<PAGE> 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 JUNE 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)
<TABLE>
<S> <C>
DELAWARE 77-0444317
STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER)
</TABLE>
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 August 3, 1999, 14,088,047 shares of common stock were outstanding.
================================================================================
1
<PAGE> 2
ITEM I. FINANCIAL STATEMENTS
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Quarter Ended Six Months Ended
June 30 June 30
----------------------- -----------------------
1999 1998 1999 1998
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues ................................... $ 26,383 $ 16,576 $ 50,744 $ 30,501
Cost of revenues ........................... 19,234 10,528 35,250 19,426
-------- -------- -------- --------
Gross margin ........................ 7,149 6,048 15,494 11,075
-------- -------- -------- --------
Operating expenses:
Research and development ............... 2,022 1,530 3,871 2,861
Sales and marketing .................... 2,965 1,973 5,594 3,808
General and administrative ............. 5,763 2,606 7,686 3,896
In process research and development .... 900 3,101 900 3,101
-------- -------- -------- --------
Total operating expenses ............ 11,650 9,210 18,051 13,666
-------- -------- -------- --------
Loss from operations ............... (4,501) (3,162) (2,557) (2,591)
Interest and other, net .................... 1,782 1,650 3,388 2,346
-------- -------- -------- --------
Loss before income taxes ............ (2,719) (1,512) 831 (245)
Provision for income taxes ................. 537 572 1,677 846
-------- -------- -------- --------
Net loss ............................ $ (3,256) $ (2,084) $ (846) $ (1,091)
======== ======== ======== ========
Net loss per share:
Basic and diluted ...................... ($0.23) ($0.16) ($0.06) ($0.09)
======== ======== ======== ========
Shares used in computing net loss per share:
Basic and diluted ...................... 14,075 13,308 14,067 12,452
======== ======== ======== ========
Comprehensive loss:
Net loss ........................... $ (3,256) $ (2,084) $ (846) $ (1,091)
Changes in cumulative foreign currency
translation account ................... (643) 279 (2,124) 75
-------- -------- -------- --------
Total comprehensive loss ........... $ (3,899) $ (1,805) $ (2,970) $ (1,016)
======== ======== ======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
2
<PAGE> 3
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
June 30, December 31,
1999 1998
--------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash, cash equivalents and short-term investments $ 121,759 $ 129,918
Accounts receivable, net ........................ 24,062 25,535
Inventories ..................................... 13,711 12,159
Prepaids and other current assets ............... 4,190 3,879
--------- ---------
Total current assets ......................... 163,722 171,491
Property and equipment, net ......................... 6,294 4,063
Goodwill ............................................ 9,085 4,847
Other assets ........................................ 2,261 2,919
--------- ---------
Total assets ................................. $ 181,362 $ 183,320
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................ $ 12,528 $ 15,046
Accrued expenses ................................ 7,952 4,941
Notes and loans payable ......................... 1,546 --
Income taxes payable ............................ 2,280 4,554
--------- ---------
Total current liabilities .................... 24,306 24,541
Stockholders' equity:
Capital stock ................................... 14 14
Additional paid-in capital ...................... 170,117 168,897
Deferred compensation ........................... (45) (72)
Accumulated deficit ............................. (12,044) (11,198)
Other cumulative comprehensive income (loss) .... (986) 1,138
--------- ---------
Total stockholders' equity ................... 157,056 158,779
--------- ---------
$ 181,362 $ 183,320
========= =========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
3
<PAGE> 4
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Six-month periods
ended June 30,
-------------------------
1999 1998
--------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net loss .................................................. $ (846) $ (1,091)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ........................... 1,157 541
Charge off of in-process research and development ....... 900 3,101
Write-off of investments ................................ 803 --
Change in accounts receivable allowance ................. 1,950 --
