<PAGE> 1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1998
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)
160 KNOWLES DRIVE, LOS GATOS, CALIFORNIA 95032
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
</TABLE>
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 370-4888
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, $0.001
PAR VALUE
(TITLE OF CLASS)
------------------------
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements or
any amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ].
The aggregate market value of voting stock held by non-affiliates of the
registrant as of March 26, 1999 was approximately $999,207,000 based upon the
last sales price reported for such date on the Nasdaq National Market. For
purposes of this disclosure, shares of Common Stock held by persons who hold
more than 5% of the outstanding shares of Common Stock and shares held by
officers and directors of the registrant, have been excluded in that such
persons may be deemed to be affiliates. This determination is not necessarily
conclusive.
At March 26, 1999 registrant had outstanding 14,057,759 shares of Common
Stock.
------------------------
DOCUMENTS INCORPORATED BY REFERENCE
No documents are incorporated herein by reference.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 2
PART I
ITEM 1. BUSINESS
SCM Microsystems designs, develops and sells hardware used to (1) control
access to computers, networks and digital television broadcasts, (2) to conduct
secure electronic commerce, and (3) to exchange information from devices such as
digital cameras and audio recorders. Our target customers are manufacturers in
the computer, telecommunications and digital television industries. We sell and
license our products through a direct sales and marketing organization,
primarily to original equipment manufacturers. We also sell through
distributors, value added resellers and systems integrators worldwide.
INDUSTRY BACKGROUND
Individuals and corporations increasingly rely upon computer networks, the
Internet, intranets and direct broadcast systems to access information,
entertainment and data in a digital form from their homes and workplaces. This
increasing proliferation and reliance upon digital data has caused data security
to become a paramount concern of businesses, government, educational
institutions and consumers. Regardless of whether the issue is controlling
access to proprietary or confidential information such as business data or
health records, or whether it is attempting to limit access to digital video
broadcasts, or DVB, to paying subscribers, content providers, network and data
managers and users of digital data are concerned with controlling access to data
and maintaining data security. The enterprise data security market, including
electronic commerce applications, and the market for DVB conditional access
require a range of products to address their needs.
ENTERPRISE DATA SECURITY AND ELECTRONIC COMMERCE
Enterprise Data Security
Enterprise computing has evolved from highly centralized mainframe
computers to widely distributed client/server network-based solutions. Modern
enterprises frequently employ one or more local area networks to connect
computer users located in a single facility, wide area networks and intranets to
connect users in disparate facilities, and the Internet or direct electronic
links to provide internal users access to third party information and to provide
customers, vendors and other interested third parties with access to an
enterprise's computing resources or information. Internet usage is expected to
increase from approximately 35 million Web users worldwide in 1996 to
approximately 160 million users worldwide by 2000 according to International
Data Corporation, or IDC. This shift towards distributed computing is being
fueled in part by the growing number of mobile computer users and telecommuters
that perform some or all of their work from home or other remote locations.
Data has become increasingly vulnerable to unauthorized access as
enterprises move toward distributed computing and make data more accessible to
internal and external users. According to the Computer Security Institute, 42%
of respondents to its 1996 CSI/FBI Computer Crime and Security Survey
acknowledged that they had experienced unauthorized use of their computer
systems within the last 12 months. Unauthorized access can range from users who
are authorized to access portions of an enterprise's computing resources
accessing unauthorized portions, to hackers who have no legitimate access
breaking into a network and stealing or corrupting data. The consequences of
unauthorized access, which can often go undetected, can range from theft of
proprietary information or other assets to the alteration or destruction of
stored data. Approximately 78% of respondents to the Fourth Annual Information
Week/Ernst & Young Information Security Survey reported that their company
suffered a loss related to information security and disaster recovery in the
past two years. Some companies reported losses of up to $1 million due to
security breaches. As a result of the consequences of unauthorized access, many
enterprises have been reluctant to make their computing resources as open as may
be otherwise desirable, and those that allow access are adopting various
security measures to guard against unauthorized access. SCM believes that
enterprises seek solutions which will allow them to expand access to data while
maintaining adequate security.
1
<PAGE> 3
Electronic Commerce
The proliferation of personal computers, or PCs, in both the home and
office combined with widespread access to the Internet have created significant
opportunities for online shopping and other electronic commerce. IDC estimates
that the total value of goods and services purchased over the Web will grow from
$3 billion in 1996 to $100 billion in 2000. SCM believes that a key factor
constraining the growth in online purchasing has been the lack of adequate data
security. As a result of the anonymity of the Internet, merchants and consumers
need assurances that customers are correctly identified and that the
confidentiality of information such as credit card numbers is maintained.
Accordingly, SCM believes that successful expansion of electronic commerce will
require the implementation of improved security measures which accurately
identify and authenticate users and reliably encrypt data transmissions over the
Internet.
Common Solutions to Secure Enterprise Data and Electronic Commerce
Data security and secure electronic commerce generally involve implementing
a patchwork of hardware and software solutions operating at a variety of points
in a data environment, including router, gateway and server-based hardware
solutions, and operating system and applications-level software solutions.
Currently, the most common security solution is the installation of one or
more firewalls that control the flow of data between segments of an internal
network or between an internal network and the Internet or other remote access
paths. A firewall essentially acts as a funnel, analyzing whether a particular
communication passing through the funnel is authorized. With the increasing
volumes of network traffic, firewalls may no longer be capable of providing
adequate levels of protection without impairing the speed of communications.
Moreover, Internet technologies such as Sun Microsystems' Java and Microsoft's
ActiveX, which involve the transfer of active programs, or applets, and
broadcast applications such as PointCast and Marimba, present security risks
that are not readily addressed by firewalls.
The key to any security system is the ability to reliably identify users in
order to prevent unauthorized access to information and resources.
Authentication of a user's identification is generally accomplished by one of
two approaches: passwords, which are codes known only by specific users; and
tokens, which are user-specific physical devices that only authorized users
possess. Passwords, while easier to use, are also the least secure because they
tend to be short and static, and are often transmitted without encryption. As a
result, passwords are vulnerable to decoding or observation and subsequent use
by unauthorized persons. Tokens are small devices ranging from simple credit
card-like devices to more complex devices capable of generating
time-synchronized or challenge-response access codes. Certain token-based
systems require both possession of the token itself and a personal
identification number, or PIN, to indicate that the token is being used by an
authorized user. Such an approach, referred to as two-factor authentication,
provides much greater security than single factor systems such as passwords or
the simple possession of a token.
Early implementation of tokens include magnetic strip cards, which are
plastic cards with data encoded on a magnetic strip on the card. These cards are
typically used in automated teller machine, or ATM, and credit card
transactions. ATM cards are an example of a two-factor authentication system.
ATM cards require the user to possess the ATM card and to know the PIN
associated with the card before engaging in any transaction. While suitable for
certain applications, the magnetic strip card is subject to counterfeiting,
tampering and inadvertent data deletion, and can hold only a very limited amount
of information.
PC Cards represent a more advanced form of token, although their use in
security applications has been limited to date. PC Cards are computer
peripherals similar in width and length to, but substantially thicker than, a
credit card. The standards for PC Cards and the corresponding slots were
developed by the Personal Computer Memory Card Industry Association, or PCMCIA.
With an installed base of approximately 10 million PCMCIA slots in 1995
according to IDC, PC Card products have been developed for a variety of
functions including modems and memory devices. While virtually all portable PCs
being sold today contain at least one, and in many cases two, PCMCIA slots as a
standard feature, the PCMCIA standard has generally not been widely adopted for
desktop computers. The use of PC Cards as security tokens has been endorsed by
the Department of Defense, or the DoD, as part of its Defense Messaging System,
or DMS. The DMS uses a PC Card known as "Fortezza" as its standard security
token. In connection with the DMS, the DoD has
2
<PAGE> 4
mandated that desktop computers supplied to the DoD and its affiliated agencies
must incorporate PCMCIA slots in order to accept the Fortezza PC Card
identification/authentication token.
A further advancement in token implementation is the smart card. Smart
cards are credit card-sized plastic cards that contain an embedded
microprocessor, memory and a secure operating system. Smart cards have
significant advantages over PC Cards, including lower cost, portability and
greater durability. Smart cards have been used in applications such as stored
value cards, either for making general purchases or for specific applications
such as prepaid telephone calling cards, and as health care cards, which are
used to store patient and provider information and records. Smart cards are
useful as health care cards because they identify the holder for insurance or
government payment purposes and store health records that can be accessed and
updated by health care providers.
Smart card use for these applications has become widespread in Europe,
where the existence of multiple languages and currencies has created a demand
for common solutions that enable businesses and consumers to conduct their
affairs effectively and efficiently while moving from country to country.
According to Dataquest, the European market for smart cards has far outpaced
that of the United States. Dataquest estimates that in 1995 the U.S. accounted
for approximately 10 million units, or 2%, of the 544 million unit worldwide
microprocessor-based smart card market, and projects that the worldwide market
will grow to 3.4 billion units by 2001. By the year 2001, Dataquest estimates
that Europe, Asia/Pacific and the Americas will account for 40%, 25% and 20%,
respectively, of this market.
In addition to providing a common record-keeping and stored value solution
across multiple languages and currencies, SCM believes that smart cards are
ideally suited to serve as tokens for network and electronic commerce security.
Microsoft and Netscape have both endorsed smart cards as key components of their
respective data security architectures, have released application program
interfaces, or APIs, for smart cards and have incorporated smart card access or
smart card security features into Microsoft Windows NT 5.0 and Netscape
Communicator 5.0, respectively. Sun Microsystems has released a Java API for
smart cards and has integrated SCM's SmartOS smart card interface architecture
and Smart Transporter chip into the next generation of its Java Station, which
is expected to begin shipping in the summer of 1998. SCM believes that these
companies, together with other enterprises with a financial stake in securing
access to digital data and enabling secure electronic commerce such as VeriSign,
Security Dynamics and Intel will drive the adoption of smart card technology for
security applications in the United States. SCM also believes that as smart
card-based security systems become accepted in the United States, users outside
the United States will adopt similar systems.
There are several reasons for these endorsements of smart card-based data
security solutions. Key end-user benefits include ease-of-use, low cost,
convenience and durability. Even more compelling is the architectural simplicity
of these systems. E-mail messages, purchase orders, credit card numbers, video
clips, data inquiries and other confidential transmissions are secured as they
are sent. Therefore, these secure transmissions can be opened only by the
intended recipient, thus eliminating many of the security weakpoints of the
communications infrastructure between the parties. Other solutions such as
firewalls, secure modems and SSL software may continue to be used or added
without interfering with the smart-card based security. SCM believes that smart
cards provide the easiest, most flexible, most cost-effective way to achieve the
key benefits of a secure, authenticated transaction between two or more parties
regardless of the specific infrastructure between them. The smart card
initiatives launched by the companies discussed in the preceding paragraph
indicate that this view is shared by some other significant companies in the PC,
LAN, WAN, Internet and digital content industries.
To date, a number of factors have limited broad adoption of smart cards as
security tokens. These factors include the requirement for special purpose
readers which have been expensive and therefore not widely deployed and the lack
of standards governing the operating systems, communication protocols, APIs and
similar features of the tokens. These factors have resulted in the deployment of
proprietary, closed, smart card reader systems that are not compatible with
other systems. In addition, smart cards are relatively low speed serial
interface devices which, although capable of providing encryption of passwords
or other limited data, are
3
<PAGE> 5
not capable of providing the real-time bulk encryption/decryption required for
many secured access applications.
DIGITAL VIDEO BROADCASTING
Digital Video Broadcasting, or DVB, involves the transmission of video
signals in a digital format. In contrast to the traditional analog approach,
digital signals allow content providers ranging from broadcast television
stations and cable carriers to specialty programming producers to deliver very
high resolution, high quality video images. DVB may take the form of direct
satellite broadcast services or digital cable services and, in the near future,
direct broadcast digital television. DVB makes it possible to provide a broader
range of private content and nontraditional services than previously available.
Businesses, educational institutions and other enterprises could broadcast
private content such as product information updates and training or educational
content to users in disparate locations, or could provide various interactive
products and services via the DVB medium. SCM believes that a primary challenge
for broadcasters will be to limit access to their content to the intended users
such as those who have purchased appropriate subscriptions or event-by-event
pay-per-view privileges.
The traditional approach to controlling access has been to sell or lease
proprietary set-top boxes (and, in the case of direct satellite broadcast, a
satellite dish receiver) to subscribers. These set-top boxes descramble digital
signals and then convert them into analog signals in order to be compatible with
the viewer's analog television. While this approach provides the controlled
access desired by broadcasters, it limits the range of content available to the
consumer. Consumers wishing to obtain content or services from more than one
provider would be required to purchase multiple proprietary set-top boxes.
Similarly, the use of proprietary set-top boxes may limit broadcasters' ability
to upgrade systems that have already been installed in their customers' homes
without a costly replacement process.
To address the limitations of the closed-system set-top box in Europe, the
DVB Project, an international consortium of over 170 enterprises involved in
varying aspects of DVB including France Telecom, Deutsche Telekom, Nokia, Sony
and Philips, has developed the DVB-CI standard. This standard makes it possible
to deliver a universal set-top box capable of receiving content from a variety
of providers. The universal set-top box requires use of a smart card token that
"unlocks" the specific services to which a consumer has subscribed. With this
approach, multiple service providers can deliver digital content to the same
"open" set-top box and consumers, using the appropriate conditional access
module, can access the content to which they have subscribed. When consumers
subscribe to different or additional content services or parents seek to limit
the viewing privileges of their children, the service providers need only
provide the appropriate smart card to allow access to the new or additional
services. The DVB-CI standard addresses the limitations of the closed-system
set-top box by making it possible: (a) for broadcasters to upgrade systems
installed in their customers' homes by downloading new operating system software
onto the universal set-top box; (b) for customers to use one universal set-top
box to access digital content from various service providers by inserting the
appropriate conditional access module for each particular service provider; and
(c) for service providers to secure access to new or additional services by
issuing new tokens coded for access to such services.
SCM believes that the members of the DVB Project and other interested
enterprises will continue to drive the adoption of DVB-CI as the European
standard for conditional access to digital content. Moreover, legislation has
been enacted in Spain (and may be enacted elsewhere in the future) mandating
that set-top boxes comply with the DVB-CI standard in order to assure broad
access to digital content without requiring consumers to purchase multiple
set-top boxes. In addition, in the United Kingdom, the British Digital
Broadcasting Consortium has defined a reference design for set-top boxes for the
British digital television market that is compliant with the DVB-CI standard. In
the United States, the NRSS Committee has proposed the NRSS-B standard for a
conditional access system which is substantially similar to the DVB-CI standard.
In February 1998, CableLabs, a research and development consortium of cable
television system operators including most of the largest multi-system
operators, or MSOs, in the United States, adopted a standard for a point of
development module as part of the OpenCable specification. The point of
development module is a PCMCIA Type II extended device which incorporates a
smart card reader and conditional access software to provide flexible
4
<PAGE> 6
security for digital set-top boxes. This OpenCable standard is an extension of
the NRSS-B standard. SCM believes that similar standards may be adopted in
certain Asian countries in the future.
SCM believes that successful implementation of the DVB-CI, OpenCable and
similar standards will require the development of hardware that is capable of
real time, high bandwidth decryption of the video signal and is remotely
updatable to permit providers to offer new content and services without the need
to replace equipment. While the current implementations of these standards use
set-top boxes, SCM believes that as the standards evolve and as flexible
hardware solutions become available, the DVB-CI and OpenCable capability will be
built directly into televisions, PCs and network computers. These devices would
then contain the appropriate DVB token slot and reader capabilities, thereby
eliminating the need for the separate set-top box while providing the same smart
card-based conditional access of current systems.
THE SCM MICROSYSTEMS SOLUTION
We provide OEMs with key standards-compliant enabling hardware, firmware
and software products and technologies used in smart card and other token-based
network security systems and conditional access to DVB content and services.
Through the use of our extensible core technologies, we are able to offer
products that address the specific needs of diverse market applications such as
enterprise data security, electronic commerce and DVB conditional access.
Enterprise Data Security and Electronic Commerce. Our products address the
needs of the enterprise data security and electronic commerce markets as
described below.
PCMCIA BRIDGES FOR SMART CARDS. We offer a range of products which enable
smart cards to be read and written through standard PCMCIA ports. This
eliminates the requirement for special purpose smart card readers and provides
interoperability between smart cards and PCs, network computers and other
devices equipped with standard PCMCIA ports.
STANDARDS-BASED, INTEROPERABLE PRODUCTS. Our products employ an
open-systems architecture that provides compatibility across a range of hardware
platforms and software environments. Our products are remotely upgradeable so
that compatibility can be maintained as the security infrastructure evolves.
SPEED AND PERFORMANCE. Some of our smart card reader products transparently
extend the speed and performance capabilities of smart cards used as security
tokens by including encryption/decryption capabilities. By this approach, smart
cards are used as keys to activate the encryption/decryption capabilities of the
reader thus eliminating the speed and performance limitations inherent in smart
cards.
Digital Video Broadcasting. Some of our products address the needs of the
DVB market as described below.
INEXPENSIVE, EASY TO DELIVER CONDITIONAL ACCESS MODULES. We provide smart
card-based conditional access readers and modules that adhere to the DVB-CI and
OpenCable standards. These products enable digital content and service providers
to control and meter access to content and services through the use of
inexpensive smart cards.
REAL TIME, HIGH-BANDWIDTH DESCRAMBLING CAPABILITIES. Our products are
structured to use smart cards as keys to activate the high-bandwidth
capabilities of PC Cards. By this approach, smart card-based tokens, which by
themselves are not capable of descrambling digital video data at the rate
required for digital video broadcast, can still be used to control and meter
access to DVB content and services.
REMOTE UPGRADE CAPABILITIES. Our DVB products incorporate read/write
capabilities that permit content and service providers to perform a virtually
no-cost upgrade of users' access rights as new products and services are
developed and introduced and as users' subscriptions change.
STRATEGY
Our objective is to utilize our expertise in smart card technologies,
digital platforms, and our extensible, updatable smart card interface
architecture to meet the growing demand for secure access to digital
5
<PAGE> 7
information and networks. We believe we are well positioned to capitalize on the
significant growth projected for smart card-based security and controlled access
systems. Key elements of our strategy include the following:
Leverage Technology Base; Support Open Systems and Interoperability. We
have developed extensive expertise and intellectual property in both PCMCIA and
smart card technologies. We intend to continue to leverage this technology base
to provide smart card products that can operate across a variety of hardware
platforms and software environments. This technology incorporates upgradeable,
firmware-based features which enable smart card readers to be upgraded as new
smart card operating systems and communication protocols are adopted. In
addition to enabling us to respond quickly to industry developments with
properly tailored products, this upgradeable architecture protects the
investments in smart card hardware.
Expand Range of Product Applications. Most of our current products are
designed to provide flexible interoperability between smart cards and PCs or
set-top boxes. We intend to expand the range of our product offerings to address
specialized applications such as health care records and identification,
televisions and television set-top boxes, customer loyalty programs, personal
identification and Internet and intranet access. In addition, we have developed
chip-level versions of some of our products in order to reduce their cost and
facilitate their easy integration into future generations of televisions, PCs,
NCs and other digital platforms. These include our SmartTransporter chip for
smart card readers and CIMax DVB-CI chip for the DVB-CAM market. We intend to
continue to develop silicon-level versions of, and to pursue silicon-level
integration of, our products in an effort to increase the effectiveness of our
products and reduce their cost.
Increase Penetration of Major OEM Customers; Expand Customer Base. We
currently sell our products to a number of OEM customers including Dell, Hughes,
Kirch Group (BetaDigital), Micron, Packard Bell, Siemens/Nixdorf, Sysorex and
Telenor. We intend to pursue additional opportunities with our existing
customers by leveraging our relationships to increase sales. For example, our
existing customer relationships provide us with insight into the current and
future needs of these customers, enabling us to design specific products to meet
the additional product needs of each customer. In addition, we attempt to locate
our technical, sales and marketing resources close to our OEM customers in order
to provide the highest level of service to our customers. Moreover, we believe
that as the needs for data security increase and smart cards gain wider market
acceptance, a significant number of additional participants will enter the
market, we intend to expand our customer base by pursuing opportunities with
these new market entrants.
Expand Strategic Industry Relationships. We have formed strategic
relationships with a number of key industry players such as Gemplus, Intel and
Telenor. These relationships provide us with access to leading edge technology,
marketing and sales leverage and access to key customers and accounts. We intend
to continue to leverage these relationships and to identify additional key
industry players with which to form strategic relationships. See
"-- Collaborative Industry Relationships."
