM 5. OTHER INFORMATION Pursuant to Rule 14a-4(c)(1) under the Securities Exchange Act of 1934, the proxies of management would be allowed to use their discretionary voting authority with respect to any non-Rule 14a-8 stockholder proposal (i.e., a stockholder proposal not included in a company's proxy) raised at the Company's annual meeting of stockholders, without any discussion of the matter in the proxy statement. Unless the stockholder has notified the Company of such proposal at least 45 days prior to the month and day on which the Company mailed its prior year's proxy statement. Since the Company mailed its proxy statement for the 1999 annual meeting of stockholders on May 12, 1999, the deadline for receipt of any such non-Rule 14a-8 stockholder proposal for the 2000 annual meeting of stockholders is March 28, 2000. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. 27 Financial Data Schedule (b) Reports on Form 8-K Form 8-K, filed July 15, 1999, listing items 2 and 7 as they related to the Company's acquisition of Dazzle Multimedia, Inc. 20 21 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SCM MICROSYSTEMS, INC. Date: November 11, 1999 /s/ ANDREW C. WARNER ------------------------------------------- Andrew C. Warner Vice President - Finance, Chief Financial Officer (Principal Financial and Accounting Officer) 21 22 INDEX TO EXHIBITS
Exhibit Number Description - ------- ----------- 27 Financial Data Schedule
EX-27 2 FINANCIAL DATA SCHEDULE
5 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 53,820 69,289 32,026 2,653 12,361 170,074 7,769 1,151 190,105 28,098 0 0 0 14 161,993 190,105 87,145 87,145 58,298 58,298 27,253 0 (4,695) 6,289 3,311 2,978 0 0 0 2,978 0.21 0.20
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