Other ................................................... 328 --
Changes in operating assets and liabilities:
Accounts receivable .................................... (461) (3,566)
Inventories ............................................ (1,922) (1,985)
Prepaid expenses ....................................... (179) (813)
Accounts payable ....................................... (2,624) 407
Accrued expenses ....................................... 1,147 870
Income taxes payable ................................... (2,094) 711
-------- --------
Net cash used in operating activities ................. (1,841) (1,797)
Cash flows used from investing activities:
Capital expenditures ...................................... (3,530) (740)
Purchase of long-term investment .......................... (2,096) --
Businesses acquired, net of cash received ................. (1,334) (9,875)
Proceeds from short-term investments ...................... 45,652 16,462
Purchases of short-term investments ....................... (37,022) (75,325)
-------- --------
Net cash provided by (used in) investing activities ... 1,670 (69,478)
Cash flows from financing activities:
Principal payments on long-term debt ...................... -- (288)
Proceeds from issuance of equity, net ..................... 1,220 89,424
-------- --------
Net cash provided by financing activities ............. 1,220 89,136
Effect of exchange rates on cash and cash equivalents ........ (583) (309)
-------- --------
Net increase in cash and cash equivalents .................... 466 17,552
Cash and cash equivalents at beginning of period ............. 47,177 25,737
-------- --------
Cash and cash equivalents at end of period ................... $ 47,643 $ 43,289
======== ========
Supplemental disclosures of cash flow information:
Cash paid for income taxes ................................ $ 3,726 $ --
======== ========
Non-cash investing and financing activities:
Fair value of assets acquired less liabilities assumed in
business combinations ................................ $ 4,128 $ 5,976
======== ========
Tax benefits from employee stock transactions ............. $ 420 $ 765
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
4
<PAGE> 5
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 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 for a fair presentation have been
included. Operating results for the three-month and six-month periods ended June
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 LOSS PER SHARE
Basic and diluted net loss per share is computed using the weighted average
number of common shares outstanding during the period. Diluted net loss per
share does not include the effect of 955,203 and 921,000 shares issuable under
stock options and warrants as of June 30, 1999 and 1998, respectively, with
weighted average exercise prices of $17.74 and $12.26, respectively, because
their inclusion would be antidilutive.
3. RECENT ACCOUNTING PRONOUNCEMENT
In June 1998, the FASB issued 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 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
Intermart and ICS
In the second quarter of 1998, the Company acquired all of the outstanding
capital stock of Intermart Systems, K.K. (Intermart) and Intellicard Systems
Pte. Ltd. (ICS) in separate transactions that were accounted for under the
purchase method of accounting. The following summary, prepared on a pro forma
basis, combines the Company's consolidated results of operations with
Intermart's and ICS' results of operations for the three months and six months
ended June 30, 1998, as if each company had been acquired as of the beginning of
the period presented. The table includes the impact of certain adjustments
including the elimination of the nonrecurring 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):
<TABLE>
<CAPTION>
Quarter ended Six months ended
June 30, 1998 June 30, 1998
------------- -------------
<S> <C> <C>
Revenues ............................. $17,709 $34,755
Net income ........................... $ 4,982 $ 6,083
Net income per share:
Basic ........................... $ 0.39 $ 0.27
Diluted ......................... $ 0.37 $ 0.25
Shares used in per share computations:
Basic ........................... 13,415 12,559
Diluted ......................... 14,436 13,621
</TABLE>
5
<PAGE> 6
The pro forma results are not necessarily indicative of what would have
occurred if the acquisitions had been effected for the periods presented. In
addition, they are not intended to be a projection of future results and do not
reflect any synergies that might be achieved from combined operations.
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, of which $307,000 was settled in the three months
ended June 30, 1999.