Support Standards Setting Organizations. We intend to continue to
participate in the standards setting activities for the industries we serve. We
are a founding member of the PCMCIA and the DVB Project and support the Common
Data Security Access standard developed by Intel and adopted by Netscape. Our
products are compliant with the RSA public key cryptographic system number 11,
or PKCS #11, standard. Through our participation in standards setting
organizations, we contributed to the adoption of the DVB-CI specification as the
standard by the PCMCIA. In addition, we were instrumental in proposing and
developing the conditional access module adopted as part of the OpenCable
specification for the U.S. cable television market. We intend to maintain an
active role in these and other standards setting groups in order to continue to
have our technologies adopted as standards where appropriate and to keep
apprised of technological advancements as they are developed.
Acquire Complementary Technologies, Products and Companies. We believe that
opportunities exist to expand the range of conditional access and data security
products, and to expand our sales and marketing operations in key markets by
acquiring or licensing complementary technologies and products and by acquiring
companies engaged in complementary businesses. In 1998 we made several
acquisitions and we intend to pursue additional acquisitions and similar
opportunities in the future.
6
<PAGE> 8
TECHNOLOGY
SCM believes that smart cards are ideally suited to serve as tokens for
digital information security. A smart card is a credit card-sized plastic card
which contains a microprocessor, memory and a secure operating system. The card
is inserted into a device that reads the information contained on the card and
performs an appropriate function. We have used our extensible smart card
interface architecture to develop open and standard products that support many
different smart cards regardless of the manufacturer, are accessible through a
variety of operating systems and platforms and enable a wide range of secure
applications. Our extensible smart card interface architecture consists of
certain core technologies which provide this interoperability as described
below.
Chip-Level Integration. We have implemented a number of our core products
and technologies into custom silicon devices. These include the SmartTransporter
chip, the CIMax DVB-CI chip and a custom PCMCIA controller based on technology
licensed from Intel and optimized by us.
Silicon and Firmware for Smart Card Readers. We have developed physical
interface technology which provides interoperability between PCs and smart cards
from many different smart card manufacturers. Our interoperable architecture
includes an ISO compliant layer as well as an additional layer for supporting
non-ISO compliant smart cards. Through our proprietary integrated circuits and
firmware, our smart card readers can be updated electronically to accommodate
new types of smart cards without the need to change the reader's hardware. Intel
Corporation has become the first company to license our smart card interface.
Proprietary PC Card Cases. Each of our proprietary PC Card cases ensures
that the smart card is positioned correctly into the PC Card reader. This
hardware technology solves the problem presented by the fact that smart cards
and PC Cards have the same width and length. In addition, we have entered into
technology licensing agreements with Gemplus and, more recently, Schlumberger,
two of the largest smart card manufacturers in the world, in order to provide
SCM with broader intellectual property rights in this area.
Proprietary Software. We have developed a flexible proprietary software
architecture for real-time downloading of firmware for new smart card protocol
handling requirements into a flash memory chip which resides on the smart card
reader. This software, combined with our proprietary integrated circuits and
firmware described above, allows the reader to accommodate new types of smart
cards without the need to change the reader's hardware. Additionally, SCM has
developed "flash filing" software, which enables PCMCIA flash memory to function
as a flash disk. SCM has filed patent applications with respect to both software
applications.
Hardware for PC Card Adapters. SCM has developed the interface technology
to accommodate multiple PCMCIA slots for ISA, SBus (Sun Microsystems) and PCI
bus structures, thus enabling desktop PCs and workstations to be equipped with
PCMCIA slots. In particular, we have developed a patented dual cable solution
with special grounding and termination methods which prevents signal
interference between the PCI/ISA bus slots and a large variety of PC Cards.
PRODUCTS
By bridging smart cards and other secure devices with PCs, workstations and
set-top boxes, our security products provide cost-effective solutions for
conditional access to mobile and desktop computers, workstations, DVB, virtual
private networks, electronic files, e-mail, the Internet and secure electronic
commerce. Our security products have been developed utilizing SCM's core
competencies in smart card and PC interoperability, PC Card expertise and flash
memory chip experience, and all are compliant with the PKCS #11 standard. Since
our acquisitions of Intermart Systems K.K. and Shuttle Technology Group Ltd. in
1998, we
7
<PAGE> 9
now provide products used to exchange information from devices such as digital
cameras and audio recorders to most computers. We provide high quality,
easy-to-use solutions in the following product categories:
<TABLE>
<CAPTION>
PRODUCT CATEGORY FEATURES
---------------- --------
<S> <C>
SWAPBOX PC CARD ADAPTERS - A peripheral with a PC Card slot that enables desktop PCs
(introduced in 1993) and workstations to accept all sizes of PC Cards (Types I,
II and III)
- Supports a wide variety of PC Card peripherals, including
Ethernet, fax/data modems, SCSI, ATA hard drives, flash
memory, GPS and Fortezza cards
- Available in wide variety of configurations (single and
dual slots, front and rear access, floppy/PC combination)
- Supports a wide variety of platforms (Win 3.X, 95, NT,
OS/2, DOS, Solaris, Unix) and architectures (ISA, PCI, SBus,
USB, EPP, SCSI)
- Compliant with the PCMCIA standard
SWAPSMART SMART CARD READERS - A smart card reader that fits in a PC Card slot
(introduced in 1995) - Supports all ISO 7816 smart card protocols as well as
asynchronous and synchronous smart cards, and supports
dual or single card applications
- Incorporates an upgradeable firmware-based chip set so
that the reader can be automatically updated with additional
smart card operating systems, protocols and emerging
industry standards
- Supports a wide variety of platforms (Win 3.X, 95, NT,
OS/2, DOS, Solaris, Unix) and architectures (ISA, PCI)
- Compliant with the PCMCIA standard
SWAPACCESS DVB-CAM MODULES - A multi-function PC Card that can include smart card
(introduced in 1996) read/write capabilities, MPEG2 descrambling, DVB
descrambling and pay-per-view functions
- Utilizes a smart card to control access to digital content
- Enables "open" set-top boxes
- Compliant with the DVB-CI and OpenCable standards
SMARTOS UNIVERSAL SMART CARD - A chip and accompanying software which provides a
INTERFACE ARCHITECTURE WITH cost-effective universal smart card reader interface easily
SMARTTRANSPORTER CHIP integrated into a wide range of devices
(introduced in 1997) - Supports all ISO 7816 smart card protocols, as well as
synchronous and asynchronous smart cards
- Software upgradeable to support new smart card protocols,
functions and industry standards
- Includes dual smart card support, serial and parallel
interfaces, LCD and keypad controls
CIMAX DVB-CI COMMON INTERFACE - The hardware extension of SCM's second generation common
CHIP HARDWARE CONTROLLER interface integration package (CI Pack+) that enables
(introduced in 1998) common interface driver software to directly address two
complete independent common interface modules
- Includes the necessary I/Os to interface the MPEG
Transport stream generated by the receiver demodulator and
to daisy chain it through two modules and back to the
demultiplexer
- Interfaces with major digital television microprocessors
- Includes a memory mode that allows the use of any of the
two common interface slots to read/write an 8-bit PC Card
memory card
</TABLE>
8
<PAGE> 10
<TABLE>
<CAPTION>
PRODUCT CATEGORY FEATURES
---------------- --------
<S> <C>
COMPACT FLASH, SMART MEDIA AND - An external device that enables high-speed data transfer
MULTI-MEDIA CARD READERS from any variety of small form-factor storage media to a PC
(part of 1998 acquisitions or laptop.
of Intermart and Shuttle) - Reads all major digital media (compact flash, smart media
and multi-media card)
- Interfaces with the PC or laptop through a variety of
portals (USB, RS-232, parallel, and SCSI)
INTELLIGENT CABLES AND ASICS - Finished products or custom application-specific
FOR CONNECTIVITY SOLUTIONS integrated circuits ("ASICs") which enable virtual any
(part of 1998 acquisition of digital devices such as scanners, printers, digital
Shuttle) cameras, and high-speed disk drives to interoperate with a
host platform (PC, laptop, etc.) through any of its
interfaces (USB, RS-232, PCMCIA, parallel, and SCSI)
- Customized designs for OEMs which significantly reduce
their time-to-market
</TABLE>
SWAPBOX PC CARD ADAPTERS
Desktop PCs and workstations, in contrast to laptop and notebook PCs,
generally do not come equipped with PC Card slots. Our SwapBox products are
devices with PC Card slots designed to be installed by OEMs into desktop
computers, workstations and servers. Coupled with PC Card security tokens, cards
or smart card readers such as our SwapSmart reader, SwapBoxes allow enterprises
to effectively provide authentication, integrity and confidentiality services.
Flash memory cards are widely used with SwapBoxes and our proprietary SwapFTL
software for data collection applications. SwapBoxes accept any PC Card
compliant cards including readers for small form factor memory devices such as
Compact Flash, SSFDC, Multimedia and Miniature Cards, allowing flash memory
cards to be connected to PCs for quick and easy exchange of electronic images,
digital audio recordings and text files.
SWAPSMART SMART CARD READERS
The SwapSmart reader is a device in a PC Card form factor that provides a
portable, universal, secure and cost effective bridge between smart cards and
the mobile PC or other products which have PC Card slots. The SwapSmart reader
supports all ISO 7816 smart card protocols as well as asynchronous and
synchronous smart cards. Furthermore, because the SwapSmart reader incorporates
an upgradeable firmware-based chip set, the functionality of SwapSmart products
can be remotely updated as additional smart card operating systems and protocols
come into use. In addition to broad smart card support, the SwapSmart reader is
easily accessible from a wide variety of operating systems and platforms. The
SwapSmart reader enables easy access to the growing number of smart card
applications such as network, virtual private network and firewall security as
well as local and remote computer access control. Additionally, the SwapSmart
reader makes it possible to use smart cards for user authorization and
authentication, for e-mail and for secure transactions required for electronic
commerce. Because of its encryption capabilities, the reader is well suited for
security applications, particularly mobile computing security.
Currently, we are working with Microsoft's PC/SC Workgroup, Netscape's
Security Infrastructure group and Sun Microsystems to ensure that our smart card
interface products support the new open specifications for integrating smart
cards with PCs, NCs and workstations. By supporting a wide range of smart cards
and complying with the open standards set by the PC/SC Workgroup, SCM's smart
card interface products provide maximum interoperability among smart cards and
easy access to smart card applications for mobile or desktop PCs. For example,
the SwapSmart reader is compliant with the B1 specification for smart card
readers developed by Deutsche Telekom, as well as the Common Data Security
Access specification developed by Intel and adopted by Netscape for use in
Netscape Communicator.
9
<PAGE> 11
SWAPACCESS DVB-CAM MODULES
By combining our smart card interface technology with the proprietary
descrambling code of a digital content provider, our SwapAccess DVB-CAM provides
a cost-effective means of controlling access to digital broadcasts through the
use of a PC Card. SwapAccess is an all-in-one PC Card that utilizes a smart card
to determine if a viewer has access to a given content provider's service. If
the viewer is authorized, SwapAccess descrambles the signal for viewing.
SwapAccess is the world's first implementation of the DVB-CI standard. Our
DVB-CAM technology enables a variety of critical functions including
video-on-demand, pay-per-view, interactive video, home shopping, home banking
and games. Since SwapAccess can be used in any DVB-CI or NRSS-B compliant "open"
set-top box, it allows acceptance of a single solution for different set-top box
systems. We believe that the use of smart card technology combined with the
DVB-CI or NRSS-B standard will eliminate the need for multiple set-top boxes in
order for users to access a broad range of desired broadcast data. SwapAccess
has already been selected, directly and indirectly, by many companies in Europe,
including major content providers such as France Telecom, Telenor (Norway
Telecom) and The Kirch Group (BetaDigital); consumer electronics companies such
as Nokia, Panasonic, Galaxis, Philips and Toshiba; and broadcasters such as BBC,
ITV (UK), Channel 4 (UK), Granada (UK), Carlton (UK), Telefonica (Spain) and SVT
(Sweden). In February 1998, CableLabs, a research and development consortium of
cable television system operators including most of the largest MSOs in the
United States, adopted a standard for a point of deployment module as part of
the OpenCable specification. The OpenCable standard is an extension of the
NRSS-B standard. SwapAccess is fully compliant with the NRSS-B and OpenCable
standards as currently proposed. We have been active and remain active in the
definition and adoption of the NRSS-B and OpenCable standards, and intend to
keep SwapAccess compliant with such standards as they evolve. We believe that
similar standards may be adopted in certain Asian countries in the future.
SMARTOS SMART CARD INTERFACE ARCHITECTURE; SMARTTRANSPORTER CHIP
SmartOS utilizes the SmartTransporter chip and a unique firmware technology
to make it possible to easily integrate smart cards with a wide variety of PC
and stand-alone devices, thus allowing companies to integrate smart card support
cost-effectively within desktop, notebook or network computers, USB or serial
devices and keyboards as well as point of sale (POS) terminals and vending
machines. The SmartOS solution allows integrators to utilize only essential
components to control cost and maximize design flexibility. Many hardware
designs, such as a keyboard or network computer, may already incorporate a
controller chip but lack an interface unit and firmware for the completion of a
smart card reader solution. Instead of being forced to purchase all components,
the SmartOS solution offers just those components an integrator needs and those
tools necessary for the quick implementation of smart card readers at a minimum
cost.
CIMAX
The CIMax controller is the hardware extension of our second generation
common interface integration package (CI Pack+) that enables CI Driver software
to directly address two complete independent common interface modules. We
believe that CIMax offers a solution for digital television manufacturers that
want to quickly implement common interface. CIMax includes the necessary I/Os to
interface the MPEG Transport stream generated by the receiver demodulator and to
daisy chain it through two modules and back to the demultiplexer. CIMax
interfaces with major digital television microprocessors and includes a memory
mode that allows to use any of the two common interface slots to read/write at
8-bit and PC Card memory card. This features gives the receiver memory extension
capability for software upgrades and better performance.
COMPACT FLASH, SMART MEDIA AND MULTI-MEDIA CARD READERS
Our range of digital media readers enable easy, high speed transfer of the
data between any of the three primary digital media form factors (compact flash,
smart media and multi-media card) and the PC. They provide a "bridge" between
the consumer electronic device and the personal computer, and are a major factor
10
<PAGE> 12
in the race to provide greater usability and functionality for the end user. Our
readers meet OEM customers' needs because of their wide range of functionality,
interface capabilities and low cost.
INTELLIGENT CABLES AND ASICS FOR CONNECTIVITY SOLUTIONS
Many digital devices such as scanners, digital cameras, hard disk drives,
CD, DVD, tape and other removable storage products require high speed
connectivity to PCs and Apple computers. We work closely with the OEM customer
to ensure total compatibility, bringing products to the market faster and at
less cost. Our intelligent cables and custom ASICs support all operating
systems, and enable customers to focus on their products' core functionality.
Our intelligent cables and ASICs enable interconnectivity through RS-232,
parallel, PCMCIA and recently-introduced USB ports, providing versatility and
extended functionality to our customers' products.
CUSTOMERS AND APPLICATIONS
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 1998, sales to BetaDigital, a division of the Kirch Group, accounted
for 17% of total net sales and sales to our top 10 customers accounted for 51%
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.
See "Factors That May Affect Future Operating Results -- We Depend on Our
Continued Sales to Original Equipment Manufacturers."
Examples of applications of our products include the following:
The Kirch Group. We have developed and provide DVB-CI compliant and
proprietary DVB-CAM modules under contract to BetaDigital, the technology arm of
the Kirch Group. These modules are installed in DVB compliant set-top boxes
which Kirch distributes to consumers to allow them to access the Kirch digital
entertainment services. These set-top boxes include a smart card, our smart card
readers and a generic receiver/tuner unit to provide secure access to its
entertainment content and services. Customers can easily add and change the
services they receive, and Kirch can easily enable and disable services. Also,
individual customers can have different smart cards which permit different
services. Although used in the same set-top box, a child's smart card could
permit different programming from a parent's smart card. Kirch also can download
completely new services to the modules, permitting new capabilities, such as
pay-per-view and other electronic transaction-based services, to be added with
no additional hardware cost. SwapAccess is the world's first implementation of
the DVB-CI standard established by the DVB Project. The principal reason for
Kirch's selection of SCM's products was their ability to provide Kirch's
customers with an open system that could be upgraded for new functions.
ADI. ADI is a leading provider of Microsoft PC/SC-compliant security and
banking software for the German home banking market. As a result of our ability
to support both market specific standards such as the German Home Banking
Computer Interface, or HBIC, as well as open standards such as PC/SC, we have
been selected to work with, among others, ADI and Giesecke & Devrient, a major
German smart card vendor, to produce a complete, smart card-based security
solution for the German home banking market. The combined solution, which we
believe is the first major PC-based consumer application for smart card readers,
was demonstrated at CeBIT in March 1998 and at a Microsoft-sponsored event in
April for the U.S. banking industry. Volume shipments in Germany are expected to
begin in the second half of 1999.
Philips. We have developed a DVB-CI compliant conditional access module, or
CAM, incorporating Philips' CryptoWorks conditional access system, or CAS. This
enables Philips to provide their own CAS to open markets. As one of the leading
consumer electronics companies worldwide, Philips is making available DVC-CI
compliant set top boxes and CAMs, both through digital entertainment providers
and retail consumer electronics outlets.
11
<PAGE> 13
SALES AND MARKETING
We market, sell and license our products primarily to OEMs, and also
through distributors, value added resellers, or VARs, system integrators and
resellers, worldwide through a direct sales and marketing organization. As of
December 31, 1998, we had 59 full-time employees and consultants engaged in
sales and marketing activities. Our direct sales staff solicits prospective
customers, provides technical advice and support with respect to our products
and works closely with customers, distributors and OEMs.
With our acquisitions of Intermart, ICS and Shuttle, we strengthened our
sales and marketing presence in Japan, Singapore, the United Kingdom and in the
U.S. Intermart has OEM relationships with Nikon, Fuji Film and other major
Japanese companies and has sales, marketing and engineering operations in Japan
and the United States. In addition, ICS is our distribution arm in Southeast
Asia, and has business relationships and OEM customers throughout the region.
Shuttle has sales and marketing based primarily in the U.K. and U.S., serving
OEM customers such as Hewlett-Packard, Iomega and Olympus worldwide. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operation -- Overview."
In support of our sales efforts, we conduct sales training courses,
comprehensive targeted marketing programs, including public relations,
advertising, seminars, trade shows and ongoing customer and third-party
communications programs. We also seek to stimulate interest in digital
information security through our public relations program, speaking engagements,
white papers, technical notes and other publications.
At December 31, 1998, our backlog was approximately $27.0 million, as
compared to approximately $13.8 million at December 31, 1997. Our backlog
consists of all written purchase orders for products which have a scheduled
shipment date within the next six months. Orders for our products are usually
placed by customers on an as-needed basis and we have typically been able to
ship products within 30 days after the customer submits a firm purchase order.
Our customer contracts generally do not require fixed long-term purchase
commitments. In view of our order and shipment patterns and because of the
possibility of customer changes in delivery schedules or cancellation of orders,
our backlog as of any particular date may not be indicative of sales in any
future period.
COLLABORATIVE INDUSTRY RELATIONSHIPS
We are party to collaborative arrangements with a number of corporations
and are a member of key industry consortia. We evaluate, on an ongoing basis,
potential strategic alliances and intend to continue to pursue such
relationships. Our future success will depend significantly on the success of
our current arrangements and our ability to establish additional arrangements.
These arrangements may not result in commercially successful products.
Gemplus. In September 1997, SCM and Gemplus, a leading smart card
manufacturer, reached an agreement to explore cooperative opportunities in
several areas. The agreement includes the development of a single smart card
reader chip and software core to form the basis of a family of smart card
readers to be sold by both companies as well as the development of
next-generation smart card readers. SCM and Gemplus have also agreed to examine
joint marketing and market development activities and joint manufacturing
opportunities. The two companies also believe that standard setting will
accelerate market acceptance of both companies' products and so have agreed to
explore joint use of a single DVB-CAM based on the DVB-CI standard and joint use
of a single PCMCIA smart card reader. The companies are not required, however,
to reach a binding cooperative agreement covering any of the foregoing items and
there can be no assurance that they will reach such an agreement. Nonetheless,
as an initial step in this cooperation, we have entered into a cross-license
agreement with Gemplus for PCMCIA-based smart card reader technology, DVB-CI
technology, and related patents and intellectual property.
Intel Corporation. In March 1997, SCM and Intel entered into a development
and license agreement for cryptographic PC Card-based secure access modules for
the PC platform. We have granted Intel a non-exclusive license to certain of our
designs and other intellectual property. Intel has agreed to support our
programs to design a PC Card token. Intel and SCM have agreed to jointly promote
various industry standards applicable to security products.
