<PAGE> 1
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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.
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1
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ITEM I. FINANCIAL STATEMENTS
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands, except per share data)
<TABLE>
<CAPTION>
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ---------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
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
======== ======== ======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
2
<PAGE> 3
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
<S> <C> <C>
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
========= =========
</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>
NINE MONTH PERIODS
ENDED SEPTEMBER 30,
-----------------------
1999 1998
-------- --------
<S> <C> <C>
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
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
4
<PAGE> 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):
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, 1998 September 30, 1998
------------------ ------------------
<S> <C> <C>
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
======== ========
</TABLE>
5
<PAGE> 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):
<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)
Core technology ......................................... 2,550
Trade name .............................................. 400
Assembled workforce ..................................... 200
Goodwill ................................................ 1,492
-------
Total ................................................ $ 5,991
=======
</TABLE>
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):
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
--------------------- ---------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
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
</TABLE>
6
<PAGE> 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):
<TABLE>
<CAPTION>
Quarter ended Nine months ended
September 30, September 30,
-------------------- ---------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
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
</TABLE>
7
<PAGE> 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):
<TABLE>
<CAPTION>
As of As of
September 30, December 31,
1999 1998
------------- ------------
<S> <C> <C>
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
======== ========
</TABLE>
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
------------------ -------------------
1999 1998 1999 1998
------- ------- ------- -------
<S> <C> <C> <C> <C>
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)
======= ======= ======= =======
</TABLE>
Additional information regarding revenues by geographic region for the three and
nine-months ended September 30, 1999 and 1998 follows (in thousands):
<TABLE>
<CAPTION>
Three months Nine months
ended ended
September30, September 30,
--------------------- ---------------------
1999 1998 1999 1998
------- ------- ------- -------
<S> <C> <C> <C> <C>
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
======= ======= ======= =======
</TABLE>
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
<PAGE> 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
<PAGE> 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
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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
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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
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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.
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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
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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.
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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
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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
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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.
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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
<PAGE> 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
<PAGE> 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
<PAGE> 22
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------- -----------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 53,820
<SECURITIES> 69,289
<RECEIVABLES> 32,026
<ALLOWANCES> 2,653
<INVENTORY> 12,361
<CURRENT-ASSETS> 170,074
<PP&E> 7,769
<DEPRECIATION> 1,151
<TOTAL-ASSETS> 190,105
<CURRENT-LIABILITIES> 28,098
<BONDS> 0
0
0
<COMMON> 14
<OTHER-SE> 161,993
<TOTAL-LIABILITY-AND-EQUITY> 190,105
<SALES> 87,145
<TOTAL-REVENUES> 87,145
<CGS> 58,298
<TOTAL-COSTS> 58,298
<OTHER-EXPENSES> 27,253
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (4,695)
<INCOME-PRETAX> 6,289
<INCOME-TAX> 3,311
<INCOME-CONTINUING> 2,978
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,978
<EPS-BASIC> 0.21
<EPS-DILUTED> 0.20
</TABLE>