<TABLE>
<CAPTION>
Decrease during
Accrued as of three months ended Accrued as of
March 31, 1999 June 30, 1999 June 30, 1999
-------------- ------------- -----------
<S> <C> <C> <C>
Legal, accounting, regulatory and other due diligence costs $203 $203 $ --
Costs relating to closure of redundant facilities 104 104 --
---- ---- --------
$307 $307 $ --
==== ==== ========
</TABLE>
As separate companies, total revenues and net income for the individual
entities for the three and six-month periods ended June 30, 1998 were as follows
(in thousands):
<TABLE>
<CAPTION>
Quarter ended Six months ended
June 30, 1998 June 30, 1998
------------- ----------------
<S> <C> <C>
Total revenue:
SCM $ 10,593 $ 18,408
Shuttle 5,983 12,093
-------- --------
$ 16,576 $ 30,501
======== ========
Total net income (loss):
SCM $ (4,758) $ (3,969)
Shuttle 2,674 2,878
-------- --------
$ (2,084) $ (1,091)
======== ========
</TABLE>
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 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
covertible 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 assets acquired of $0.5 million) 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 for the three and six months ended June 30, 1999. The Company expects a
final independent valuation in the third quarter. At that time the purchase
price allocation will be finalized.
6
<PAGE> 7
A summary of the preliminary allocation of the purchase price is as follows
(in thousands):
<TABLE>
<S> <C>
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)
Goodwill ............................ 4,642
-------
Total ............................ $ 5,991
=======
</TABLE>
At the time of the acquisition, the 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 $4.6 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 six months ended June 30, 1999 and 1998, as if the company 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):
<TABLE>
<CAPTION>
Quarter ended June 30 Six months ended June 30
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues ............................. $ 29,611 $ 18,672 $ 56,802 $ 33,823
Net income ........................... $ (4,024) $ 2,308 $ (2,377) 3,205
Net income per share:
Basic ........................... $ (0.29) $ 0.18 $ (0.17) $ 0.27
Diluted ......................... $ (0.29) $ 0.17 $ (0.17) $ 0.25
Shares used in per share computations:
Basic ........................... 14,075 12,627 14,067 11,771
Diluted ......................... 14,075 13,548 14,067 12,733
</TABLE>
5. RESTRUCTURING
As of June 30, 1999, the Company has accrued restructuring charges of
$568,000 consisting of headcount related restructuring costs of $328,000 and
legal and other costs of $240,000.
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.
Capital expenditures for long-lived assets are not reported to management by
segment and are excluded, as presenting such information is not practicable.
Summary information by segment as of June 30, 1999 and December 31, 1998, and
for the three and six months ended June 30, 1999 and 1998, is as follows (in
thousands):
7
<PAGE> 8
<TABLE>
<CAPTION>
Quarter ended Six months ended
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Digital TV:
Revenues ...................... $ 8,743 $ 4,992 $17,697 $10,681
Gross margin .................. 2,807 2,312 5,944 4,715
Segment operating profit ...... 176 1,092 1,675 2,544
Segment assets ................ 8,882 4,582 8,882 4,582
Long-lived assets ............. 3,734 2,229 3,734 2,229
Digital Media:
Revenues ...................... $13,857 $ 6,797 $ 26,266 $13,047
Gross margin .................. 2,429 1,985 6,380 4,253
Segment operating loss ........ (2,410) (773) (1,793) (766)
Segment assets ................ 25,229 13,265 25,229 13,265
Long-lived assets ............. 10,606 6,453 10,606 6,453
PC and Network Security:
Revenues ...................... $ 3,783 $ 4,787 $ 6,781 $ 6,773
Gross margin .................. 1,913 1,751 3,170 2,107
Segment operating profit (loss) (188) 201 (360) (687)
Segment assets ................ 7,852 5,226 7,852 5,226
Long-lived assets ............. 3,301 2,542 3,301 2,542
</TABLE>
A reconciliation of the Company's segment assets and segment operating