12
<PAGE> 14
Telenor. In May 1997, SCM and Telenor entered into a development and supply
agreement pursuant to which we will design, manufacture, test and supply next
generation DVB-CAM modules to Telenor. Pursuant to this agreement, Telenor may
pay up to an aggregate of $1.2 million to us for development costs as we achieve
certain development milestones. Once the prototype has been approved by Telenor,
we will supply these modules pursuant to the terms of the agreement. As part of
this arrangement, each party will retain rights to its preexisting intellectual
property, and it is expected that any intellectual property that is jointly
developed under the agreement will be jointly owned.
PCMCIA. We are an executive and founding member of PCMCIA, an international
standards body and trade association with over 500 member companies. PCMCIA was
founded in 1989 to establish standards for integrated circuit cards and to
promote interchangeability among mobile PCs. Other executive members include
Advanced Micro Devices, Apple Computer, Compaq, IBM, Intel, Motorola, Texas
Instruments and U.S. Robotics. Since 1990, we have been a member of PCMCIA in
Europe and currently hold the European Chair position. In 1996, we introduced to
PCMCIA the DVB-CI standard which was adopted as an extension to its PC Card
standard Release 2.0.
DVB Project. We are a member of the DVB Project, an international standards
body with over 200 members that was founded in 1993 to define platforms for the
digital television industry. Other key members include France Telecom, Deutsche
Telekom, Telenor, Nokia, Sony and Philips. In 1994, we were instrumental in the
DVB Project's adoption of the PC Card standard as the common interface for
digital set-top boxes. As the DVB Project's Compatibility Chair, we advance and
oversee proposals to provide optimum interoperability between PC Cards and
digital set-top boxes.
Teletrust. We are a member of Teletrust, a German organization whose goal
is to provide a legally accepted means to adopt digital signatures. Digital
signatures are encrypted personal identifiers, typically stored on a secure
smart card, which allow for a high level of security through internationally
accepted authentication methods. We are actively working on the smart card
terminal committee which defines the standards for connecting smart cards to
computers for applications such as secure electronic commerce over the Internet.
RESEARCH AND DEVELOPMENT
To date, we have made substantial investments in research and development,
particularly in the areas of physical, token-based access devices. Our
engineering design teams work cross-functionally with marketing managers,
applications engineers and customers to develop products and product
enhancements. We also strive to develop and maintain close relationships with
key suppliers of components and technologies in order to enable us to quickly
introduce new products that incorporate the latest technological advances. Our
future success will depend upon our ability to develop and to introduce new
products on a timely basis that keep pace with technological developments and
emerging industry standards and address the increasingly sophisticated needs of
our customers.
Our research and development expenses were approximately $6.4 million, $4.5
million and $3.2 million for the years ended December 31, 1998, 1997 and 1996,
respectively. As of December 31, 1998, we had approximately 106 full-time
employees engaged in research and development activities, including software and
hardware engineering, testing and quality assurance and technical documentation.
All of our research and development activities occur in France, Germany, and
India. We have in the past funded a portion of its research and development
activities with technology development revenues received from OEM customers in
connection with design and development of specific products. We recognized $2.8
million, $1.4 million and $1.6 million in technology development revenues in
1998, 1997 and 1996, respectively.
MANUFACTURING AND SOURCES OF SUPPLY
We source our products through three contract manufacturers in Europe and
Asia. We have implemented a global sourcing strategy that we believe will enable
us to achieve greater economies of scale, improve gross margins and maintain
uniform quality standards for our products. In the event any of our contract
manufacturers were unable or unwilling to continue to manufacture our products,
we may have to rely on
13
<PAGE> 15
other current manufacturing sources or identify and qualify new contract
manufacturers. Any significant delay in our ability to obtain adequate supplies
of our products from current or alternative sources would harm our business and
operating results.
We believe that our success will depend in large part on our ability to
provide quality products and services. As of December 31, 1998, we had 76
full-time employees engaged in manufacturing activities. We have a formal
quality control program to satisfy our customers' requirements for high quality
and reliable products. To ensure that products manufactured by others are
consistent with our standards, we manage all key aspects of the production
process, including establishing product specifications, selecting the components
to be used to produce our products and the suppliers of these components and
negotiating the prices for these components. In addition, we work with our
suppliers to improve process control and product design. Our quality control
specialists conduct on-site inspections of our suppliers, and our products are
tested by our contract manufacturers prior to shipment.
In connection with our acquisition of ICS, we acquired all of ICS's
manufacturing facilities in Singapore. We believe that ICS's engineering
resources in Singapore, its familiarity with our product lines and its
experience in marketing smart card solutions in Southeast Asia are complementary
to our business. We also believe that the acquisition of ICS will lower the cost
of our products and hence enhance our competitiveness and improve gross margins.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Overview."
We rely upon a limited number of suppliers of several key components of our
products. For example, we currently purchase ASICs for our DVB modules
exclusively from TEMIC, PCBs for SwapBoxes exclusively from Vertek in Taiwan and
Degussa in Singapore, smart card connectors exclusively from ITT Canon and
SwapSmart mechanical components exclusively from Stocko. 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.
COMPETITION
The market for digital data security and access control 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;
- Gemplus, 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 certain of our customers which
currently offer alternative products or are expected to introduce competitive
products in the future. We may in the future face competition from these and
other parties that develop digital data security products based upon approaches
similar to or different from those employed by us. In addition, the market for
digital information security and access control products may ultimately be
dominated by approaches other than the approach marketed by us.
Many of our current and potential competitors have significantly greater
financial, technical, marketing, purchasing and other resources than we do, and
as a result, may be able to respond more quickly to new or emerging technologies
or standards and to changes in customer requirements, or to devote greater
resources to the development, promotion and sale of products, or 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. Accordingly, it is possible that
new competitors or alliances among competitors may emerge and
14
<PAGE> 16
rapidly acquire significant market share. Increased competition is likely to
result in price reductions, reduced operating margins and loss of market share,
any of which could harm 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 support industry standards and provide
interoperability;
- technical features;
- ease of use;
- quality/reliability;
- level of security;
- strength of distribution channels and price.
While we believe that we compete favorably with respect to these factors,
we may not be able to successfully compete as to these or other factors and
competitive pressures we face will not materially and adversely affect our
business and operating results.
PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY
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. We seek to protect our software, documentation and other
written materials under trade secret and copyright laws, which afford only
limited protection. We generally enter 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 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.
EMPLOYEES
As of December 31, 1998, we had a total of 293 full-time employees, of
which 106 were engaged in engineering, research and development; 59 in sales and
marketing; 76 in manufacturing; and 52 in general management and administration.
In addition, we had a total of six part-time employees as of December 31,
15
<PAGE> 17
1998. None of our employees is represented by a labor union. We have experienced
no work stoppages and believe that our employee relations are good.
ITEM 2. PROPERTIES
Our corporate headquarters are in Los Gatos, California, where we lease
approximately 23,500 square pursuant to a lease agreement dated November 17,
1998 which expires on December 31, 2001 and contains an option to renew the
lease for an additional three-year term. Of this amount, approximately 5,760
square feet is subleased to a third party under a sublease which expires
December 31, 2001. Our European headquarters are located in Pfaffenhofen,
Germany, where we lease approximately 6,000 square feet pursuant to a lease
agreement dated September 30, 1994. The Pfaffenhofen lease ends on June 30,
2000. In 1998, we acquired Intermart, headquartered in Tokyo, ICS, headquartered
in Singapore, and Shuttle, headquartered in the U.K. The Tokyo lease covers
approximately 1,200 square feet and expires in October 2000. The Singapore lease
covers approximately 15,300 square feet and expires in March 2001. The U.K.
lease covers approximately 10,950 square feet and expires in September of 2015.
We also lease our research and development facilities in La Ciotat, France,
Erfurt, Germany, Pondicherry, India and Madras, India. We believe that our
existing facilities are adequate for our current needs.
ITEM 3. LEGAL PROCEEDINGS
We have been notified by Smith Corona Corporation that Smith Corona
believes that the "SCM" in our name, logo and a certain product name infringe a
trademark held by Smith Corona and that we have engaged in unfair competition.
We believe that we have defenses to Smith Corona's claim and have so notified
Smith Corona. In the event that Smith Corona were to initiate legal proceedings
against us with respect to this matter, we would vigorously defend the action.
Defending any action can be costly and time consuming regardless of the outcome
and, as with any litigation matter, the outcome of any such dispute may not be
favorable to us. An unfavorable outcome in the matter could subject us to
monetary damages and may result in our having to change our name and logo, which
would require us to incur costs and may result in a loss of the goodwill
associated with our name and logo.
In April 1997, Gemplus served us with a complaint alleging that certain of
our products infringe certain claims of a French patent held by Gemplus. In
September 1997, we entered into a license agreement and memorandum of
understanding, and settled this dispute, with Gemplus. In connection with these
transactions, we sold 200,000 shares of common stock to Gemplus for net proceeds
of $1,643,000. Additionally, we issued warrants to Gemplus to purchase up to
200,000 shares of common stock at an exercise price of $13.00 per share and up
to 200,000 shares of common stock at an exercise price of $14.00 per share. At
the time granted, the fair value of these warrants approximated $453,000 and
this amount, along with related legal fees of approximately $62,000, was charged
to operations as patent claim settlement expense in the third quarter of 1997.
These warrants were exercised in the first quarter of 1998.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to SCM's stockholders during the fourth quarter
of 1998.
16
<PAGE> 18
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Price Range of common stock; Number of Holders; Dividends
Our common stock is quoted on the Nasdaq National Market under the symbol
"SCMM" and on the Neuer Markt of the Frankfurt Stock Exchange under the symbol
"SMY." The following table lists the high and low closing prices since our
common stock began trading on the Nasdaq National Market and the Neuer Markt on
October 7, 1997.
<TABLE>
<CAPTION>
NASDAQ
NATIONAL MARKET NEUER MARKT
---------------- --------------------
HIGH LOW HIGH LOW
------ ------ -------- --------
<S> <C> <C> <C> <C>
FISCAL 1997:
Fourth Quarter (From October 7,
1997).......................... $31.50 $19.13 DM51.20 DM38.00
FISCAL 1998:
First Quarter.................... $88.00 $23.59 DM159.70 DM41.50
Second Quarter................... $78.88 $52.00 DM147.30 DM89.00
Third Quarter.................... $68.75 $42.69 DM123.50 DM72.00
Fourth Quarter................... $78.25 $30.00 DM121.50 DM49.00
FISCAL 1999
First Quarter (through March
26)............................ $94.75 $71.00 DM166.25 DM120.09
</TABLE>
On March 26, 1999, the closing prices of our common stock were $76.875 per
share as reported by the Nasdaq National Market and DM138.08 per share as
reported by the Neuer Markt of the Frankfurt Stock Exchange. As of March 26,
1999, we had 2,052 stockholders of record.
We have never declared or paid cash dividends on our common stock or other
securities. Our U.S. line of credit requires us to obtain the bank's prior
written consent in order to declare or pay any cash dividends. We currently
anticipate that we will retain all of our future earnings for use in the
expansion and operation of our business and do not anticipate paying any cash
dividends in the foreseeable future.
(b) Sales of Unregistered Securities
The Registrant has recently issued and sold the following unregistered
securities:
(i) Concurrently with our initial public offering in October 1997, the
we issued and sold 200,000 shares of common stock at $9.00 per share.
The issuances referred to in paragraph (i) were deemed exempt from
registration under the Securities Act in reliance upon Section 4(2) thereof. The
purchasers of securities in this transaction represented their intentions to
acquire the securities for investment only and not with a view to or for sale in
connection with any distribution thereof and appropriate legends were affixed to
the share certificates issued in such transactions. All purchasers had adequate
access, through their relationships with us, to information about us.
(b) Use of Proceeds from Initial Public Offering and Secondary Offering
On October 6, 1997 SCM filed a Registration Statement on Form S-1
(Registration No. 333-29073) with the Securities and Exchange Commission
pursuant to which we sold 3,875,000 shares of common stock to the public at a
price of $13.00 per share (the IPO). The managing underwriters for the U.S.
portion of the offering were Cowen & Company and Hambrecht & Quist and the
managing underwriters for the international portion of the offering were Cowen
International L.P., Hambrecht & Quist and Westdeutsche Landesbank Girozentrale.
The amount of expenses incurred by SCM in connection with the issuance and
distribution of the common stock was $5,099,505. Of that amount $3,417,505 was
paid to the underwriters in
17
<PAGE> 19
the form of an underwriters' discount, and $1,682,000 was paid directly to
third-parties to satisfy legal, accounting and other similar costs. The net
proceeds to SCM after deducting expenses were $43,722,000.
On April 16, 1998, the Company's Registration Statement on Form S-1 (File
No. 333-47635) (the Secondary Offering) was declared effective by the SEC
pursuant to which we sold 1,450,000 shares of common stock to the public at a
price of $61.00 per share. Additionally, 2,000,000 shares were sold by selling
shareholders. The managing underwriters for the U.S. portion of the offering
were Cowen & Company, Hambrecht & Quist and Dain Rauscher, and the managing
underwriters for the international portion of the offering were Cowen
International L.P., Hambrecht & Quist and Westdeutsche Landesbank Girozentrale.
The amount of expenses incurred by us in connection with the issuance and
distribution of the common stock was $5,383,500. Of that amount $4,335,500 was
paid to the underwriters in the form of an underwriters' discount, and
$1,048,000 was paid directly to third-parties to satisfy legal, accounting and
other similar costs. The net proceeds to SCM from the Secondary Offering after
deducting expenses were $83,067 ,000.
As of December 31, 1998, we had used approximately $16.0 million of the
aggregate net proceeds of the aforementioned two offerings of $126.7 million as
follows:
<TABLE>
<S> <C>
Repayment of indebtedness $3.1 million
Acquisition of businesses (net of cash acquired) $9.9 million
Purchases of equipment $3.0 million
</TABLE>
No such payments were made to directors or officers of SCM or their
associates, holders of 10 percent or more of any class of equity securities of
SCM or to affiliates us. We have retained the remaining net proceeds of the
offerings for general corporate purposes.
18
<PAGE> 20
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data as of December 31, 1998 and
1997 and for each of the years in the three-year period ended December 31, 1998
are derived from consolidated financial statements of SCM that have been audited
by KPMG LLP, independent certified public accountants, and are included
elsewhere in this document. The consolidated financial data as of December 31,
1996, 1995 and 1994 and the consolidated statement of operations data for the
years ended December 31, 1995 and 1994 are derived from the audited consolidated
financial statements of SCM that are not included herein. The historical results
are not necessarily indicative of the operating results to be expected in the
future. The following selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and Notes
thereto included elsewhere in this document.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------------------
1998 1997 1996 1995 1994
-------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Net sales................................... $ 85,009 $46,423 $30,152 $23,588 $10,940
Cost of sales............................... 57,148 30,213 21,030 19,076 8,311
-------- ------- ------- ------- -------
Gross profit................................ 27,861 16,210 9,122 4,512 2,629
Operating Expenses:
Research and development.................. 6,356 4,501 3,196 1,809 1,392
Sales and marketing....................... 8,904 5,923 4,459 3,128 2,038
General and administrative................ 9,288 3,872 2,375 1,820 733
In-process research and development....... 3,101 -- -- -- --
Accelerated amortization of goodwill...... 5,211 -- -- -- --
Other acquisition expenses................ 3,153 -- -- -- --
-------- ------- ------- ------- -------
Total operating expenses............... 36,013 14,296 10,030 6,757 4,163
-------- ------- ------- ------- -------
Income (loss) from operations............... (8,152) 1,914 (908) (2,245) (1,534)
Interest income (expense), net............ 5,832 815 (309) (381) (290)
Foreign currency transaction gains
(losses)............................... 192 688 288 42 (7)
-------- ------- ------- ------- -------
Income (loss) before income taxes........... (2,128) 3,417 (929) (2,584) (1,831)
Provision for income taxes................ 2,845 1,068 19 78 (11)
-------- ------- ------- ------- -------
Net income (loss)........................... (4,973) 2,349 (948) (2,662) (1,820)
Accretion on redeemable convertible
preferred stock........................... -- (802) (287) (139) --
-------- ------- ------- ------- -------
Net income (loss) applicable to common
stockholders.............................. $ (4,973) $ 1,547 $(1,235) $(2,801) $(1,820)
======== ======= ======= ======= =======
Basic net income (loss) per share........... $ (0.38) $ 0.35 $ (0.67) $ (1.52) $ (1.04)
======== ======= ======= ======= =======
Diluted net income (loss) per share......... $ (0.38) $ 0.28 $ (0.67) $ (1.52) $ (1.04)
======== ======= ======= ======= =======
Shares used in computations:
Basic net income (loss) per share......... 13,253 4,394 1,838 1,838 1,752
======== ======= ======= ======= =======
Diluted net income (loss) per share....... 13,253 5,614 1,838 1,838 1,752
======== ======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------
1998 1997 1996 1995 1994
-------- ------- ------- ------- -------
(in thousands)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments............................... $129,918 $56,073 $ 2,666 $ 936 $ 93
Working capital (deficit)................... 146,950 62,363 (1,442) 1,930 910
Total assets................................ 183,320 75,602 13,820 9,777 4,553
Long-term debt, less current portion........ -- -- -- 2,147 3,027
Redeemable convertible preferred stock...... -- -- 5,068 4,781 --
Total stockholders' equity (deficit)........ 158,779 65,183 (5,428) (4,369) (1,904)
</TABLE>
19
<PAGE> 21
ITEM 7. 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.
ACQUISITIONS
On May 19, 1998, the Company completed its acquisition of Intermart Systems
K.K. ("Intermart") based in Tokyo, Japan. Intermart designs and sells memory
card readers and adapters used primarily in digital photography and other
digital media transfers. Total consideration paid was $8 million, with $4.9
million paid in cash and the balance paid through the issuance of 46,551 shares
of the Company's stock.
On June 3, 1998, the Company completed its acquisition of Intellicard
Systems Pte. Ltd. ("ICS"), based in Singapore. ICS is a contract manufacturing
company that manufactures certain of the Company's products, including smart
card readers, DVB conditional access modules, and PC Card adapters. Total
consideration paid was $18.4 million, of which $14.9 million was paid in cash
and $3.5 million was paid through the issuance of 61,185 shares of the Company's
stock. Approximately $11.4 million of the cash portion of the consideration was
paid in exchange for cash and a $2.0 million shareholder note held by ICS at the
closing of the transaction. The note was repaid by the shareholder prior to June
30, 1998.
The acquisitions of Intermart and ICS were accounted for pursuant to the
purchase method of accounting. Accordingly, the historical financial statements
of the Company exclude the assets and liabilities, results of operation and cash
flows of Intermart and ICS for all periods ending at or prior to the respective
dates of acquisition. The assets and liabilities of Intermart and ICS were
recorded at their fair values at the respective acquisition dates.
In the second quarter of 1998, in connection with these acquisitions, the
Company originally allocated approximately $5.9 million of the $26.2 million
purchase price to in-process research and development projects. This allocation
represented the estimated fair value based on risk-adjusted cash flows related
to the incomplete research and development projects. At the date of acquisition,
this amount was expensed as a non-recurring charge as the in-process technology
had not yet reached technological feasibility and had no alternative future
uses. In light of the Securities and Exchange Commission's recent interpretation
of the accounting for acquired in-process research and development, as discussed
in Note 2 to the consolidated financial statements, during the fourth quarter of
1998, the Company revised the amount of purchase price allocated to in-process
research and development relating to these acquisitions. Accordingly, the
Company's consolidated financial statements for the nine months ended September
30, 1998, were voluntarily restated to reduce the in-process research and
development charge by $2.8 million and to increase goodwill by a like amount.
ICS and Intermart had approximately 10 projects in progress at the time of the
acquisition including USB interface readers for compact flash, mini-card and
smart media ("the PCD-30USB Series"), higher speed digital media readers for
compact flash, mini-card and smart media formats ("the PCD-10X/25X Series"),
digital media readers redesigned for lower cost and complementary product
compatibilities ("the PCD-10/15/25 Versions"), and improved high-speed PC card
modems.
20
<PAGE> 22
The percentage completion of the projects at the time of acquisition were
as follows:
<TABLE>
<S> <C>
PCD-30USB Series (three projects)........................... 50%
PCD-10X/25X Series (three projects)......................... 90%
PCD-10/15/25 Versions (three projects)...................... 10%
High-speed PC modems (one project).......................... 40%
</TABLE>
The Company currently expects to complete development of these projects at
various dates through 1999, at a total cost to complete of approximately
$721,000.
The nature of the efforts required to develop the acquired in-process
technology into commercially viable products principally relate to the
completion of all planning, designing and testing activities necessary to
establish that the product can be produced to meet its design requirements
including functions, features and technical performance requirements. Though the
Company currently expects that the acquired in process technology will be
successfully developed, there can be no assurance that commercial or technical
viability of these products will be achieved. Furthermore, future industry
developments, changes in network security and conditional access environments,
changes in other product offerings or other developments may cause the Company
to alter or abandon these plans.
The fair value assigned to purchased in-process technology was determined
by estimating the completion percentage of research and development efforts at
the acquisition date, forecasting risk adjusted revenues considering the
completion percentage, estimating the resulting net cash flows from the projects
and discounting the net cash flows to their present values. The completion
percentages were estimated based on cost incurred to date, importance of
completed development tasks and the elapsed portion of the total project time.
The fair value of the in-process research and development was allocated to the
projects as follows (in thousands):
<TABLE>
<S> <C>
PCD-30USB Series............................................ $ 676
PCD-10X/25X Series.......................................... 1,468
PCD-10/15/25 Versions....................................... 256
High-speed PC modems (one project).......................... 701
------
$3,101
======
</TABLE>
The revenue projection used to value the in-process research and
development is based on unit sales forecasts for worldwide sales territories and
adjusted to consider only the revenue related to development achievements
completed at the acquisition date. Projected annual revenues for each of the
in-process development projects were assumed to increase from product release
through 2000, decline somewhat in 2001 and 2002, and decline significantly from
2003 and 2004. An insignificant amount of revenue is projected for the PCD-30USB
Series in 2005 through 2007, which is estimated to be the end of the in-process
technology's economic life. Gross profit was assumed to be 45% for the PCD-USB
Series, 30% on the PCD-10X/25X Series, and 40% on the PCD-10/15/25 Versions and
the high-speed PC modems. The projected gross margins were based on estimated
costs of revenues which primarily include printed circuit boards, integrated
circuits and related electronic components, plastic molding and tooling costs,
assembly and testing costs, and packaging. These projections were based on the
Company's experience with similar products. Estimated operating expenses, income
taxes and capital charges to provide a return on other acquired assets were
deducted from gross profit to arrive at net operating income for each of the
in-process development projects. Operating expenses were estimated as a
percentage of revenue and included sales and marketing expenses, administrative
expenses, and development costs to maintain the technology once it has achieved
technological feasibility. In addition, net cash flow estimates were adjusted to
allow for fair return on working capital and fixed assets, charges for franchise
and technology leverage and return on other intangibles. A 30% discount rate,
which represents a premium to the Company's cost of capital, was used to
discount the net cash flows back to their present value. If these projects are
not successfully developed, the Company may not realize the value assigned to
the in-process research and development projects.
21
<PAGE> 23
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 Shuttle merger, in the fourth quarter of 1998 the
Company recorded nonrecurring charges totaling $9,683,000, consisting of
$2,253,000 of expenses for attorneys, accountants, financial printing, due
diligence, filing fees and other regulatory costs; $5,211,000 for accelerated
amortization of goodwill resulting from its impairment due to product line and
sales channel redundancies, and $2,219,000 for impaired and redundant assets and
personnel severance costs. Of this amount, $1,900,000 was included in costs of
revenues and the remainder included in operating expenses.
As separate companies, total revenues and net income for the individual
entities were as follows (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Total revenue:
SCM......................................... $64,755 $27,769 $21,520
Shuttle..................................... 20,254 18,654 8,632
------- ------- -------
$85,009 $46,423 $30,152
======= ======= =======
Total net income (loss):
SCM......................................... $(4,424) $ 301 $(1,397)
Shuttle..................................... (549) 1,246 162
------- ------- -------
$(4,973) $ 1,547 $(1,235)
======= ======= =======
</TABLE>
Memory Technology Limited
In December 1997, Shuttle acquired all of the outstanding share capital of
Memory Technology Limited ("Memory") in exchange for 82,810 shares of its
capital stock (230,733 shares the Company's common stock on a post-converted
basis). The transaction has been accounted for under the purchase method of
accounting. The fair value of consideration tendered exceeded the fair value of
net assets acquired by $1,149,000 and was attributed to goodwill. Following the
Company's merger with Shuttle, management determined that the Memory product
offerings were not consistent with its core businesses. As a result, the Company
evaluated the prospects for the Memory products and concluded that the revenues
to be generated from future sales of these products would not be sufficient to
recover the carrying amount of the related goodwill. Accordingly, the
unamortized amount of this goodwill at the time of the Shuttle merger of
$766,000 was written off in the fourth quarter of 1998 (see above).
Pro forma information giving effect to the acquisition of Memory has not
been presented as pro forma results would not have differed materially from the
Company's consolidated results of operations.
22
<PAGE> 24
RESULTS OF OPERATIONS
The following table sets forth certain items from the Company's
consolidated statement of operations as a percentage of total revenues for the
periods indicated:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Net sales:
Digital TV Access Products................................ 31.0% 36.0% 12.1%
PC and Network Security Products.......................... 21.9 23.5 43.1
Digital Media and Connectivity Products................... 47.1 40.2 28.6
PCMCIA Peripheral Products................................ -- 0.3 16.2
----- ----- -----
Total net sales................................... 100.0 100.0 100.0
Cost of sales............................................... 67.2 65.1 69.7
Gross profit................................................ 32.8 34.9 30.3
Operating expenses:
Research and development.................................. 7.5 9.7 10.6
Sales and marketing....................................... 10.5 12.8 14.8
General and administrative................................ 10.9 8.3 7.9
In-process research and development....................... 3.6 -- --
Accelerated amortization of goodwill...................... 6.1 -- --
Other acquisition-related charges......................... 3.7 -- --
----- ----- -----
Total operating expenses.......................... 42.3 30.8 33.3
----- ----- -----
Income (loss) from operations............................... (9.5) 4.1 (3.0)
Interest income (expense), net.............................. 6.8 1.8 (1.0)
Foreign currency transaction gain........................... 0.2 1.5 0.9
----- ----- -----
Income (loss) before income taxes........................... (2.5) 7.4 (3.1)
Provision for income taxes.................................. 3.3 2.3 --
----- ----- -----
Net income (loss)........................................... (5.8)% 5.1% (3.1)%
===== ===== =====
</TABLE>
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Net Sales. Net sales reflect the invoiced amount for goods shipped less
estimated returns. Revenue is recognized upon product shipment. Net sales for
the twelve months ended December 31, 1998 were $85.0 million compared to $46.4
million in 1997, an increase of 83%. The increase in revenues in 1998 over 1997
was due primarily to revenues from the companies acquired by the Company during
1998 (Intermart and ICS) of $8.3 million, an increase in shipments of the
Company's digital media and connectivity products of $21.4 million, an increase
in shipments of the Company's smartcard readers, an increase in shipments of
DVB-CAM products and services in Europe, and an increase in shipments of adapter
products in the U.S., primarily to OEM customers supplying U.S. government
agencies. Adapter product revenues increased due to higher unit shipments,
offset somewhat by declines in average unit prices. For all other product
groups, average unit prices remained relatively stable, and the increases in net
sales were due to increased volume shipments. Sales to the Company's top 10
customers during 1998 accounted for 51% of total net sales.
Gross Profit. Gross profit for 1998 was $27.9 million, or 33% of total net
sales, compared to $16.2 million or 35% in 1997. The increase in gross profit in
absolute dollars for the year was due to the aforementioned increase in net
sales. The decrease in gross profit as a percentage of net sales from the 1997
level was due primarily to a $1.9 million charge taken in the fourth quarter of
1998 related to excess inventory in the Company's digital media reader product
group. This excess was the result of overlapping product lines following the
Company's merger with Shuttle in November of 1998. The Company believes that its
gross profit in 1999 in absolute dollars will be higher than in 1998, due to
anticipated increased demand for the Company's products. The Company's gross
profit 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
23
<PAGE> 25
enhancements, software and services, all of which tend to carry higher gross
profit than older products, and the cost and availability of components.
Accordingly, gross profit 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 1998, research and development expenses were $6.4
million, compared with $4.5 million in 1997, an increase of 41%. As a percentage
of total net sales, research and development expenses were 7% in 1998 compared
to 10% for 1997. The increase in absolute amounts in 1998 was primarily due to
increased engineering headcount and related product development costs at the
Company's development centers in France and India, and due to research and
development expenses of Intermart and ICS, companies acquired in May and June of
1998, respectively ("the acquired companies"). The Company believes that the
absolute amount of research and development expenses in 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 sales.
Sales and Marketing. Sales and marketing expenses consist primarily of
employee compensation and trade show and other marketing costs. Sales and
marketing expenses for 1998 were $8.9 million, or 10% of revenues, compared with
$5.9 million in 1997, or 13% of revenues, an increase of 50%. The increase in
absolute amounts in 1998 was primarily due to increased sales headcount and
sales personnel compensation expenses in the Company's U.S. and European
offices, increased tradeshow expenses and sales and marketing costs of the
acquired companies, 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, third-party administrative services costs such as
legal, auditing and investor relations fees, and charges for allowances for
doubtful accounts receivable. For 1998, general and administrative expenses were
$9.3 million, an increase of 140% compared with $3.9 million in 1997,
representing 11% and 8% of total net sales 1998 and 1997, respectively. These
increases, both in absolute amounts and as a percentage of net sales, were
primarily due to increases in administrative headcount in the Company's U.S.,
U.K. and German offices to support higher levels of business activities, costs
related to relocation of the U.K. offices, increased costs relating to the
Company operating as a public company subsequent to its IPO in October 1997,
administrative costs of the acquired companies, and an increase in the Company's
allowance for doubtful accounts of $2.6 million, $2.3 million of which was the
result of cash flow difficulties experienced by one its customers. As of
December 31, 1998, the gross accounts receivable balance due from this customer
was $4.2 million. The Company continues to aggressively pursue collection,
including negotiating a structured repayment program. Although the Company has
reserved a significant portion of the outstanding exposure relating to this
customer, management believes there can be no assurance that further increases
to the provision for doubtful receivables for this customer may not be necessary
in future periods. The Company believes general and administrative expenses in
1999 will increase in absolute amount over 1998 levels due primarily to
compensation increases to existing employees, increases in headcount to support
increased levels of business activity, and new facilities in the U.S. to
accommodate merged sales and marketing operations with Shuttle Technology, but
that such costs will fluctuate as a percentage of total net sales.
In-Process Research and Development. The aggregate fair value of
Intermart's and ICS' research and development efforts that had not reached
technological feasibility as of the respective dates of acquisition and had no
alternative future uses was originally determined by appraisal to be $5.9
million, and was expensed at the respective dates of the acquisitions. As
discussed in Note 2 to the consolidated financial statements, during the fourth
quarter of 1998, the Company's management revised the amount of purchase price
allocated to in-process research and development relating to these acquisitions.
As a result, the Company's consolidated financial statements for the second and
third quarters of 1998 have been restated to reduce the in-process research and
development charge by $2.8 million and to increase goodwill by a like amount.
24
<PAGE> 26
Accelerated Amortization of Goodwill. In connection with the merger with
Shuttle Technology Group in the fourth quarter of 1998, the Company incurred a
charge of $5.2 million for accelerated amortization of goodwill related to the
Intermart and Memory acquisitions. The goodwill remaining from the Intermart and
Memory acquisitions was written of as it was determined that recoverability of
this amount through undiscounted future operating cash flows from these
operations was unlikely. Following the Company's merger with Shuttle, management
determined that the Memory product offerings were not consistent with its core
businesses, and that a significant portion of the Intermart products were
redundant to lower cost products provided by Shuttle. As a result, the Company
evaluated the prospects for the Memory and Intermart products and concluded that
the revenues to be generated from future sales of these products would not be
sufficient to recover the carrying amount of the related goodwill. Accordingly,
the unamortized amount of this goodwill at the time of the Shuttle merger of
$5.2 million was written off in the fourth quarter of 1998.
Other Acquisition Expenses. In connection with the Intermart and ICS
acquisitions in the second quarter of 1998, and the merger of Shuttle Technology
Group in the fourth quarter of 1998, the Company incurred non-recurring expenses
totaling $3.2 million, consisting of $2.5 million of expenses for attorneys,
accountants, financial printing, due diligence, filing fees and other regulatory
costs and $0.7 million for impaired and redundant assets and personnel severance
costs.
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 1998, interest income and other, net, was $5.8 million,
compared to $815,000 in 1997. 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 1998 as a result of the aforementioned stock
offering and minimal debt service requirements resulted in the increase in
interest income and other, net in 1998 over 1997. Continued investment of the
net proceeds from this offering will generate future net investment income in
1999.
Income Taxes. The provision for income taxes was $2.8 million in 1998
resulting principally from tax liabilities associated with domestic and foreign
operations of the Company. The increase in the provision over 1997 is due to
utilization of net operating loss carryforwards, which were available to offset
a larger portion of taxable income in Germany in 1997 compared to 1998, and
higher taxable income in the U.S., where the Company is limited in its
utilization of net operating loss carryforwards. 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.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Net sales. Net sales were $46.4 million in 1997, compared to $30.2 million
in 1996, an increase of 54%. Sales of security and access products were $46.2
million in 1997, compared to $25.2 million in 1996, an increase of 83%. The
substantial increase in security and access products sales in 1997 was primarily
related to sales of the Company's digital television access products, which were
first shipped in the fourth quarter of 1996, and digital media reader products.
One customer accounted for 27% of the Company's net sales in 1997. Accounts
receivable from this customer totaled approximately $3.2 million at December 31,
1997.
Gross Profit. Gross profit was $16.2 million, or 35% of net sales, in 1997,
compared to $9.1 million, or 30% of net sales, in 1996. The increase in gross
profit, both in absolute amount and as a percentage of net sales, was primarily
due to the introduction of digital television access products and the concurrent
shift away from lower margin PCMCIA peripheral products. In addition, the
Company's transition from the PCMCIA peripheral products business resulted in
reduced labor requirements. The Company's gross profit has been and will
continue to be affected by a variety of factors, including competition, product
configuration and mix, the availability of new products and product enhancements
which tend to carry higher gross profit than older products and the costs and
availability of components. Accordingly, gross profits are expected to fluctuate
from period to period.
25
<PAGE> 27
Research and Development. In 1997, research and development expenses were
$4.5 million, or 10% of net sales, compared with $3.2 million, or 11% of net
sales, in 1996. The increase in absolute amounts was primarily due to
engineering headcount in the Company's French facility and related product
development costs. The Company believes that research and development expenses
during 1998 will be higher than in 1997 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 sales.
Sales and Marketing. Sales and marketing expenses were $5.9 million, or 13%
of revenues in 1997, compared with $4.5 million, or 15% of revenues, in 1996.
The increase in absolute amounts in 1997 was primarily due to growth of the
Company's sales and marketing headcount and promotional efforts in the U.S. and
initial promotional efforts in the Asia-Pacific region. Sales and marketing
expenses in 1998 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 were $3.9
million in 1997 compared with $2.4 million in 1996, an increase of 63%. As a
percentage of net sales, general and administrative expenses were 8% in both
years. This increase in absolute amounts was primarily due to increases in
administrative headcount in the Company's U.S. and Pfaffenhofen, Germany offices
to support higher levels of business activities, increased costs relating to the
Company operating as a public company subsequent to its IPO in October 1997. In
addition, in September 1997 the Company settled a patent infringement claim with
a third party. In connection therewith, the Company incurred a one-time charge
of $515,000, of which $453,000 represented a non-cash charge equal to the
estimated fair value of the common stock warrants issued to the third party and
$62,000 of legal costs. The Company believes general and administrative expenses
in 1998 will continue to increase in absolute due to anticipated general
business growth and support requirements, but will fluctuate as a percentage of
total net sales.
Interest Income (Expense), Net. Interest income and other, net consists of
interest earned on invested cash, offset by interest paid or accrued on
outstanding debt. Net interest income (expense), net was $815,000 in 1997,
compared to ($309,000) in 1996. During the first two quarters of 1997, the
Company raised $12.1 million through the sale of preferred stock, and converted
$4.2 million of convertible debt into preferred stock. In October 1997, the
Company completed the sale of 3.8 million shares of Common Stock in an initial
public offering, resulting in net proceeds of $43.4 million. These transactions
resulted in both a reduction of outstanding debt and corresponding interest
expense and an increase in short-term investments and cash balances.
Foreign Currency Transaction Gains. In 1997, the foreign currency
transaction gain of $688,000 related to intercompany receivables resulting from
intercompany sales transactions.
Income Taxes. A provision for income taxes of $1.1 million was booked in
1997, resulting principally from tax liabilities associated with foreign
operations of the Company and minimum state income taxes. As of December 31,
1997, the Company had German net operating loss carry forwards of approximately
$1.4 million available for an indefinite period to offset income from the
Company's German operations. In addition, the Company had net operating loss
carry forwards of approximately $3.3 million and $1.6 million for United States
federal and California income tax purposes, respectively. Approximately $2.2
million of the Company's aforementioned U.S. federal net operating loss
carryforward is limited in its utilization to approximately $340,000 per year.
The Company had a deferred tax asset as of December 31, 1997 of approximately
$2.2 million and recorded a full valuation allowance to offset these deferred
tax assets as management has concluded that it is more likely than not that the
deferred tax assets would not be realized in the future due to recent operating
losses. A future change in the Company's assessment of the likelihood of future
realization of deferred tax assets could result in a reduction of the valuation
allowance, a corresponding reduction in the Company's income tax expense
recorded for financial statement purposes and a corresponding increase in net
income. This would not, however, result in a change in actual income taxes
payable by the Company in any future period.