profit (loss) as of June 30, 1999 and December 31, 1998 and for the three and
six months ended June 30, 1999 and 1998 follows (in thousands):
<TABLE>
<CAPTION>
As of June 30 As of December 31
------------- -----------------
1999 1998
---- ----
<S> <C> <C>
Segment assets - Digital TV ............................... $ 8,882 $ 8,257
Segment assets - Digital Media ............................ 25,229 23,901
Segment assets - PC and Network Security .................. 7,852 9,415
-------- --------
Total segment assets .................................. 41,963 41,573
Corporate cash, cash equivalents and short-term investments 139,399 129,918
-------- --------
Total assets ....................................... $181,362 $171,491
======== ========
</TABLE>
<TABLE>
<CAPTION>
Quarter ended Six months ended
----------------------- ----------------------
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Segment operating profit (loss) - Digital TV ............ $ 176 $ 1,092 $ 1,675 $ 2,544
Segment operating loss - Digital Media .................. (2,419) (773) (1,802) (766)
Segment operating profit (loss) - PC and Network Security (188) 201 (360) (687)
------- ------- ------- -------
Total segment operating profit (loss) ............... (2,431) 520 (487) 1,091
Special charges recorded at corporate level ............. (2,070) (3,682) (2,070) (3,682)
------- ------- ------- -------
Total loss from operations .......................... $(4,501) $(3,162) $(2,557) $(2,591)
======= ======= ======= =======
</TABLE>
8
<PAGE> 9
Additional information regarding revenues by geographic region as of and for the
three and six months ended June 30, 1999 and 1998 follows (in thousands):
<TABLE>
<CAPTION>
Quarter ended Six months ended
--------------------- ---------------------
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
United States ........................................................ $11,081 $ 7,331 $20,489 $11,600
Europe ............................................................... 12,928 7,885 23,376 15,443
Asia-Pacific ......................................................... 2,374 1,360 6,879 3,458
------- ------- ------- -------
$26,383 $16,576 $50,744 $30,501
======= ======= ======= =======
</TABLE>
A summary of the net sales to major customers that exceeded 10% of total
net sales during the three and six months ended June 30, 1999 and 1998, and the
amount due from these customers as of June 30, 1999, follows (accounts
receivable in thousands):
<TABLE>
<CAPTION>
Quarter ended Six months ended
------------------ ---------------- Accounts
June 30 June 30 receivable
------- ------- ----------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Customer 1 14% - 14% 17% 1,125
Customer 2 12% - 13% - 2,809
</TABLE>
9
<PAGE> 10
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 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 assets acquired of $0.5 million) 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 for the three and six months ended June 30, 1999. The Company expects a
final independent valuation in the third quarter. At that time the purchase
price allocation will be finalized.
At the time of the acquisition, the 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 $4.6 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 June 30, 1999 were $26.4 million compared to
$16.6 million in 1998, an increase of 59%. For the first six months of 1999, net
revenues were $50.7 million compared to $30.5 million in the first six months of
1998, an increase of 66%. The increase in revenues in the first six months of
1999 was due primarily to an increase in shipments of the Company's digital
media and connectivity products of $13.0 million and an increase in shipments of
DVB-CAM products and services in Europe of $7.0 million. The increase in the
second quarter of 1999 was due primarily to an increase in shipments of the
Company's digital media and connectivity products of $7.1 million and an
increase in shipments of DVB-CAM
10
<PAGE> 11
products and services in Europe of $3.7 million, offset by a $1.0 million
decrease in PC and Network security revenue.