26
<PAGE> 28
FINANCIAL INFORMATION BY QUARTER
The following tables present certain unaudited consolidated statement of
operations data for each of the eight quarters in the two-year period ended
December 31, 1998, as well as such data expressed as a percentage of the
Company's total net sales for the periods indicated. This data has been derived
from unaudited consolidated financial statements and has been prepared on the
same basis as the Company's audited Consolidated Financial Statements which
appear elsewhere in this report. In the opinion of management, this data
includes all adjustments (consisting only of normal recurring adjustments)
necessary for a fair presentation of such data.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
----------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30,
1997 1997 1997 1997 1998 1998
STATEMENTS OF OPERATIONS DATA (IN THOUSANDS): -------- -------- --------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Net sales........................ $6,349 $8,298 $13,955 $17,821 $13,925 $16,576
Cost of sales.................... 4,154 5,263 9,015 11,781 8,898 10,528
------ ------ ------- ------- ------- -------
Gross profit..................... 2,195 3,035 4,940 6,040 5,027 6,048
------ ------ ------- ------- ------- -------
Operating expenses:
Research and development......... 897 1,174 1,160 1,270 1,331 1,530
Sales and marketing.............. 1,283 1,492 1,345 1,803 1,835 1,973
General and administrative....... 682 727 866 1,082 1,290 2,025
Settlement of patent claim....... -- -- 515 -- -- --
In-process research and development... -- -- -- -- -- 3,101
Accelerated amortization of goodwill... -- -- -- -- -- --
Other acquisition integration expenses... -- -- -- -- -- 581
------ ------ ------- ------- ------- -------
Total operating expenses... 2,862 3,393 3,886 4,155 4,456 9,210
------ ------ ------- ------- ------- -------
Income (loss) from operations.... (667) (358) 1,054 1,885 571 (3,162)
Interest income (expense), net... (31) 79 92 675 715 1,611
Foreign currency transaction gain (loss)... 164 249 158 117 (19) 39
------ ------ ------- ------- ------- -------
Income (loss) before income taxes... (534) (30) 1,304 2,677 1,267 (1,512)
Provision for income taxes....... 14 19 329 706 274 572
------ ------ ------- ------- ------- -------
Net income (loss)................ (548) (49) 975 1,971 993 (2,084)
Accretion on redeemable convertible preferred
stock.......................... (160) (318) (324) -- -- --
------ ------ ------- ------- ------- -------
Net income (loss) applicable to common
stockholders................... $ (708) $ (367) $ 651 $ 1,971 $ 993 $(2,084)
====== ====== ======= ======= ======= =======
AS A PERCENTAGE OF TOTAL NET SALES:
Net sales........................ 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales.................... 65.4 63.4 64.6 66.1 63.9 63.5
------ ------ ------- ------- ------- -------
Gross profit..................... 34.6 36.6 35.4 33.9 36.1 36.5
------ ------ ------- ------- ------- -------
Operating expenses:
Research and development......... 14.1 14.1 8.3 7.1 9.5 9.2
Sales and marketing.............. 20.2 18.0 9.6 10.1 13.2 11.9
General and administrative....... 10.8 8.8 6.2 6.1 9.3 12.2
Settlement of patent claim....... -- -- 3.7 -- -- --
In-process research and development... -- -- -- -- -- 18.7
Accelerated amortization of goodwill... -- -- -- -- -- --
Other acquisition integration expenses... -- -- -- -- -- 3.5
------ ------ ------- ------- ------- -------
Total operating expenses... 45.1 40.9 27.8 23.3 32.0 55.5
------ ------ ------- ------- ------- -------
Income (loss) from operations.... (10.5) (4.3) 7.6 10.6 4.1 (19.0)
Interest income (expense), net... (0.5) 0.9 0.6 3.8 5.1 9.7
Foreign currency transaction gain (loss)... 2.6 3.0 1.1 0.6 (0.1) 0.2
------ ------ ------- ------- ------- -------
Income (loss) before income taxes... (8.4) (0.4) 9.3 15.0 9.1 (9.1)
Provision for income taxes....... 0.2 0.2 2.3 3.9 2.0 3.5
------ ------ ------- ------- ------- -------
Net income (loss)................ (8.6) (0.6) 7.0 11.1 7.1 (12.6)
Accretion on redeemable convertible preferred
stock.......................... (2.5) (3.8) (2.3) -- -- --
------ ------ ------- ------- ------- -------
Net income (loss) applicable to common
stockholders................... (11.1)% (4.4)% 4.7% 11.1% 7.1% (12.6)%
====== ====== ======= ======= ======= =======
<CAPTION>
THREE MONTHS ENDED
--------------------
SEPT. 30, DEC. 31,
1998 1998
STATEMENTS OF OPERATIONS DATA (IN THOUSANDS): --------- --------
<S> <C> <C>
Net sales........................ $19,402 $35,106
Cost of sales.................... 11,987 25,735
------- -------
Gross profit..................... 7,415 9,371
------- -------
Operating expenses:
Research and development......... 1,603 1,892
Sales and marketing.............. 2,365 2,731
General and administrative....... 2,408 3,565
Settlement of patent claim....... -- --
In-process research and development... -- --
Accelerated amortization of goodwill... -- 5,211
Other acquisition integration expenses... -- 2,572
------- -------
Total operating expenses... 6,376 15,971
------- -------
Income (loss) from operations.... 1,039 (6,600)
Interest income (expense), net... 1,820 1,686
Foreign currency transaction gain (loss)... 216 (44)
------- -------
Income (loss) before income taxes... 3,075 (4,958)
Provision for income taxes....... 1,099 900
------- -------
Net income (loss)................ 1,976 (5,858)
Accretion on redeemable convertible preferred
stock.......................... -- --
------- -------
Net income (loss) applicable to common
stockholders................... $ 1,976 $(5,858)
======= =======
AS A PERCENTAGE OF TOTAL NET SALES:
Net sales........................ 100.0% 100.0%
Cost of sales.................... 61.8 73.3
------- -------
Gross profit..................... 38.2 26.7
------- -------
Operating expenses:
Research and development......... 8.3 5.4
Sales and marketing.............. 12.2 7.8
General and administrative....... 12.4 10.1
Settlement of patent claim....... -- --
In-process research and development... -- --
Accelerated amortization of goodwill... -- 14.9
Other acquisition integration expenses... -- 7.3
------- -------
Total operating expenses... 32.9 45.5
------- -------
Income (loss) from operations.... 5.3 (18.8)
Interest income (expense), net... 9.4 4.8
Foreign currency transaction gain (loss)... 1.1 (0.1)
------- -------
Income (loss) before income taxes... 15.8 (14.1)
Provision for income taxes....... 5.7 2.6
------- -------
Net income (loss)................ 10.1 (16.7)
Accretion on redeemable convertible preferred
stock.......................... -- --
------- -------
Net income (loss) applicable to common
stockholders................... 10.1% (16.7)%
======= =======
</TABLE>
27
<PAGE> 29
The Company experiences substantial seasonality in its business, with
approximately one-third of annual net sales being realized in the first half of
the year and the remaining two-thirds being realized in the second half of the
year. In general, this is due to the buying patterns of the Company's customers
for its digital television and digital media and connectivity products, most of
whom are OEMs in the computer, digital television and consumer electronics
industries. These industries have historically been affected by new product
introductions timed for release in the second half of the year. In addition, the
Company's SwapBox products are sold to OEMs that in turn are selling to U.S.
government agencies. The buying pattern of U.S. government agencies tend to be
substantially weighted to the third quarter and, to a somewhat lesser extent,
the fourth quarter of the calendar year. The strength in net sales in the third
quarter which results from the U.S. government buying patterns is somewhat
offset by relatively weaker sales in Europe in the same quarter as a result of
the traditional European summer vacation patterns. In contrast to net sales,
operating expenses tend to be spread relatively evenly across the year. As a
result, the Company's operating results have tended to be weakest in first and
second quarter of the year. This revenue seasonality is evident in the table
above, in which the Company's net sales in 1997 increased each quarter, then
declined in the first quarter of 1998. The Company's acquisitions in 1998,
particularly Intermart and Shuttle which both offer digital media and
connectivity products, contributed to higher second half revenues. Many of these
products are purchased by OEMs in the consumer electronics market, which
typically exhibits higher shipment levels in the second half of each calendar
year.
Gross profit, in absolute amounts, generally improved each quarter in 1997
and 1998, following the same seasonality trend as revenues. In terms of the
gross profit margin rate expressed as a percentage of net sales, the decline in
the second half of 1997 was due to price decreases on certain digital
connectivity products. These products were discontinued in the fourth quarter of
1997, resulting in the increase in the gross profit margin rate in the first
half of 1998. The decline in the gross profit margin rate in the fourth quarter
of 1998 was due primarily to a $1.9 million charge related to excess inventory
in the Company's digital media reader product group. This excess was the result
of overlapping product lines following the Company's merger with Shuttle in
November of 1998.
Excluding merger and acquisition-related charges incurred in the second and
fourth quarters of 1998, operating expenses for research and development, sales
and marketing, and general and administrative activities generally increase
slightly each quarter due to headcount additions to support increased levels of
business and normal increases in compensation and other expenses relating to
existing personnel. Beginning in the second quarter of 1998, these expenses
increased above the comparable quarterly trends in 1997 due to the acquisitions
of Intermart in Japan and ICS in Singapore. Also, in the second half of 1998,
general and administrative expenses increased substantially due to the
aforementioned increases in the Company's allowance for doubtful accounts
(increases of $400,000 in the third quarter of 1998 and $2.0 million in the
fourth quarter of 1998).
The Company's quarterly operating results have in the past varied and may
in the future vary significantly. Factors affecting operating results include:
the level of competition; the size, timing, cancellation or rescheduling of
significant orders; market acceptance of new products and product enhancements;
new product announcements or introductions by the Company or its competitors;
adoption of new technologies and standards; changes in pricing by the Company or
its competitors; the ability of the Company to develop, introduce and market new
products and product enhancements on a timely basis, if at all; hardware
component costs and availability, particularly with respect to hardware
components obtained from sole or limited source suppliers; the timing and
success of the Company's acquisitions and any related write-offs; the Company's
success in expanding its sales and marketing organization and programs;
technological changes in the market for digital information security products;
levels of expenditures on research and development; foreign currency exchange
rates; key personnel changes, anticipated or otherwise; and general economic
trends. In addition, because a high percentage of the Company's operating
expenses are fixed, a small variation in revenue can cause significant
variations in operating results from quarter to quarter. See "Overview".
28
<PAGE> 30
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 December 31, 1998, the Company's working capital was $147.0 million.
Working capital increased during 1998 by approximately $84.6 million, primarily
due to the net proceeds from the secondary offering of $83.1 million and the
Company's receipt of $6.9 million in net proceeds from the exercise of warrants
and options, partially offset by $9.9 million used for acquisitions of Intermart
and ICS (net of cash received), and $3.0 million used for capital expenditures.
During 1998, cash and cash equivalents increased by $21.4 million due
primarily to net proceeds of $90.1 million from the issuance of common stock and
$61.8 million proceeds from maturities of short-term investments, partially
offset by $114.2 million used to purchase short-term investments, $9.9 million
for the businesses acquired in the second quarter (net of cash received), $0.5
million used in operations, and $3.0 million used for capital expenditures. Cash
was used in operations primarily for an increase in accounts receivable of $11.7
million and an increase in inventories of $5.1 million, partially offset by
increases in accounts payable, accrued expenses and income taxes of $4.6
million, $1.8 million and $3.4 million, respectively. These increases were due
primarily to higher levels of business activity including the activities of the
acquired companies.
In 1997, cash and cash equivalents increased by $23.1 million due primarily
to financing activities discussed previously, $1.5 million provided by
operations, offset by $973,000 used for capital expenditures and $30.6 million
for purchases of short-term investments. Cash was used in operations primarily
for an increase in accounts receivable of $3.8 million and an increase in
inventories of $1.6 million, both increases were due primarily to higher levels
of business activity partially offset by increases in accounts payable, accrued
expenses and income taxes.
The Company has revolving lines of credit with two banks in Germany
providing total borrowings of up to 1.5 million DM each (approximately $1.7
million in total at December 31, 1998). One of these lines of credit expires on
September 30, 1999 and the other line 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. In the United
Kingdom, the Company has a L1.5 million (approximately $2.5 million as of
December 31, 1998) overdraft facility with a bank secured by the assets of the
U.K. subsidiary, which bears interest at 2% over the bank's base rate (6.25% as
of December 31, 1998) and expires on May 31, 1999. 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 December 31, 1998), and expires
in May 1999. At December 31, 1998, no amounts were outstanding under any of the
Company's lines of credit.
The Company presently 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.
29
<PAGE> 31
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 first and third quarters of 1998 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. As of
December 31, 1998, SCM had an accumulated deficit of $11.2 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.
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 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
30
<PAGE> 32
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.
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
31
<PAGE> 33
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.
In 1998, almost all of our sales were to OEMs and we expect this dependence
on OEM sales to continue. In 1998, sales to BetaDigital (a division of the Kirch
Group) accounted for 17% of total net sales and sales to our top 10 customers
(all of which were OEMs) accounted for 51% of total net sales.
Our sales to government contractors are subject to uncertainties and may
decrease.
Approximately 12%, 17%, and 28% of our net sales during 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.
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.
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 Tritheim 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
32
<PAGE> 34
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.
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 and Intellicard Systems Pte. Ltd., based in Singapore, in June 1998. 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, SCM incurred significant non-recurring charges associated
with the acquisitions of Shuttle, Intermart and Intellicard. 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 sales
increasing from $10.9 million in 1994 to $85.0 million in 1998. 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.
33
<PAGE> 35
In addition, the number of employees has increased from 67 at December 31, 1995
to 260 as of December 31, 1998.
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 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.
34
<PAGE> 36
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.
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 is 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 62%, 51% and 50% of
our revenues in 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
will continue to account for a
35
<PAGE> 37
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.
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.
36
<PAGE> 38
We estimate the total Year 2000 costs to be between $75,000 and $100,000.
In addition, we plan to implement a new ERP system to serve our worldwide
information system, which we estimate will cost $1.0 million to $1.3 million. As
of December 31, 1998, 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.
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 Robert Schneider, our Chairman
of the Board, Steven Humphreys, our President and Chief Executive Officer, and
Bernd Meier, our 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.
37
<PAGE> 39
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 7A. 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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is incorporated by reference to pages
F-1 through F-25 of this Form 10-K.
38
<PAGE> 40
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
EXECUTIVE OFFICERS AND DIRECTORS
Our executive officers and directors, and their ages as of December 31,
1998, are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Robert Schneider................. 49 Chairman of the Board
Steven Humphreys................. 37 President, Chief Executive Officer and Director
Bernd Meier...................... 48 Chief Operations Officer and Director
John Niedermaier................. 42 Vice President, Finance and Chief Financial Officer
Friedrich Bornikoel(1)........... 48 Director
Oystein Larsen(2)................ 38 Director
Poh Chuan Ng(2).................. 36 Director
Andrew Vought(1)(2).............. 44 Director
</TABLE>
- ---------------
(1) Member of Compensation Committee.
(2) Member of Audit Committee.
Robert Schneider founded SCM in May 1990 as President, Chief Executive
Officer, General Manager and Chairman of the Board. Mr. Schneider is currently
Chairman of the Board. Mr. Schneider is a Managing Director of SCM's German
subsidiary. Mr. Schneider holds a degree in engineering from HTBL Salzburg and a
B.A. degree from the Akademie for Business Administration in Uberlinger.
Steven Humphreys joined SCM in July 1996 as President and Chairman of the
Board. Mr. Humphreys currently is President, Chief Executive Officer and a
Director of SCM. From April 1994 until February 1996, Mr. Humphreys was
President of Caere Corporation, an optical character recognition software and
systems company. From November 1990 until March 1994, he was Vice President of
General Electric Information Services, an electronic commerce services provider.
Mr. Humphreys holds a B.S. degree from Yale University and a M.S. degree and a
M.B.A. degree from Stanford University.
Bernd Meier joined SCM in January 1992 as General Manager and as a Director
of SCM. Mr. Meier is currently the Chief Operations Officer, a Director of SCM
and a Managing Director of SCM's German subsidiary. Mr. Meier holds a degree in
engineering from Fachhochschule Dieburg.
John Niedermaier joined SCM in April 1997 as Vice President, Finance and
Chief Financial Officer. From November 1995 until March 1997, Mr. Niedermaier
was Vice President, Finance and Chief Financial Officer of Voysys Corporation, a
provider of telecommunications systems for small businesses, and from April 1994
until November 1995, he was Director, Business Planning at Octel Communications
Corporation, a voice messaging company. From November 1989 until March 1994, Mr.
Niedermaier was Vice President, Corporate Controller of VMX, Inc., a voice
processing company, which merged with Octel in March 1994. Mr. Niedermaier is a
Certified Public Accountant and holds a B.S. degree from Wayne State University.
Friedrich Bornikoel has served as a Director of SCM since September 1993.
Mr. Bornikoel joined TVM Techno Venture Management GmbH, a venture capital firm,
in July 1987 and has been a Partner since 1990. Mr. Bornikoel is a director of
several privately held companies. Mr. Bornikoel holds a Masters degree in
Physics from the Technical University of Munich.
Oystein Larsen has served as a Director of SCM since October 1998. Mr.
Larsen is currently Chief Executive Officer of Telenor Conax AS, a company based
in Norway engaged in the development and marketing of smart card-based systems
for digital pay TV, telecommunications and security, and has served in
39
<PAGE> 41
this role since 1994. Prior to that, Mr. Larsen was Director, Development
Division of Telenor CTV, a provider of cable TV services based in Norway.
Poh Chuan Ng has served as a Director of SCM since June 1995. Mr. Ng is
currently a Managing Director and Chairman of the Board of Global Team
Technology Pte. Ltd., a manufacturer's representative for computer products.
From September 1994 through May 1997, Mr. Ng served as Director, Business
Development at ICS, a contract manufacturing company and developer of
communications products. Prior to joining ICS, Mr. Ng was a product engineering
manager for Compaq Computer Corp. Mr. Ng is a director of several privately held
companies. Mr. Ng holds a B.S.E. degree from the National University of
Singapore.
Andrew Vought has served as a Director of SCM since March 1996. Mr. Vought
has been a Partner of Cheyenne Capital Corporation since January 1995 and has
been Vice President, Chief Financial Officer and Secretary of Advanced
Telecommunications Modules Ltd., an ATM networking equipment company, since May
1996. From May 1990 until April 1994, Mr. Vought was Vice President, Chief
Financial Officer and Secretary of MicroPower Systems, Inc., an analog and mixed
signal semiconductor company. Mr. Vought is a director of several privately held
companies. Mr. Vought holds a B.S. degree and a B.A. degree from the University
of Pennsylvania and a M.B.A. degree from Harvard University.
TERM OF OFFICE OF DIRECTORS AND OFFICERS
SCM's Bylaws and Certificate of Incorporation provide that effective as of
the date of the first regularly scheduled meeting of the stockholders following
the date on which SCM becomes subject to the periodic requirements of the
Securities Exchange Act of 1934, as amended, the directors of SCM will be
divided into three classes equal in size with each class elected to a staggered
three-year term. Each director will hold office until the expiration of the term
of his or her respective class and until his or her respective successor has
been duly elected and qualified.
BOARD COMMITTEES
In March 1997, the Board established an Audit Committee and a Compensation
Committee. The Audit Committee, currently comprised of directors Poh Chuan Ng,
Andrew Vought and Oystein Larsen, recommends to the Board of Directors the
engagement of SCM's independent accountants and reviews with the accountants the
plan, scope and results of their examination of the consolidated financial
statements. The Compensation Committee, currently comprised of directors
Friedrich Bornikoel and Andrew Vought, reviews and makes recommendations to the
Board of Directors regarding all forms of compensation to be provided to the
executive officers, directors and consultants to SCM.
DIRECTOR COMPENSATION
Beginning April 1, 1997, nonemployee members of SCM's Board of Directors
("Outside Directors") receive an annual fee of $10,000 plus $1,000 for each
board meeting attended in person for their services as directors. Prior to that
time, directors did not receive compensation for services as directors.
SCM's 1997 Director Option Plan (the "Director Plan") was adopted by the
Board of Directors in March 1997. A total of 50,000 shares of Common Stock was
originally reserved for issuance under the Director Plan, and annual increases
will be made to the Director Plan on each anniversary date of adoption of the
Director Plan, in amounts equal to the number of shares underlying options
granted in the immediately preceding year or lesser amounts determined by the
Board. Each Outside Director of SCM was granted an initial option to purchase
5,000 shares of Common Stock upon the effective date of the Director Plan and
each person who becomes an Outside Director after that date will automatically
be granted an initial option to purchase 10,000 shares of Common Stock. Each
Outside Director will automatically be granted subsequent annual options to
purchase 5,000 additional shares of Common Stock under the Director Plan on the
date of each annual meeting of stockholders. All such options have an exercise
price equal to the fair market value of the Common Stock at the date of grant,
have a term of ten years and vest monthly over one year from the date of grant.
Options granted under the Director Plan are not transferable unless approved by
the Board. SCM's Director Plan will terminate in 2007.
40
<PAGE> 42
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No interlocking relationship exists between SCM's Board of Directors or
Compensation Committee and the board of directors or compensation committee of
any other company, nor has any such interlocking relationship existed in the
past.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table. The following table sets forth all compensation
awarded to, earned by, or paid for services rendered to SCM in all capacities
during the years ended December 31, 1997 and 1998 for SCM's Chief Executive
Officer and SCM's most highly compensated other executive officers whose salary
and bonus for 1998 exceeded $100,000 (collectively, the "Named Executive
Officers").
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
------------
ANNUAL COMPENSATION SECURITIES ALL OTHER
-------------------- UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS(#) ($)
--------------------------- ---- --------- -------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Robert Schneider..................... 1998 190,000 60,000 30,000 1,935(1)
Managing Director of German 1997 190,000 75,000 120,000 1,935(1)
subsidiary
Steven Humphreys(2).................. 1998 190,000 60,000 30,000 --
President and Chief Executive
Officer 1997 190,000 75,000 -- --
Bernd Meier.......................... 1998 190,000 60,000 30,000 1,935(1)
Chief Operations Officer and 1997 190,000 75,000 120,000 1,935(1)
Managing Director of German
subsidiary
John Niedermaier(3).................. 1998 149,300 38,596 15,000 --
Vice President, Finance and 1997 108,750 20,164 80,000 --
Chief Financial Officer
</TABLE>
- ---------------
(1) Represents payments of life insurance premiums.
(2) Mr. Humphreys began working at SCM in July 1996.
(3) Mr. Niedermaier began working at SCM in April 1997.
Option Grants During 1998. The following table sets forth for each of the
Named Executive Officers certain information concerning stock options granted
during 1998.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
----------------------------------------------- VALUE AT ASSUMED
PERCENT OF ANNUAL RATES OF
NUMBER OF TOTAL STOCK PRICE
SECURITIES OPTIONS EXERCISE APPRECIATION FOR
UNDERLYING GRANTED TO PRICE OPTION TERM(2)
OPTIONS EMPLOYEES PER EXPIRATION ---------------------
NAME GRANTED IN 1998 SHARE($) DATE(1) 5%($) 10%($)
---- ---------- ---------- -------- ---------- -------- ----------
<S> <C> <C> <C> <C> <C> <C>
Robert Schneider............ 30,000 3.0 30.00 10/9/2008 566,000 1,434,400
Steven Humphreys............ 30,000 3.0 30.00 10/9/2008 566,000 1,434,400
Bernd Meier................. 30,000 3.0 30.00 10/9/2008 566,000 1,434,400
John Niedermaier............ 15,000 1.5 30.00 10/9/2008 283,000 717,200
</TABLE>
- ---------------
(1) The option grants presented here vest as to 100% of the shares four years
from the date of grant. Options may generally be exercised ahead of vesting,
subject to a right of SCM to repurchase the unvested portion of the shares
if the optionee's status as an employee or consultant is terminated or upon
the optionee's death or disability prior to the shares vesting.
(2) The 5% and 10% assumed annual rates of compounded stock price appreciation
are mandated by rules of the Securities and Exchange Commission and do not
represent SCM's estimate or projection of SCM's future Common Stock prices.
The actual value realized may be greater or less than the potential
realizable values set forth in the table.
41
<PAGE> 43
Year-End Option Values. The following table sets forth, for each of the
Named Executive Officers, the year-end value of unexercised options as of
December 31, 1998:
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE(1) OF UNEXERCISED IN-THE-
OPTIONS AT YEAR-END(#): MONEY OPTIONS AT YEAR-END($):
NAME EXERCISABLE/UNEXERCISABLE(1) EXERCISABLE/UNEXERCISABLE(2)
---- ---------------------------- -------------------------------
<S> <C> <C>
Robert Schneider..................... 41,458/108,542 2,570,654/ 6,097,721
Steven Humphreys..................... 32,094/139,476 2,277,497/ 9,000,539
Bernd Meier.......................... 41,458/108,542 2,570,654/ 6,097,721
John Niedermaier..................... 15,851/ 61,667 1,035,766/ 3,665,254
</TABLE>
- ---------------
(1) Options are generally exercisable by the optionee ahead of vesting. Unvested
shares purchased on exercise of an option are subject to a repurchase right
of SCM, and may not be sold by an optionee until the shares vest. Options
indicated as "Exercisable" are those options which were both vested and
exercisable as of December 31, 1998. All other options are indicated as
"Unexercisable."
(2) Market value of underlying securities at year-end minus the exercise price.
EMPLOYMENT CONTRACTS
SCM's 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 agreement continues for an
indefinite term and each party may terminate the agreement at any time with six
months notice. Each executive receives an annual base salary of $190,000 and an
annual bonus of up to $75,000. Furthermore, each executive is subject to a
non-compete provision for a period of one year after the termination of
employment.
EMPLOYEE STOCK PLANS
1997 Stock Plan
SCM's 1997 Stock Plan (the "1997 Plan") provides for the granting to
employees of incentive stock options within the meaning of Section 422 of the
Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"), and for
the granting to employees and consultants of nonstatutory stock options and
stock purchase rights ("SPRs"). The 1997 Plan was approved by the Board of
Directors in March 1997, and by the stockholders in April 1997. Unless
terminated sooner, the 1997 Plan will terminate automatically in March 2007. A
total of 1,685,950 shares of Common Stock are currently reserved for issuance
and options to purchase 1,677,350 shares have been issued pursuant to the 1997
Plan. An annual increase will be made to the 1997 Plan on each anniversary date
of the adoption of the 1997 Plan, in an amount equal to the lesser of 500,000
shares, three percent of the outstanding shares on such date, or a lesser amount
determined by the Board.
The 1997 Plan may be administered by the Board of Directors or a committee
of the Board (the "Committee"), which Committee shall, in the case of options
intended to qualify as "performance-based compensation" within the meaning of
Section 162(m) of the Internal Revenue Code, consist of two or more "outside
directors" within the meaning of Section 162(m) of the Internal Revenue Code.
The Committee has the power to amend, suspend or terminate the 1997 Plan
(provided that no such action may affect any share of Common Stock previously
issued and sold or any option or SPR previously granted under the 1997 Plan), to
determine the terms of the options and SPRs granted, including the exercise
price, the number of shares subject to each or SPR option, the exercisability
thereof, and the form of consideration payable upon such exercise. In addition,
the Committee has the authority to prescribe, amend and rescind rules and
regulations relating to the 1997 Plan. Pursuant to this authority, the Committee
has approved the 1997 Stock Option Plan for French Employees (the "French Plan")
in April 1997, pursuant to which stock options that qualify for preferential tax
treatment under French tax law may be granted. The French Plan was approved by a
vote of SCM's stockholders in July 1998.
42
<PAGE> 44
Options and SPRs granted under the 1997 Plan are not generally transferable
by the optionee, and each option and SPR is exercisable during the lifetime of
the optionee only by such optionee. Options granted under the 1997 Plan must
generally be exercised within three months of the end of optionee's status as an
employee or consultant of SCM, or within twelve months after such optionee's
termination by death or disability, but in no event later than the expiration of
the option's term. In case of SPRs, unless the Committee determines otherwise,
the Restricted Stock Purchase Agreement shall grant SCM a repurchase option
exercisable upon the voluntary or involuntary termination of the purchaser's
employment with SCM for any reason (including death or disability). The purchase
price for Shares repurchased pursuant to the Restricted Stock Purchase Agreement
shall be the original price paid by the purchaser and may be paid by
cancellation of any indebtedness of the purchaser to SCM. The repurchase option
shall lapse at a rate determined by the Committee. The exercise price of options
granted under the 1997 Plan is determined by the Committee, but with respect to
incentive stock options, and nonstatutory stock options intended to qualify as
"performance-based compensation" within the meaning of Section 162(m) of the
Internal Revenue Code, the exercise price must at least be equal to the fair
market value of the Common Stock on the date of grant. The term of options
granted under the 1997 Plan generally may not exceed ten years.
The 1997 Plan provides that in the event of a merger of SCM with or into
another corporation, a sale of substantially all of SCM's assets or a like
transaction involving SCM, each option shall be assumed or an equivalent option
substituted by the successor corporation. If the outstanding options are not
assumed or substituted for as described in the preceding sentence, the Optionee
shall fully vest in and have the right to exercise the option or SPR as to all
of the optioned stock, including shares as to which it would not otherwise be
vested or exercisable. If the Administrator makes an option or SPR fully vested
and exercisable in the event of a merger or sale of assets, the Administrator
shall notify the optionee that the option or SPR shall be fully vested and
exercisable for a specified period from the date of such notice, and the option
or SPR will terminate upon the expiration of such period.
1997 Employee Stock Purchase Plan
SCM's 1997 Employee Stock Purchase Plan (the "Purchase Plan") was adopted
by the Board of Directors in March 1997 and by the stockholders in April 1997. A
total of 175,000 shares of Common Stock has been reserved for issuance under the
Purchase Plan. However, an annual increase will be made to the Purchase Plan on
each anniversary date of the adoption of the Purchase Plan, in an amount equal
to the lesser of 150,000 shares, one percent of the outstanding shares on such
date, or a lesser amount determined by the Board. The Purchase Plan, which is
intended to qualify under Section 423 of the Internal Revenue Code, is
implemented by consecutive overlapping twenty-four month offering periods
beginning on the first trading day on or after May 1 and November 1 each year,
except for the first such offering period which commenced on February 1, 1998
and ends on the last trading day on or after April 30, 1999. Each offering
period contains four purchase periods of approximately six months duration
during which a participant may accumulate payroll deductions and purchase Common
Stock. The Purchase Plan is administered by the Board of Directors or by a
committee appointed by the Board. Employees are eligible to participate if they
are customarily employed by SCM or any participating subsidiary for at least 20
hours per week and more than five months in any calendar year. The Purchase Plan
permits eligible employees to purchase Common Stock through payroll deductions
of up to 10% of an employee's compensation (including commissions, overtime and
other bonuses and incentive compensation), up to a maximum of $5,000 for each
purchase period. The price of stock purchased under the Purchase Plan is 85% of
the lower of the fair market value of the Common Stock at the beginning of the
offering period or the end of the applicable purchase period. Employees may end
their participation at any time during an offering period, and they will be paid
their payroll deductions to date. Participation ends automatically upon
termination of employment with SCM.
Rights granted under the Purchase Plan are not transferable by a
participant other than by will, the laws of descent and distribution, or as
otherwise provided under the Purchase Plan. The Purchase Plan provides that, in
the event of a merger of SCM with or into another corporation or a sale of all
or substantially all of SCM's assets, each participant's right to purchase
Common Stock will be assumed or an equivalent right substituted by the successor
corporation. If the successor corporation refuses to undertake such an
assumption
43
<PAGE> 45
or substitution, the Board of Directors shall shorten the offering period then
in progress (so that employees' rights to purchase stock under the Purchase Plan
are exercised prior to the merger or sale of assets). The Purchase Plan will
terminate in 2007. The Board of Directors has the authority to amend or
terminate the Purchase Plan, except that no such action may adversely affect any
outstanding rights to purchase stock under the Purchase Plan. In 1998, 6,982
shares were purchased by participants under the Purchase Plan and 168,018 shares
were available under the Purchase Plan as of December 31, 1998.
1997 Employee Stock Purchase Plan for Non-U.S. Employees
The 1997 Employee Stock Purchase Plan for Non-U.S. Employees (the
"International Purchase Plan") was adopted by the Board of Directors in April
1997. The number of shares reserved for issuance under the International
Purchase Plan equals the number of shares reserved for issuance under the
Purchase Plan, but not yet issued. The terms of the International Purchase Plan
are substantially similar to those of the Purchase Plan, except that employees
need not be customarily employed by SCM or a participating subsidiary for at
least 20 hours per week and more than five months per calendar year to
participate. The International Purchase Plan is not intended to qualify under
Section 423 of the Code.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information with respect to the
beneficial ownership of our common stock as of March 26, 1999 for: (a) each
person or entity who is known by us to beneficially own five percent or more of
our outstanding common stock; (b) each of our directors; (c) each of the Named
Executive Officers; and (d) all of our directors and executive officers as a
group.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED(1)
--------------------
NAME OF BENEFICIAL OWNER NUMBER PERCENT
------------------------ --------- -------
<S> <C> <C>
TVM Techno Venture Management GmbH(2)....................... 143,580 1.0
c/o Friedrich Bornikoel
Tolzerstrasse 12A
82031 Grunwald Germany
Robert Schneider(3)......................................... 525,402 3.7
c/o SCM Microsystems GmbH
Luitpoldstrasse 6
D-85276 Pfaffenhofen Germany
Bernd Meier(4).............................................. 244,637 1.7
c/o SCM Microsystems GmbH
Luitpoldstrasse 6
D-85276 Pfaffenhofen Germany
Steven Humphreys(5)......................................... 106,570 *
John Niedermaier(6)......................................... 18,333 *
Friedrich Bornikoel(7)...................................... 148,163 1.1
Oystein Larsen(8)........................................... 6,667 *
Poh Chuan Ng(9)............................................. 4,583 *
Andrew Vought(10)........................................... 5,583 *
All directors and executive officers as a group (8
persons)(11).............................................. 1,059,940 7.5
</TABLE>
- ---------------
* Less than one percent.
(1) Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission. In computing the number of shares
beneficially owned by a person and the percentage ownership of that person,
shares of common stock subject to options held by that person that are
currently exercisable or exercisable but not necessarily vested within 60
days of April 30, 1999 are deemed outstanding. Such shares, however, are
not deemed outstanding for the purpose of computing the percentage
ownership of each other person. Except as indicated in the footnotes to
this table and
44
<PAGE> 46
pursuant to applicable community property laws, each stockholder named in
the table has sole voting and investment power with respect to the shares
set forth opposite such stockholder's name.
(2) Includes 52,081 shares held by TVM Eurotech Ltd.
(3) Includes: (i) 13,510 shares held by Robert Schneider's wife, Ursula
Schneider; and (ii) options to purchase 56,458 shares and 500 shares of
common stock exercisable within 60 days of April 30, 1999 held by Robert
Schneider and Ursula Schneider, respectively.
(4) Includes: (i) 5,000 shares held by Bernd Meier's wife, Sonja Meier; (ii)
options to purchase 56,458 shares and 500 shares of common stock
exercisable within 60 days of April 30, 1999 held by Bernd Meier and Sonja
Meier, respectively, and (iii) 35,064 shares held in trust for Nicholas
Efthymiou.
(5) Includes 74,904 shares of common stock which are subject to repurchase by
SCM until vested.
(6) Includes options to purchase 15,851 shares of common stock exercisable
within 60 days of April 30, 1999.
(7) Includes: (i) 143,580 shares held by TVM Techno Venture Management GmbH.
Mr. Bornikoel is a partner of TVM Techno Venture Management GmbH. Mr.
Bornikoel disclaims beneficial ownership of shares beneficially owned by
such entity except to the extent of his pecuniary interest therein and (ii)
options to purchase 4,583 shares of common stock exercisable within 60 days
of April 30, 1999.
(8) Includes options to purchase 6,667 shares of common stock exercisable
within 60 days of April 30, 1999.
(9) Includes options to purchase 4,583 shares of common stock exercisable
within 60 days of April 30, 1999.
(10) Includes options to purchase 4,583 shares of common stock exercisable
within 60 days of April 30, 1999.
(11) Includes shares and exercisable options which may be deemed to be
beneficially owned by certain directors and executive officers. See Notes
3, 4, 6, 7, 8, 9, and 10 above.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In March 1997, SCM and Intel entered into a three-year development and
license agreement. As part of this arrangement, Intel made an equity investment
of $2.0 million in SCM and, as of December 31, 1998, beneficially owned less
than 1% of SCM's Common Stock.
In May 1997, SCM and Telenor entered into a development and supply
agreement. As part of this agreement, Telenor purchased 640,000 shares of
Preferred Stock for approximately $5.5 million, received 34,965 additional
shares of Preferred Stock in exchange for certain technology rights and received
a warrant to purchase an additional 194,930 shares of Preferred Stock for $8.58
per share. As of December 31, 1998, Telenor beneficially owned less than 1% of
SCM's Common Stock.
During 1996 and 1997, SCM purchased contract manufacturing services
totaling $3.3 million and $3.4 million, respectively, from ICS. Poh Chuan Ng, a
director of SCM, served as Director, Business Development for ICS from September
1994 through May 1997. SCM acquired ICS in June of 1998.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents Filed with Report
1. Financial Statements
The following Consolidated Financial Statements and Report of
Independent Public Accountants are incorporated by reference to page F-1
through F-24 of this Form 10-K.
The consolidated balance sheets for the years ended December 31, 1998
and 1997, and the consolidated statements of operations and
comprehensive income (loss), stockholders' equity (deficit), and cash
flows for each of the years in the three-year period ended December 31,
1998, together with the notes thereto.
45
<PAGE> 47
The report of KPMG LLP, independent public accountants, dated February
23, 1999.
2. Financial Statement Schedules
The following financial statement schedule should be read in conjunction
with the consolidated financial statements and the notes thereto.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
BALANCE AT BALANCE AT
BEGINNING OF END OF
CLASSIFICATION PERIOD ADDITIONS DEDUCTIONS PERIOD
-------------- ------------ --------- ---------- ----------
<S> <C> <C> <C> <C>
Allowance for returns and doubtful accounts
Year ended December 31, 1996....................... 93 172 42 223
Year ended December 31, 1997....................... 223 54 87 190
Year ended December 31, 1998....................... 190 2,606 -- 2,796
Warranty accrual
Year ended December 31, 1996....................... 84 19 -- 103
Year ended December 31, 1997....................... 103 40 42 101
Year ended December 31, 1998....................... 101 5 -- 106
</TABLE>
3. Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
<S> <C>
3.1* Fourth Amended and Restated Certificate of Incorporation.
3.2* Bylaws, as amended, of Registrant.
4.1* Form of Registrant's Common Stock Certificate.
9.1* Form of Director and Officer Indemnification Agreement.
9.2* 1997 Stock Plan.
10.1* 1997 Employee Stock Purchase Plan.
10.4* 1997 Director Option Plan.
10.5* 1997 Stock Option Plan for French Employees.
10.6* 1997 Employee Stock Purchase Plan for Non-U.S. Employees.
10.7** Revolving Credit Loan and Security Agreement, dated
September 26, 1997, between Registrant and Comerica Bank.
10.8* Line of Credit, dated October 23, 1996, between Registrant
and Deutsche Bank.
10.9* Line of Credit, dated December 3, 1996, between Registrant
and BHF Bank.
10.10* Line of Credit, dated November 11, 1996, between Registrant
and Stadtsparkasse Munchen.
10.11* Lease, dated September 29, 1994, between Registrant and Los
Gatos Business Park.
10.12* Sublease Agreement, dated December 17, 1996, between
Intermart Systems, Inc. and Registrant.
10.13* Lease, dated September 30, 1994, between Registrant and
Olbrich Franz.
10.14* Amended and Restated Stockholders' Agreement, dated April
11, 1997, between Registrant and certain investors.
10.15* Form of Employment Agreement between SCM GmbH and Messrs.
Schneider and Meier.
10.16* Employment Agreement, dated May 15, 1995, between Registrant
and Jean-Yves Le Roux.
</TABLE>
46
<PAGE> 48
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
<S> <C>
10.17*+ Commitment Instrument, dated August 7, 1996, among France
Telecom, Matra Communication, Registrant and Matra MHS.
10.18*+ Teaming Agreement, dated October 6, 1995, between
Temic/Matra MHS, Matra Communication and Registrant.
10.19*+ Development Agreement, dated March 6, 1997, between Intel
Corporation and Registrant.
10.20*+ Technology Development and License Agreement, dated
September 27, 1996, between Registrant and Sun Microsystems,
Inc.
10.21* Cooperation Contract, dated March 25, 1996, between
Registrant and Stocko Metallwarenfabriken Henkels and Sohn
GmbH & Co.
10.22*+ Development and Supply Agreement, dated October 9, 1996,
between BetaDigital Gesellschaft fur digitale Fernsehdienste
mbH and Registrant.
10.23* Framework Contract, dated December 23, 1996, between Siemens
Nixdorf Informationssysteme AG and Registrant.
10.24* B-1 License and Know-How Contract, dated September 4, 1996,
between Deutsche Telekom AG and Registrant, as amended.
10.25* Technology Option Agreement, dated January 31, 1997, between
Wolfgang Neifer and Registrant.
10.26*+ Development and Supply Agreement, dated May 15, 1997,
between Telenor Conax and Registrant.
10.27*+ Manufacturer's Sales Representative Agreement, dated
December 8, 1994, between Registrant and AGM.
10.28* License Agreement, dated September 5, 1997, between the
Registrant and Gemplus.
10.29* Warrant Issuance and Common Stock Agreement, dated September
5, 1997, between the Registrant and Gemplus.
10.30* Common Stock Purchase Warrant dated September 5, 1997,
issued to Gemplus.
10.31* Common Stock Purchase Warrant dated September 5, 1997,
issued to Gemplus.
10.32* Waiver and Amendment to Amended and Restated Stockholders'
Agreement dated September 5, 1997.
11.1* Statement of computation of earnings per share.
21.1* Subsidiaries of the Registrant.
23.1 Consent of KPMG LLP, Independent Certified Public
Accountants.
27.1 Financial Data Schedule.
</TABLE>
- ---------------
* Filed previously as an exhibit to SCM's Registration Statement on Form S-1
(SEC Registration No. 333-29073).
** Filed previously as an exhibit to SCM's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1997 (See File No. 000-22689).
+ Certain information in these exhibits has been omitted pursuant to a
confidential treatment request under 17 C.F.R. Section Section 200.80(b)(4),
200.83 and 230.46.
(b) Reports on Form 8-K
(i) On November 18, 1998, SCM filed a Form 8-K reporting the closing
of its acquisition of Shuttle Technology Group Limited.
47
<PAGE> 49
(ii) On August 12, 1998, SCM filed a Form 8-K/A amending the financial
statements of its Form 8-K filed on June 3, 1998.
(iii) On June 18, 1998, SCM filed a Form 8-K reporting the closing of
its acquisition of Intellicard Systems Pte. Ltd.
(iv) On June 3, 1998, SCM filed a Form 8-K reporting the closing of its
acquisition of Intermart Systems, K.K.
(c) See response to Item 14(a)(3) above.
(d) See response to Item 14(a)(2) above.
48
<PAGE> 50
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
Registrant
SCM MICROSYSTEMS, INC.