Gross Margin. Gross margin for the second quarter of 1999 was $7.1 million,
or 27% of total net revenues, compared to $6.0 million or 36% for the second
quarter of 1998. Gross margin for the first six months of 1999 was $15.5 million
or 31% of total net revenues, compared to $11.1 million or 36% in the first six
months of 1998. The increase in gross margin in absolute dollars for the second
quarter and the first six months of 1999, was primarily due to the increase in
shipments of digital media and connectivity products and an increase in
shipments of DVB-CAM 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 second quarter 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. 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 second quarter of 1999, research and development
expenses were $2.0 million, compared with $1.5 million in the second quarter of
1998, an increase of 32%. As a percentage of total net revenues, research and
development expenses were 8% in the second quarter of 1999 compared to 9% in the
second quarter of 1998. For the first six months of 1999, research and
development expenses were $3.9 million compared to $2.9 million in the
comparable period of 1998. As a percentage of total net revenues, research and
development expenses were 8% in the first six months of 1999 compared to 9% in
the comarable period of 1998. The increases in absolute amounts for the second
quarter and the first six 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 ("the
acquired companies"). 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 second quarter of 1999, were $3.0 million, or 11% of
total net revenues, compared with $2.0 million in the first quarter of 1998, or
12% of total net revenues, an increase of 50%. For the first six months of 1999,
sales and marketing expenses were $5.6 million compared with $3.8 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 six 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,
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. General and administrative expenses consist
primarily of compensation expenses for employees performing the Company's
administrative functions. In the second quarter of 1999, general and
administrative expenses were $5.8 million, an increase of 121% compared with
$2.6 million in the second quarter of 1998, representing 22% and 16% of total
net revenues in the second quarter of 1999 and 1998, respectively. For the six
month period, general and administrative expenses were $7.7 million in 1999, an
increase of 97% compared with $3.9 million in 1998, representing 15% and 13% of
total net revenues in the first six months of 1999 and 1998, respectively. In
the second quarter of 1999, general and administrative expenses include charges
for additions to the Company's allowance for doubtful accounts totaling $2.0
million as a result of cash flow difficulties experienced by one its customers.
An initial provision of $2.3 million for bad debts from this customer was made
in December 1998. The customer continued to trade during the first quarter of
1999. During the second quarter of 1999, the customer filed bankruptcy. As of
June 30, 1999 the outstanding balance due from this customer is fully reserved.
General and administrative expenses also include a $600,000 write down of the
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. These increases in absolute amounts in 1999 were also
due to increases in administrative headcount to support higher levels of
business activities and administrative costs of the companies acquired in 1998.
The Company believes general and administrative expenses in 1999 will
11
<PAGE> 12
continue to increase in absolute amount for the last aforementioned reasons, but
will fluctuate as a percentage of total net revenues.
Interest Income and Other, Net. Interest income and other, net consists of
interest earned on invested cash, offset by interest paid or accrued on
outstanding debt. In the second quarter of 1999, interest income and other, net,
was $1.8 million, compared to $1.7 million in the second quarter of 1998. In the
first six months of 1999, interest income and other, net, was $3.4 million,
compared to $2.3 million in the comparable period 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 no debt service requirements resulted in the
increase in interest income and other, net in the first six months of 1999 over
the first six months of 1998.
Income Taxes. The provision for income taxes was $537,000 in the second
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 carry forwards 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.
As of June 30, 1999, the Company's working capital was $139.4 million,
compared to a working capital of $147.0 million as of December 31, 1998. Working
capital decreased in the first six months of 1999 primarily due to working
capital used in operations and capital expenditures.
During the first six months of 1999, cash and cash equivalents increased by
$466,000 due primarily to $1.8 million used in operations, offset by $1.7
million provided by investing activities and $1.2 million increase in financing
activities from issuance from equity. Cash was used in operations primarily for
an increase in inventories of $1.9 million, an increase in accounts payable of
$2.6 million, an increase of income taxes payable of $2.1 million, offset by a
decrease in accrued expenses of $1.1 million and an increase in the allowance
for doubtful accounts of $2.0 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 June 30, 1999). One of these lines of credit expires on
September 30, 1999. The second line of credit has 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 June 30,
1999), and expires in June 2001. At June 30, 1999, no amounts were outstanding
under any of the Company's lines of credit. The notes and loans payable consist
mainly of $1.4 million of convertible notes for Dazzle, convertible into Series
B Preferred Stock 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.
12
<PAGE> 13
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 BECOME PROFITABLE.
Although SCM was profitable for the quarters ended March 31, 1999 and the
year ended December 31, 1997, SCM incurred net operating losses on an annual
basis from our inception in 1993 through the year ended December 31, 1996 and in
1998 and incurred an operating loss in the quarter ended June 30, 1999. As of
June 30, 1999, SCM had an accumulated deficit of $12.0 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.