March 31, 1999 By: /s/ STEVEN HUMPHREYS
------------------------------------
Steven Humphreys
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE CAPACITY IN WHICH SIGNED DATE
--------- ------------------------ --------------
<S> <C> <C>
/s/ ROBERT SCHNEIDER Chairman of the Board March 31, 1999
- ---------------------------------------------------
Robert Schneider
/s/ STEVEN HUMPHREYS President and Chief Executive March 31, 1999
- --------------------------------------------------- Officer (Principal Executive
Steven Humphreys Officer) and Director
/s/ JOHN NIEDERMAIER Vice President, Finance and March 31, 1999
- --------------------------------------------------- Chief Financial Officer
John Niedermaier (Principal Financial and
Accounting Officer)
/s/ BERND MEIER Chief Operations Officer and March 31, 1999
- --------------------------------------------------- Director
Bernd Meier
/s/ FRIEDRICH BORNIKOEL Director March 31, 1999
- ---------------------------------------------------
Friedrich Bornikoel
/s/ OYSTEIN LARSEN Director March 31, 1999
- ---------------------------------------------------
Oystein Larsen
/s/ POH CHUAN NG Director March 31, 1999
- ---------------------------------------------------
Poh Chuan Ng
/s/ ANDREW VOUGHT Director March 31, 1999
- ---------------------------------------------------
Andrew Vought
</TABLE>
49
<PAGE> 51
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report................................ F-2
Consolidated Balance Sheets as of December 31, 1998 and
1997...................................................... F-3
Consolidated Statements of Operations and Comprehensive
Income (Loss) for the years ended December 31, 1998, 1997
and 1996.................................................. F-4
Consolidated Statements of Stockholders' Equity (Deficit)
for the years ended December 31, 1998, 1997 and 1996...... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996.......................... F-6
Notes to Consolidated Financial Statements.................. F-7
</TABLE>
F-1
<PAGE> 52
INDEPENDENT AUDITORS' REPORT
The Board of Directors
SCM Microsystems, Inc.:
We have audited the accompanying consolidated balance sheets of SCM
Microsystems, Inc. and subsidiaries (the Company) as of December 31, 1998 and
1997, and the related consolidated statements of operations and comprehensive
income (loss), stockholders' equity (deficit), and cash flows for each of the
years in the three-year period ended December 31, 1998. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SCM
Microsystems, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting principles.
/s/ KPMG LLP
Mountain View, California
February 23, 1999
F-2
<PAGE> 53
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1998 1997
----------- ----------
(IN THOUSANDS, EXCEPT
SHARE AND PER SHARE DATA)
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 47,177 $25,737
Short-term investments.................................... 82,741 30,336
Accounts receivable, less allowance of $2,796 and $190 as
of December 31, 1998 and 1997, respectively............ 25,535 11,157
Inventories............................................... 12,159 5,001
Deferred income taxes..................................... 1,996 --
Prepaid expenses.......................................... 1,883 551
-------- -------
Total current assets.............................. 171,491 72,782
Property and equipment, net................................. 4,063 1,671
Intangible assets, net...................................... 4,847 1,149
Other assets................................................ 2,919 --
-------- -------
$183,320 $75,602
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Line of credit and other current debt..................... $ -- $ 802
Accounts payable.......................................... 15,046 6,168
Accrued payroll and related expenses...................... 950 796
Other accrued expenses.................................... 3,991 1,509
Income taxes payable...................................... 4,554 1,144
-------- -------
Total current liabilities......................... 24,541 10,419
-------- -------
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock -- Series A, $0.001 par value;
10,000,000 shares authorized; no shares issued and
outstanding as of December 31, 1998 and 1997........... -- --
Common stock, $0.001 par value; 40,000,000 shares
authorized as of December 31, 1998 and 1997; 14,006,477
and 11,502,953 shares issued and outstanding as of
December 31, 1998 and 1997, respectively............... 14 12
Additional paid-in capital................................ 168,897 72,027
Deferred stock compensation............................... (72) (125)
Accumulated deficit....................................... (11,198) (6,225)
Other cumulative comprehensive income (loss).............. 1,138 (506)
-------- -------
Total stockholders' equity........................ 158,779 65,183
-------- -------
$183,320 $75,602
======== =======
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE> 54
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Net sales................................................... $85,009 $46,423 $30,152
Cost of sales............................................... 57,148 30,213 21,030
------- ------- -------
Gross profit...................................... 27,861 16,210 9,122
------- ------- -------
Operating expenses:
Research and development.................................. 6,356 4,501 3,196
Sales and marketing....................................... 8,904 5,923 4,459
General and administrative................................ 9,288 3,872 2,375
In-process research and development....................... 3,101 -- --
Accelerated amortization of goodwill...................... 5,211 -- --
Other acquisition-related charges......................... 3,153 -- --
------- ------- -------
Total operating expenses.......................... 36,013 14,296 10,030
------- ------- -------
Loss from operations.............................. (8,152) 1,914 (908)
Interest income (expense), net.............................. 5,832 815 (309)
Foreign currency transaction gains.......................... 192 688 288
------- ------- -------
Income (loss) before income taxes................. (2,128) 3,417 (929)
Provision for income taxes.................................. 2,845 1,068 19
------- ------- -------
Net income (loss)................................. (4,973) 2,349 (948)
Accretion on redeemable convertible preferred stock......... -- (802) (287)
------- ------- -------
Net income (loss) applicable to common
stockholders.................................... $(4,973) $ 1,547 $(1,235)
======= ======= =======
Basic net income (loss) per share........................... $ (0.38) $ 0.35 $ (0.67)
======= ======= =======
Diluted net income (loss) per share......................... $ (0.38) $ 0.28 $ (0.67)
======= ======= =======
Shares used to compute basic net income (loss) per share.... 13,253 4,394 1,838
======= ======= =======
Shares used to compute diluted net income (loss) per
share..................................................... 13,253 5,614 1,838
======= ======= =======
Comprehensive income (loss):
Net income (loss)......................................... $(4,973) $ 2,349 $ (948)
Other comprehensive income (loss) -- foreign currency
translation adjustment, net of related taxes (benefit)
of $548, ($170) and $0 in 1998, 1997 and 1996,
respectively........................................... 1,644 (379) 23
------- ------- -------
Comprehensive income (loss)............................ $(3,329) $ 1,970 $ (925)
======= ======= =======
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE> 55
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED
STOCK -- SERIES A COMMON STOCK ADDITIONAL DEFERRED
----------------- ------------------- PAID-IN STOCK ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION DEFICIT
-------- ------ ---------- ------ ---------- ------------ -----------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCES AS OF DECEMBER 31, 1995..... 854,038 $ 1 1,837,656 $ 2 $ 2,315 $ -- $ (6,537)
Deferred compensation related to
grants of restricted stock........ -- -- 377 (377) --
Amortization of deferred stock
compensation...................... -- -- -- -- -- 153 --
Foreign currency translation
adjustment........................ -- -- -- -- -- -- --
Net loss............................ -- -- -- -- -- -- (948)
Accretion on redeemable convertible
preferred stock, Series B......... -- -- -- -- -- -- (287)
-------- --- ---------- --- -------- ----- --------
BALANCES AS OF DECEMBER 31, 1996..... 854,038 1 1,837,656 2 2,692 (224) (7,772)
Issuance of common stock upon
exercise of options and
warrants.......................... -- -- 680,531 1 63 -- --
Deferred compensation related to
grants of stock options........... -- -- -- 175 (175) --
Common stock warrants issued in
settlement of patent claim........ -- -- -- 453 -- --
Sale of common stock, net of
issuance costs.................... -- -- 3,955,500 4 45,361 -- --
Issuance of common stock in exchange
for the net assets of business
acquired.......................... -- -- 230,733 -- 1,640 -- --
Conversion of convertible preferred
stock, Series A, to common
stock............................. (854,038) (1) 854,038 1 -- -- --
Conversion of redeemable convertible
preferred stock, Series B through
F, to common stock................ -- -- 3,944,495 4 21,643 -- --
Amortization of deferred stock
compensation...................... -- -- -- -- 274 --
Foreign currency translation
adjustment........................ -- -- -- -- -- -- --
Net income.......................... -- -- -- -- -- -- 2,349
Accretion on redeemable convertible
preferred stock, Series B through
F................................. -- -- -- -- -- (802)
-------- --- ---------- --- -------- ----- --------
BALANCES AS OF DECEMBER 31, 1997..... -- 11,502,953 12 72,027 (125) (6,225)
Issuance of common stock upon
exercise of options and
warrants.......................... -- 938,806 1 6,859 -- --
Sale of common stock, net of
issuance costs.................... -- 1,450,000 1 83,066 -- --
Issuance of common stock under
Employee Stock Purchase Plan...... -- -- 6,982 -- 204 -- --
Issuance of common stock in exchange
for the net assets of business
acquired.......................... -- -- 107,736 -- 5,976 -- --
Tax benefits resulting from
disqualifying dispositions of
stock options..................... -- -- 765 -- --
Amortization of deferred stock
compensation...................... -- -- -- 53 --
Foreign currency translation
adjustment........................ -- -- -- -- -- -- --
Net loss............................ -- -- -- -- -- -- (4,973)
-------- --- ---------- --- -------- ----- --------
BALANCES AS OF DECEMBER 31, 1998..... -- $-- 14,006,477 $14 $168,897 $ (72) $(11,198)
======== === ========== === ======== ===== ========
<CAPTION>
OTHER
CUMULATIVE
COMPREHENSIVE TOTAL
INCOME STOCKHOLDERS'
(LOSS) EQUITY (DEFICIT)
------------- ----------------
<S> <C> <C>
BALANCES AS OF DECEMBER 31, 1995..... $ (150) $ (4,369)
Deferred compensation related to
grants of restricted stock........ -- --
Amortization of deferred stock
compensation...................... -- 153
Foreign currency translation
adjustment........................ 23 23
Net loss............................ -- (948)
Accretion on redeemable convertible
preferred stock, Series B......... -- (287)
------ --------
BALANCES AS OF DECEMBER 31, 1996..... (127) (5,428)
Issuance of common stock upon
exercise of options and
warrants.......................... -- 64
Deferred compensation related to
grants of stock options........... --
Common stock warrants issued in
settlement of patent claim........ -- 453
Sale of common stock, net of
issuance costs.................... -- 45,365
Issuance of common stock in exchange
for the net assets of business
acquired.......................... -- 1,640
Conversion of convertible preferred
stock, Series A, to common
stock............................. --
Conversion of redeemable convertible
preferred stock, Series B through
F, to common stock................ -- 21,647
Amortization of deferred stock
compensation...................... -- 274
Foreign currency translation
adjustment........................ (379) (379)
Net income.......................... -- 2,349
Accretion on redeemable convertible
preferred stock, Series B through
F................................. -- (802)
------ --------
BALANCES AS OF DECEMBER 31, 1997..... (506) 65,183
Issuance of common stock upon
exercise of options and
warrants.......................... -- 6,860
Sale of common stock, net of
issuance costs.................... -- 83,067
Issuance of common stock under
Employee Stock Purchase Plan...... -- 204
Issuance of common stock in exchange
for the net assets of business
acquired.......................... -- 5,976
Tax benefits resulting from
disqualifying dispositions of
stock options..................... -- 765
Amortization of deferred stock
compensation...................... -- 53
Foreign currency translation
adjustment........................ 1,644 1,644
Net loss............................ -- (4,973)
------ --------
BALANCES AS OF DECEMBER 31, 1998..... $1,138 $158,779
====== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE> 56
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
--------- -------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)......................................... $ (4,973) $ 2,349 $ (948)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Deferred income taxes................................. (1,231) -- --
Depreciation and amortization......................... 7,831 660 511
Charge off of in-process research and development..... 3,101 -- --
Amortization of deferred stock compensation........... 53 274 153
Change in allowance for doubtful accounts
receivable......................................... 2,606 (33) 130
Noncash charges from issuance of warrants............. -- 453 --
Changes in operating assets and liabilities:
Accounts receivable................................ (11,664) (3,718) (1,627)
Inventories........................................ (5,070) (1,615) (227)
Prepaid expenses................................... (887) (93) (605)
Accounts payable................................... 4,565 1,495 623
Accrued expenses................................... 1,815 765 191
Income taxes payable............................... 3,395 1,015 31
--------- -------- -------
Net cash provided by (used in) operating
activities..................................... (459) 1,552 (1,768)
--------- -------- -------
Cash flows from investing activities:
Capital expenditures...................................... (2,985) (973) (883)
Businesses acquired, net of cash received................. (9,875) -- --
Proceeds from short-term investments...................... 61,779 -- --
Purchases of short-term investments....................... (114,184) (30,336) --
Purchase of convertible note.............................. (2,500) -- --
--------- -------- -------
Net cash used in investing activities............ (67,765) (31,309) (883)
--------- -------- -------
Cash flows from financing activities:
Proceeds from notes payable............................... -- 380 5,057
Payments on line of credit and other current debt......... (770) (4,330) (1,531)
Proceeds from issuance of equity, net..................... 90,131 45,424 --
Proceeds from issuance of redeemable convertible preferred
stock, net.............................................. -- 11,437 --
Proceeds from line of credit.............................. -- 523 1,117
--------- -------- -------
Net cash provided by financing activities........ 89,361 53,434 4,643
--------- -------- -------
Effect of exchange rates on cash and cash equivalents....... 303 (606) (262)
--------- -------- -------
Net increase in cash and cash equivalents................... 21,440 23,071 1,730
Cash and cash equivalents at beginning of year.............. 25,737 2,666 936
--------- -------- -------
Cash and cash equivalents at end of year.................... $ 47,177 $ 25,737 $ 2,666
========= ======== =======
Supplemental disclosures of cash flow information:
Cash paid for income taxes................................ $ 601 $ -- $ --
========= ======== =======
Cash paid for interest.................................... $ 113 $ 161 $ 321
========= ======== =======
Noncash investing and financing activities:
Businesses acquired for common stock.................... $ 5,976 $ -- $ --
========= ======== =======
Tax benefits from employee stock transactions........... $ 765 $ -- $ --
========= ======== =======
Accretion on redeemable convertible preferred stock..... $ -- $ 802 $ 287
========= ======== =======
Conversion of related party and nonrelated party debt
into redeemable convertible preferred stock........... $ -- $ 4,330 $ --
========= ======== =======
Conversion of convertible preferred stock and redeemable
convertible preferred stock into common stock......... $ -- $ 23,269 $ --
========= ======== =======
</TABLE>
See accompanying notes to supplemental consolidated financial statements.
F-6
<PAGE> 57
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The Company
SCM Microsystems (the Company or SCM) 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 its 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. The Company maintains its U.S. headquarters in
California and maintains its international headquarters in Germany.
Reincorporation
From inception in 1990 until December 1996, the Company was incorporated in
Germany. During 1993, the Company formed a U.S. subsidiary which is incorporated
in Delaware.
In December 1996, the Company incorporated a holding company in the state
of Delaware and entered into a stock exchange agreement with the stockholders of
the German corporation. The Board of Directors approved an exchange of one share
in the German corporation for 6.4021 shares in the new Delaware corporation. The
Certificate of Incorporation of the Delaware corporation authorizes 19,000,000
shares of common stock at $0.001 par value per share and 6,000,000 shares of
preferred stock at $0.001 par value per share. The authorized number of shares
of common and preferred stock was subsequently increased to 40,000,000 shares
and 10,000,000 shares, respectively (see Note 6). The accompanying consolidated
financial statements have been retroactively restated to give effect to the
reincorporation and stock split.
Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include those of the
Company and its wholly owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.
Acquisitions
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 merger has been accounted for as a pooling of
interests and, accordingly, the accompanying 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.
Also in 1998, the Company made two business acquisitions which were
accounted for under the purchase method of accounting. Under the purchase
method, the results of operations of acquired companies are included
prospectively from the date of acquisition, and the acquisition cost is
allocated to the acquirees' tangible and identifiable intangible assets and
liabilities based upon their fair market values at the date of acquisition, with
any residual being treated as goodwill.
Intangible Assets
Intangible assets include workforce in place, noncompete agreements and
goodwill associated with acquisitions accounted for under the purchase method.
Such amounts are being amortized using the straight-line method over the useful
lives of the related assets, from five to seven years.
F-7
<PAGE> 58
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
Use of Estimates
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the consolidated
financial statements and reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates.
Cash Equivalents and Short-term Investments
The Company considers all highly liquid investments with a remaining
maturity of three months or less at the date of acquisition to be cash
equivalents. Short-term investments are classified as "available-for-sale" and
are stated at amortized cost which approximates fair value, with unrealized
gains or losses reported as a separate component of stockholders' equity
(deficit). To date, unrealized gains and losses have not been material.
Financial Instruments and Concentration of Credit Risk
The carrying value of the Company's financial instruments, including cash
and cash equivalents, short-term investments and accounts receivable,
approximates their fair market value due to the short maturities of these
instruments. Financial instruments that potentially expose the Company to a
concentration of credit risk principally consist of cash and cash equivalents,
short-term investments and accounts receivable. Substantially all of the
Company's cash, cash equivalents, and short-term investments are held by five
major financial institutions.
The Company sells its products to a diversified group of customers which
are typically large computer OEMs located mainly in the United States, Europe,
Japan and Southeast Asia. The Company extends credit based on an evaluation of
each customer's financial condition and generally requires no collateral from
its customers. Credit losses, if any, have been provided for in the consolidated
financial statements and have been within management's expectation.
Inventories
Inventories are stated at the lower of cost or market, using the first-in,
first-out method.
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using
the straight-line method based upon the lesser of the useful lives of the
respective assets or the lease term, generally three to seven years.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
The Company evaluates its long-lived assets (including goodwill) and
certain identifiable intangibles for impairment whenever events or changes in
circumstances indicate that the carrying amount of such assets or intangibles
may not be recoverable. Recoverability of assets to be held and used (including
goodwill) is measured by a comparison of the carrying amount of an asset to
future net cash flows expected to be generated by an asset. If such assets are
considered to be impaired, the impairment to be recognized is measured by the
amount by which the carrying amount of the assets exceed the fair value of the
assets. Assets to be disposed of are reported at the lower of the carrying
amount or fair value less costs to sell. In 1998, the Company recorded a charge
of $5,211,000 relating to the accelerated amortization of goodwill recorded on
the acquisitions of Intermart Systems K.K. (Intermart) and Memory Technology
Ltd. (Memory) (see Note 2).
F-8
<PAGE> 59
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
Revenue Recognition
Revenue from product sales is recognized upon product shipment. Provisions
for estimated warranty repairs and returns and allowances are provided for at
the time products are shipped. Nonrecurring engineering contract revenue is
recognized using the percentage of completion method.
Stock-Based Compensation
The Company uses the intrinsic value-based method to account for all of its
employee stock-based compensation plans. The Company amortizes deferred
stock-based compensation on an accelerated basis in accordance with Financial
Accounting Standards Board (FASB) Interpretation No. 28.
Income Taxes
Income taxes are accounted for using the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amount of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.
Foreign Currency Translation
The functional currency of the Company's foreign subsidiaries is the local
foreign currency. The Company translates the assets and liabilities of its
foreign subsidiaries to U.S. dollars at the rates of exchange in effect at the
end of the year. Net sales and expenses are translated at the average rates of
exchange for the year. Translation gains and losses are included in other
cumulative comprehensive income (loss) in the accompanying consolidated balance
sheets. Gains and losses resulting from foreign currency transactions
denominated in a currency other than the functional currency are included in
income.
Earnings (Loss) Per Share
On October 1, 1997, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 128, Earnings Per Share (EPS). In accordance with SFAS No.
128, basic EPS is computed using the weighted-average number of common shares
outstanding during the period. Diluted EPS is computed using the
weighted-average number of common and, when dilutive, common equivalent shares
outstanding during the period. Dilutive common equivalent shares consist of
common stock issuable upon exercise of stock options and warrants using the
treasury stock method. The following is a reconciliation of the
F-9
<PAGE> 60
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
shares use in the computation of basic and diluted EPS for the years ended
December 31, 1998, 1997 and 1996 (in thousands except for per share amounts):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------
1998 1997 1996
------- ------ -------
<S> <C> <C> <C>
BASIC EARNINGS (LOSS) PER SHARE:
Net income (loss) applicable to common
stockholders...................................... $(4,973) $1,547 $(1,235)
======= ====== =======
Basic net income (loss) per share.................... $ (0.38) $ 0.35 $ (0.67)
======= ====== =======
Weighted average common shares outstanding........... 13,253 4,394 1,838
======= ====== =======
DILUTED EARNINGS (LOSS) PER SHARE:
Net income (loss) applicable to common
stockholders...................................... $(4.973) $1,547 $(1,235)
======= ====== =======
Diluted net income (loss) per share.................. $ (0.38) $ 0.28 $ (0.67)
======= ====== =======
SHARES USED:
Weighted average common shares outstanding........... 13,253 4,394 1,838
Series A convertible preferred stock................. -- 655 --
Stock options outstanding............................ -- 424 --
Stock warrants outstanding........................... -- 141 --
------- ------ -------
13,253 5,614 1,838
======= ====== =======
</TABLE>
Excluded from the computation of diluted EPS for the year ended December
31, 1998 are common equivalent shares resulting from the effect of 1,496,068 and
16,731 shares issuable under stock options and warrants, respectively, using the
treasury stock method, because their inclusion would be antidilutive. Such
options and warrants had weighted average exercise prices of $21.23 and $5.72
per share, respectively. Excluded from the computation of diluted EPS for the
year ended December 31, 1997 are the common equivalent shares resulting from the
assumed conversion of the redeemable convertible preferred stock, because their
effects were antidilutive prior to their conversion into common stock on October
7, 1997. Excluded from the computation of diluted EPS for the year ended
December 31, 1996 are common equivalent shares resulting from the effect of
940,098 shares issuable under stock options using the treasury stock method,
because their inclusion would be antidilutive. Such options had an average
exercise price of $0.10 per share.