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. Seasonal business trends may be caused by a number of
factors, including higher consumer sales during the holiday season and the
fiscal year end for companies. We believe that the seasonal trends in our
business and operating results are principally due to the U.S. government's
budgeting requirements. This government related seasonality occurs because
original equipment manufacturers, or OEMs incorporate our data security products
into personal computers, or PCs, and workstations which are then sold to the
U.S. government. The back-ended nature of the U.S. government's budgetary cycle
encourages OEMs to purchase our products in the second half of each fiscal year.
Another reason for our seasonality is that we currently sell our digital video
broadcasting, or DVB products mainly to OEMs for the European consumer market.
We expect these sales to
13
<PAGE> 14
increase. Because consumer market's sales are highest in the third and fourth
quarter of the year, we expect the seasonal trends in our business and operating
results to continue.
ANY DELAYS IN OUR NORMALLY LENGTHY SALES CYCLE COULD RESULT IN SIGNIFICANT
FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS.
When we obtain a new 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 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.
We believe that our operating results may vary significantly in future
periods and that our historical results are not reliable indicators of future
performance. It is possible that, in the future, our operating results will be
below the expectations of stock market analysts and investors. In such event,
the market price of our Common Stock could decline significantly.
OUR EMERGING MARKETS MAY NOT ACCEPT OUR PRODUCTS.
SCM's future growth and operating results will depend on whether our
security and connectivity product families 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.
From SCM's inception through 1994, we focused on Personal Computer Memory
Card Industry Association, or PCMCIA, peripheral products, including flash
memory and fax/modem devices. In 1994, we began emphasizing security and access
products. We made our final shipment of PCMCIA peripheral products in the
quarter ended March 31, 1997, completing our exit from this business. We have
since strategically shifted our product focus to security and connectivity
products, which have increased from 13% of our total net sales in 1994 to 100%
of total net sales in 1998. Therefore, our net sales are now and will continue
to be dependent upon the success of our security and connectivity products.
We believe that smart cards are ideally suited to serve as tokens for
network and electronic commerce security. Smart card token-based security
applications are designed to provide protection from unauthorized access to
digital information. Our SwapBox and SwapSmart product families are designed to
provide smart card token-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 for these applications.
Our DVB product family provides a means of controlling access to digital
television broadcasts. Our SwapAccess DVB-CAM product implements the DVB-CI and
NRSS-B 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. The market for DVB products
in the United States has only recently begun to develop and may not grow. In
addition, 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.
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.
14
<PAGE> 15
WE DEPEND ON OUR CONTINUED SALES TO ORIGINAL EQUIPMENT MANUFACTURERS.
Most of our products are intended for use as components or subsystems 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 competitor's 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 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 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 second quarter of 1999, sales to BetaDigital (a division of the
Kirch Group) accounted for 12% of total net sales, sales to Solectron
Corporation accounted for 14% of our net sales and sales to our top 10 customers
(all of which were OEMs) accounted for 65% of total net sales. 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 12%, 17%, 28% and 8% of our net revenues for the years ended
1998, 1997, 1996 and the first six months of 1999, 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 and 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, Gemplus
and Telenor. We evaluate, on an ongoing basis, potential strategic alliances and
intend to continue to pursue such relationships. These arrangements may not
result in commercially successful products.
15
<PAGE> 16
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 security products. We
currently experience competition from a number of sources, including:
- ActionTec, Carry Computer Engineering, Greystone and Litronic in PC
Card adapters;
- SmartDisk Corporation, Philips and PubliCard in smart card readers and
universal smart card reader interfaces; 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 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.
16
<PAGE> 17
WE MAY NOT BE ABLE TO INTEGRATE RECENTLY ACQUIRED COMPANIES.
We continually evaluate potential acquisitions of complementary businesses,
products and technologies. SCM acquired Shuttle Technology Group Limited, based
in the U.K., in November 1998, Intermart Systems K.K., based in Japan, in May
1998, Intellicard Systems Pte. Ltd., based in Singapore, in June 1998 and Dazzle
Multimedia, Inc., based in California, in June 1999. We may not realize the
desired benefits of these recent transactions or of future transactions. In
order to successfully integrate acquired companies, we must, among other things:
- continue to attract and retain key management and other personnel;
- integrate, from both an engineering and sales and marketing perspective,
the acquired products;
- establish a common corporate culture; and
- integrate geographically distant facilities and employees.
If our management's attention to day-to-day operations is diverted to
integrating acquired companies or if problems in the integration process arise,
these difficulties could have a material adverse effect on our business and
operating results. In addition, any acquisition, depending on its size, could
result in the use of a significant portion of our available cash. If an
acquisition is made utilizing our securities, a significant dilution to our
stockholders and significant acquisition related charges to earnings could
occur. During 1998 and 1999, SCM incurred significant special charges associated
with the acquisitions of Shuttle, Intermart, Intellicard and Dazzle. SCM may
also incur additional material charges in the future resulting from redundancies
in product lines, customer lists and sales channels associated with these
acquisitions. Acquisitions may also result in the incurrence or the assumption
of liabilities, including liabilities that are unknown or not fully known to us
at the time of acquisition, which could have a material adverse effect on us.
Furthermore, we cannot assure you that any products we acquire in connection
with any acquisition will gain acceptance in our markets.
WE HAVE EXPERIENCED SIGNIFICANT GROWTH IN OUR BUSINESS IN RECENT PERIODS AND OUR
ABILITY TO MANAGE THIS GROWTH AND ANY FUTURE GROWTH WILL AFFECT OUR BUSINESS.
Our business has grown substantially in recent periods, with net revenues
increasing from $10.9 million in 1994 to $85.0 million in 1998, with revenues of
$50.7 million in the first six months of 1999. The growth of our business has
placed a significant strain on our management and operations. In 1993, we
commenced operations in North America, which included the establishment of a
U.S. management team. As a result, we have a limited operating history under our
current U.S. management. In addition, the number of employees has increased from
67 at December 31, 1995 to 358 as of June 30, 1999.
If we are successful in achieving our growth plans, our growth is likely 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.
WE MUST INTEGRATE OUR GLOBAL LOCATIONS.
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
systems. Although we believe that our information systems are adequate, we may
in the future have to implement new information systems. Implementation of new
information systems may be costly and may require us to train personnel. Any
failure or delay in implementing these systems, procedures and
17
<PAGE> 18
controls on a timely basis, if necessary, or in expanding these areas 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. 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. In April 1997,
Gemplus served SCM with a complaint alleging that our SwapSmart product
infringes certain claims of a French patent held by Gemplus. Although this
dispute was settled on terms acceptable to us, future disputes with third
parties may arise and these disputes 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 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. A significant portion of our products are
now manufactured by SCM Microsystems (Asia) Pte. Ltd., formerly Intellicard, our
wholly-owned subsidiary in Singapore, but we also source some of our products
through two contract manufacturers in Europe. If Intellicard 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. In this regard, one of our contract manufacturers has
recently been involved in bankruptcy proceedings and may be unable to continue
manufacturing our products. 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.
In an effort to reduce our manufacturing costs, SCM has shifted volume
production of many of our product components to Singapore. We are currently
considering shifting the production of other product components to other
suppliers in Europe or Asia. Transferring production to these new locations
could disrupt our manufacturing process and increase overall production costs.
In addition, 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.
18
<PAGE> 19
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 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 50%, 51%, 62% and
60% of our revenues for the years ended 1996, 1997, 1998 and in the first six
months of 1999, respectively, were derived from customers located outside the
United States. Because a significant number of our principal customers are
located in other countries, we anticipate that international sales will continue
to account for a significant 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. In
addition, we recently 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.
19
<PAGE> 20
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
includes 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 by the end of the third quarter of 1999. We are
currently on schedule to complete all critical Year 2000 problems by the end of
the third 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. As
of June 30, 1999, we have not incurred any significant costs related to Year
2000 issues. We have budgeted all Year 2000 costs independently of our
information technology department. All costs will be paid from our operating
funds.
SCM is currently in the process of completing a comprehensive inventory and
evaluation of our systems, equipment and facilities. We are in the process of
identifying all essential suppliers and plan to contact them, if required, to
determine that the suppliers' operations, products and services are Year 2000
compliant. We have a number of projects underway to replace or upgrade systems,
equipment and facilities that are not currently 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. The Year 2000
problem may have a material adverse effect on our business and operating
results.
IT IS UNCERTAIN WHETHER THE ADOPTION OF THE EURO WILL AFFECT OUR BUSINESS.
On January 1, 1999, eleven of the fifteen member countries of the European
Union established a fixed conversion rates between their existing currencies
(the "old currency") and the one common legal currency known as the "Euro". From
January 1, 1999 through June 30, 2002 the countries will be able to use their
old currencies or the Euro to transact business. By July 1, 2002, the conversion
to the Euro will be complete, at which time the old currencies will no longer be
legal tender. The conversion to the Euro will eliminate currency exchange rate
risk between the member countries.
We do not anticipate any material impact from the Euro conversion on our
financial information systems which currently accommodate multiple currencies.
Computer software changes necessary to comply with the Year 2000 issue are
generally compliant to the Euro conversion issue. Because there are many
uncertainties, we cannot reasonably estimate the effect that the Euro conversion
issue will have on our pricing or market strategies, and the impact, if any, it
will have on our financial condition and result of operations.
20
<PAGE> 21
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 six 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
increase our manufacturing capability as required by customer demand; - 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.
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.
21
<PAGE> 22
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
Prior to the Annual Meeting of Stockholders of the Company the Board of
Directors reduced the number of shares required for a quorum at any stockholders
meeting from one-half to one-third. At the Annual Meeting of Stockholders of the
Company on June 10, 1999, the following matters were acted on by the
shareholders of the Company:
1. The re-election of Steven Humphreys, Oystein Larsen and Poh Chuan Ng as Class
I directors for additionally three year terms:
<TABLE>
<CAPTION>
Steven Humphreys
<S> <C>
Shares in Favor 4,920,086
Shares Against 13,770
Oystein Larsen
Shares in Favor 4,920,086
Shares Against 13,770
Poh Chuan Ng
Shares in Favor 4,920,086
Shares Against 13,770
</TABLE>
2. The approval of an amendment to the Company's 1997 Stock Plan, to increase
the number of shares of the Company's Common Stock reserved for issuance by
800,000 shares:
<TABLE>
<S> <C>
Shares in Favor 4,919,534
Shares Against 14,322
</TABLE>
3. The ratification of the appointment of KPMG LLC as the independent
accountants of the Company for the fiscal year ending December 31, 1999:
<TABLE>
<S> <C>
Shares in Favor 4,920,324
Shares Against 13,532
</TABLE>
22
<PAGE> 23
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.
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: August 3, 1999
/s/ ANDREW C. WARNER
----------------------------------------
Andrew C. Warner
Vice President- Finance, Chief Financial
Officer (Principal Financial and
Accounting Officer)
23
<PAGE> 24
Exhibit Index
Ex. 27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> JUN-30-1999
<CASH> 47,643
<SECURITIES> 74,116
<RECEIVABLES> 26,715
<ALLOWANCES> 2,653
<INVENTORY> 13,711
<CURRENT-ASSETS> 163,722
<PP&E> 7,054
<DEPRECIATION> 760
<TOTAL-ASSETS> 181,362
<CURRENT-LIABILITIES> 24,306
<BONDS> 0
0
0
<COMMON> 14
<OTHER-SE> 157,042
<TOTAL-LIABILITY-AND-EQUITY> 181,362
<SALES> 50,744
<TOTAL-REVENUES> 50,744
<CGS> 35,250
<TOTAL-COSTS> 35,250
<OTHER-EXPENSES> 18,051
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,388)
<INCOME-PRETAX> 831
<INCOME-TAX> 1,677
<INCOME-CONTINUING> (846)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (846)
<EPS-BASIC> (0.06)
<EPS-DILUTED> (0.06)
</TABLE>