Comprehensive Income (Loss)
Effective January 1, 1998, the Company adopted the provisions of SFAS No.
130, Reporting Comprehensive Income, which establishes standards for reporting
and disclosure of comprehensive income and its components (revenues, expenses,
gains and losses) in a full set of general-purpose financial statements.
Comprehensive income includes all changes in equity during a period except those
resulting from the issuance of shares of stock and distributions to
stockholders.
Recent Accounting Pronouncements
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
F-10
<PAGE> 61
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
will be effective for all annual and interim periods beginning after December
15, 1999 and management does not believe the adoption of SFAS No. 133 will have
a material effect on the consolidated financial position of the Company.
NOTE 2. BUSINESS COMBINATIONS
Intermart and ICS
In the second quarter of 1998, the Company acquired all of the outstanding
capital stock Intermart and Intellicard Systems Pte. Ltd. (ICS). A summary of
the purchase price for the acquisitions is as follows (in thousands):
<TABLE>
<S> <C>
Cash............................................... $19,751
Common stock....................................... 5,976
Direct acquisition costs........................... 433
-------
Total.................................... $26,160
=======
</TABLE>
The acquisitions of Intermart and ICS were accounted for pursuant to the
purchase method of accounting. At the time of the respective acquisitions, the
aggregate fair value of Intermart's and ICS' research and development efforts
that had not reached technological feasibility as of the respective dates of
acquisition and had no alternative future uses was determined by appraisal to be
$5.9 million, and was expensed at the respective dates of the acquisitions. At
that time, goodwill for the acquisitions approximated $7.4 million and
represented the excess of the purchase price over the fair value of identifiable
tangible and intangible assets acquired. During the fourth quarter of 1998, the
Company's management revised the amount of purchase price allocated to
in-process research and development relating to the acquisition of Intermart in
order to reflect the recently announced views of the Securities and Exchange
Commission regarding the measurement of in-process research and development. As
a result, the Company restated its quarterly consolidated financial statements
for the quarters ended June 30, 1998 and September 30, 1998 to reflect this
revision. The effect of this restatement increased net income in the June
quarter by $2,804,000, or $0.22 per share, and decreased net income in the
September quarter by $108,000, or $0.01 per share.
A summary of the original and restated allocations of the purchase price is
as follows (in thousands):
<TABLE>
<CAPTION>
INTERMART/ICS INTERMART/ICS
------------- -------------
(ORIGINAL) (RESTATED)
<S> <C> <C>
In-process research and development............... $ 5,941 $ 3,101
Cash acquired..................................... 9,876 9,876
Other net assets acquired......................... 2,980 2,980
Goodwill.......................................... 7,363 10,203
------- -------
Total................................... $26,160 $26,160
======= =======
</TABLE>
F-11
<PAGE> 62
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
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 years ended December 31, 1998 and 1997, as if each company
had been acquired as of the beginning of the periods 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>
YEARS ENDED
DECEMBER 31,
------------------
1998 1997
------- -------
<S> <C> <C>
Revenues.................................................... $89,263 $53,932
Net income (loss)........................................... $ (526) $ 1,096
Net income (loss) per share:
Basic..................................................... $ (0.04) $ 0.24
Diluted................................................... $ (0.04) $ 0.19
Shares used in per share computations:
Basic..................................................... 13,360 4,501
Diluted................................................... 13,360 5,721
</TABLE>
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
In connection with the merger with Shuttle, in the fourth quarter the
Company recorded nonrecurring charges totaling $9,683,000, which consisted of
the following (in thousands):
<TABLE>
<CAPTION>
INCURRED ACCRUED TOTAL
-------- ------- ------
<S> <C> <C> <C>
Legal, accounting, regulatory and other due diligence
costs.................................................. $1,656 $597 $2,253
Severance costs relating to five redundant personnel..... 23 -- 23
Costs relating to closure of redundant facilities........ -- 160 160
Costs relating to elimination of redundant equipment..... 136 -- 136
Lower of cost or market reserves on redundant product
lines.................................................. 1,900 -- 1,900
Accelerated amortization of goodwill resulting from
product line redundancies.............................. 5,211 -- 5,211
------ ---- ------
$8,926 $757 $9,683
====== ==== ======
</TABLE>
Of these amounts, the $1,900,000 charge relating to inventory was included
in costs of revenues and the remainder was included in operating expenses. The
Company incurred a charge of $5,211,000 for accelerated amortization of goodwill
resulting from the impairment of goodwill relating to the Intermart and Memory
acquisitions. Following the Company's merger with Shuttle, management determined
that the Memory product offerings were not consistent with its core businesses,
and that a significant portion of the Intermart products were redundant to lower
cost products provided by Shuttle. As a result, the Company evaluated the
prospects for the Memory and Intermart products and concluded that the revenues
to be generated from future sales of these products would not be sufficient to
recover the carrying amount of the related goodwill. Accordingly, the
unamortized amount of this goodwill at the time of the Shuttle merger of
$5,211,000 was written off.
F-12
<PAGE> 63
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
As separate companies, total revenues and net income for the individual
entities were as follows (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Total revenue:
SCM......................................... $64,755 $27,769 $21,520
Shuttle..................................... 20,254 18,654 8,632
------- ------- -------
$85,009 $46,423 $30,152
======= ======= =======
Total net income (loss):
SCM......................................... $(4,424) $ 301 $(1,397)
Shuttle..................................... (549) 1,246 162
------- ------- -------
$(4,973) $ 1,547 $(1,235)
======= ======= =======
</TABLE>
Memory Technology Limited
In December 1997, Shuttle acquired all of the outstanding share capital of
Memory in exchange for 82,810 shares of Shuttle's capital stock (230,733 shares
of the Company's common stock on a post-converted basis). The transaction has
been accounted for under the purchase method of accounting. The fair value of
consideration tendered exceeded the fair value of net assets acquired by
$1,149,000 and was attributed to goodwill. Following the Company's merger with
Shuttle, management determined that the Memory product offerings were not
consistent with its core businesses. Pro forma information giving effect to the
acquisition of Memory has not been presented as pro forma results would not have
differed materially from the Company's consolidated results of operations.
F-13
<PAGE> 64
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
NOTE 3. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The fair value of investments included in cash equivalents and short-term
investments as of December 31, 1998 and 1997 were as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997
-------- -------
<S> <C> <C>
Corporate Bonds $ 33,885 $ 4,002
Money Market Funds 19,076 --
Commercial Paper 17,175 31,244
Corporate Notes 15,450 2,611
Certificates of Deposit 12,952 8,699
Treasury Notes 7,478 900
Market Auction Preferreds 7,119 --
Municipal Obligations 4,029 --
Auction Rates 3,009 --
U.S. Government Agencies 507 2,899
-------- -------
$120,680 $50,355
======== =======
Amounts included in:
Cash and cash equivalents $ 37,939 $20,019
Short-term investments 82,741 30,336
-------- -------
$120,680 $50,355
======== =======
</TABLE>
The contractual maturities of available-for-sale debt securities,
regardless of their balance sheet classification as of December 31, 1998, were
as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997
------- -------
<S> <C> <C>
Due within one year...................................... $55,450 $28,937
Due after one year through two years..................... 27,291 1,399
------- -------
$82,741 $30,336
======= =======
</TABLE>
F-14
<PAGE> 65
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
NOTE 4. BALANCE SHEET COMPONENTS
A summary of consolidated balance sheet components is as follows (in
thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1998 1997
------- ------
<S> <C> <C>
Inventories:
Raw materials........................................... $ 6,764 $2,669
Finished goods.......................................... 5,395 2,332
------- ------
$12,159 $5,001
======= ======
Property and equipment:
Land.................................................... $ 139 $ --
Furniture, fixtures, and office equipment............... 5,544 2,500
Automobiles............................................. 290 90
Purchased software...................................... 1,566 366
------- ------
7,539 2,956
Less accumulated depreciation............................. 3,476 1,285
------- ------
Property and equipment, net............................... $ 4,063 $1,671
======= ======
</TABLE>
NOTE 5. LINE OF CREDIT AND OTHER DEBT
Line of credit and other current debt consisted of the following (in
thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1998 1997
---- ----
<S> <C> <C>
Notes payable to banks........................ $ -- $ 9
Line of credit................................ -- 779
Other......................................... -- 14
---- ----
$ -- $802
==== ====
</TABLE>
Nonconvertible Loans
In October 1993, the Company's German subsidiary entered into a Deutsche
Mark (DM) 1,000,000 loan agreement, bearing interest at 5% per annum, expiring
on December 31, 2003. In June 1995, the Company entered into an additional DM
3,000,000 loan agreement with the same party, bearing interest at 6% per annum,
expiring on December 31, 2005. Under this second agreement, DM 2,000,000 was
drawn in June 1995, and the remaining DM 1,000,000 was drawn on April 2, 1996.
The terms of these agreements also provided the lender with the option to
request an additional compensation of 25% of the then outstanding loan amount
after the fifth year of each of the respective agreements or upon early
termination of the loans by the Company.
In May 1997, the Company and the lender resolved the additional
compensation arrangement in exchange for a warrant to purchase 138,000 shares of
the Company's common stock at a price of $5.72 per share. The fair value of
these warrants was not significant. In November 1997, the Company repaid the
outstanding balance of these loans and, in December 1997, the lender exercised
the warrants pursuant to which it received 107,199 shares of the Company's
common stock, net of the exercise price of the warrants.
F-15
<PAGE> 66
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
Lines of Credit
The Company has revolving lines of credit with two banks in Germany
providing total borrowings of up to DM 3,000,000 (approximately $1,700,000 as of
December 31, 1998). One of the German lines expires September 30, 1999 and the
other German line has no expiration date. The German lines of credit bear
interest at rates ranging from 8.0% to 8.75%, and borrowings under these lines
of credit are unsecured. In the United States, the Company has a $3,000,000 line
of credit which is secured by all assets of the Company, bears interest at the
bank's prime rate (7.75% as of December 31, 1998), and expires in May 1999. In
addition, the Company has a L1,500,000 (approximately $2,500,000 as of December
31, 1998) overdraft facility with a bank in the United Kingdom expiring on May
31, 1999. The U.K. facility bears interest at 2% above the U.K. base rate (6.25%
as of December 31, 1998) and is secured by the assets of the U.K. subsidiary.
There were no amounts outstanding under any of these credit facilities as of
December 31, 1998, and there was $779,000 outstanding under the U.K. credit
facility as of December 31, 1997.
Convertible Notes Payable, Series B
In August 1994, certain stockholders advanced the Company loans totaling
$2,059,000. In June 1995, these loans and accrued interest of approximately
$242,000 were converted into Series B preferred stock. Under terms of the Series
B preferred stock agreement, all outstanding shares of Series B preferred stock
were converted into common stock on a one-for-one basis at the time of the
Company's initial public offering (the IPO) in October 1997.
Convertible Notes Payable, Series C
In February 1996, the Company's German subsidiary entered into a loan
agreement for DM 4,009,000. The loan required interest of 4% per annum and was
convertible into 653,642 shares of the Company's Series C preferred stock. The
outstanding balance of this loan as of December 31, 1996, was $1,959,000 payable
to third parties and $627,000 payable to stockholders. In accordance with the
provisions of the loan agreement, the loan was converted into 653,642 shares of
the Company's Series C preferred stock in March 1997. Under terms of the Series
C preferred stock agreement, all outstanding shares of Series C preferred stock
were converted into common stock on a one-for-one basis at the time of the
Company's IPO.
Convertible Notes Payable, Series D
In December 1996, the Company's German subsidiary entered into a loan
agreement for a total of DM 3,179,000 with stockholders of which DM 2,564,000
was tendered as of December 31, 1996. The loan required no interest and was
convertible into 377,580 shares of Series D preferred stock. The outstanding
balance of this loan as of December 31, 1996, was $1,654,000. Under terms of the
Series D preferred stock agreement, all outstanding shares of Series D preferred
stock were converted into common stock on a one-for-one basis at the time of the
Company's IPO. In connection with this loan agreement, the Company issued 22,652
warrants to purchase Series D preferred stock at $5.72 per share. The fair value
of these warrants was not significant.
NOTE 6. STOCKHOLDERS' EQUITY
Convertible Preferred Stock
As of December 31, 1996, the Company was authorized to issue 6,000,000
shares of convertible preferred stock, with a par value of $0.001. The Company
had designated 854,038 shares as convertible Series A and 1,211,914 shares as
convertible Series B.
F-16
<PAGE> 67
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
In March 1997, the Company issued 388,284 shares of Series D redeemable
convertible preferred stock for proceeds of $2,221,000 and 463,285 shares of
Series E redeemable convertible preferred stock for proceeds of $2,650,000. In
April 1997, the Company issued 849,790 shares of Series F redeemable convertible
preferred stock for proceeds of $6,991,199.
In conjunction with the designation of Series F preferred stock, the
Company approved an increase to the authorized number of shares of common stock
and preferred stock to 40,000,000 shares and 10,000,000 shares, respectively.
Each share of Series A, B, C, D, E and F convertible preferred stock
outstanding was converted into one share of common stock upon the completion of
the Company's IPO. The holders of Series A, B, C, D, E and F convertible
preferred stock had voting rights equal to common stock on an "as if converted"
basis.
In connection with the issuance of Series D redeemable convertible
preferred stock, the Company issued 28,539 warrants to purchase Series D
preferred stock at $5.72 per share to a stockholder. The fair value of these
warrants was not significant.
Stock Options
In October 1995, the Company authorized issuance of options to acquire
376,443 shares of the Company's common stock. The options generally vest over a
4-year period, 25% vesting on the first anniversary date of the employee's date
of employment and 1/48 vesting each additional full month thereafter, and are
exercisable for a term of 10 years after issuance. During July 1996, the number
of shares authorized to be issued pursuant to the exercise of options was
increased to 1,030,097 shares.
Employee Stock Plans
1997 Stock Plan
In April 1997, the Company's stockholders approved the 1997 Stock Plan (the
1997 Plan) under which employees and consultants may be granted incentive or
nonqualified stock options for the purchase of the Company's common stock and
stock purchase rights. Options granted under the 1997 Plan generally vest over a
4-year period, 25% vesting on the first anniversary date of the date of grant
and 1/48 vesting each additional month thereafter, and are generally exercisable
for a term of 10 years after issuance. Unless terminated sooner, the 1997 Plan
will terminate automatically in 2007. A total of 1,000,000 shares of common
stock are currently reserved for issuance pursuant to the exercise of options
granted under the 1997 Plan.
1997 Director Option Plan
In April 1997, the Company's stockholders approved the 1997 Director Option
Plan (the Director Plan). A total of 50,000 shares of common stock has been
reserved for issuance pursuant to the exercise of options granted under the
Director Plan. Each outside director of the Company will automatically be
granted an option to purchase up to 10,000 shares of common stock upon their
initial election as a Director, and will automatically be granted annual
subsequent options to purchase additional shares of common stock under the
Director Plan. The price of stock purchased under the Director Plan is 100% of
the fair market value of the common stock as of the grant date.
1997 Employee Stock Purchase Plan
In April 1997, the Company's stockholders approved the 1997 Employee Stock
Purchase Plan (the Purchase Plan) which authorizes the issuance of up to 175,000
shares of the Company's common stock. The Purchase Plan permits eligible
employees to purchase common stock through payroll deductions at a purchase
F-17
<PAGE> 68
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
price of 85% of the lower of fair market value of the common stock at the
beginning or end of each offering period. During 1998, a total of 6,982 shares
were purchased under the Purchase Plan at a price of $29.325 per share. As of
December 31, 1998, 168,018 shares were available under the Purchase Plan for
future issuance.
Stock option activity during the periods indicated is as follows:
<TABLE>
<CAPTION>
OUTSTANDING OPTIONS
---------------------------
SHARES WEIGHTED
AVAILABLE NUMBER AVERAGE
FOR GRANT OF SHARES EXERCISE PRICE
--------- --------- --------------
<S> <C> <C> <C>
BALANCES AS OF JANUARY 1, 1996.................. 94,757 288,067 $ 0.11
Shares reserved............................... 653,654 -- --
Options granted............................... (733,657) 733,657 0.10
Options canceled.............................. 81,626 (81,626) 0.10
--------- ---------
BALANCES AS OF DECEMBER 31, 1996................ 96,380 940,098 0.10
Shares reserved............................... 33,436 -- --
Shares assumed under 1997 stock plans......... (96,380) -- --
Shares reserved under 1997 stock plans........ 1,050,000 -- --
Options granted............................... (872,936) 872,936 8.96
Options canceled.............................. -- (43,700) 0.10
Options exercised............................. -- (573,332) 0.10
--------- ---------
BALANCES AS OF DECEMBER 31, 1997................ 210,500 1,196,002 6.58
Shares reserved............................... 771,521 -- --
Options granted............................... (988,421) 988,421 33.83
Options canceled.............................. 182,275 (182,275) 44.41
Options exercised............................. -- (506,080) 2.85
--------- ---------
BALANCES AS OF DECEMBER 31, 1998................ 175,875 1,496,068 21.23
========= =========
</TABLE>
The following table summarizes information about options outstanding as of
December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ------------------------------------------------------------- -------------------
WEIGHTED-
AVERAGE WEIGHTED- WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF CONTRACTUAL LIFE EXERCISE EXERCISE
EXERCISE PRICES NUMBER (YEARS) PRICE NUMBER PRICE
- --------------- --------- ---------------- --------- ------- --------
<S> <C> <C> <C> <C> <C>
$0.10 2,667 7.81 $0.10 2,667 $0.10
5.72 67,518 8.26 5.72 20,851 5.72
8.10 - 9.50 514,762 8.55 9.01 130,179 9.17
13.00 - 17.84 120,171 9.03 16.45 10,092 13.00
25.06 - 30.00 745,950 9.76 29.95 2,000 25.06
48.81 - 65.56 45,000 9.73 54.73 6,250 65.56
--------- -------
0.10 - 65.56 1,496,068 9.21 21.26 172,039 11.07
========= =======
</TABLE>
The Company uses the intrinsic value-based method to account for its
stock-based compensation plans. Accordingly, no compensation cost has been
recognized for its stock options in the accompanying consolidated financial
statements because the exercise price of the stock options equals or exceeds the
fair value of the underlying common stock at the date of grant, except with
respect to the options and restricted stock granted in July and October 1996.
The Company has recorded deferred stock compensation of $377,000 for the
difference at the grant date between the exercise price and the fair value, as
determined by an independent
F-18
<PAGE> 69
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
valuation, of the restricted stock and the common stock underlying the options.
This amount is being amortized on the straight-line basis over the vesting
period of the individual options and restricted stock, generally four years. For
the years ended December 31, 1998, 1997 and 1996, the Company expensed
approximately $53,000, $274,000 and $153,000, respectively, of the deferred
stock compensation reflecting the commencement of vesting from the date of
employment. Had the Company determined compensation cost based on the fair value
at the grant date for its stock options under SFAS No. 123, the Company's net
income (loss) applicable to common stockholders would have been changed to the
pro forma amounts indicated below (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------- ------ -------
<S> <C> <C> <C>
Net income (loss) applicable to common stockholders:
As reported.......................................... $(4,973) $1,547 $(1,235)
Pro forma............................................ (7,529) 947 (1,235)
Net income (loss) per share:
As reported:
Basic............................................. $ (0.38) $ 0.35 $ (0.67)
Diluted........................................... (0.38) 0.28 (0.67)
Pro forma:
Basic............................................. $ (0.57) $ 0.22 $ (0.67)
Diluted........................................... (0.57) 0.17 (0.67)
</TABLE>
The per share weighted-average fair value of stock options granted during
1998, 1997 and 1996 was $23.12, $6.69 and $0.54, respectively, on the date of
grant using the minimum value method prior to the IPO and the Black-Scholes
option pricing model after the IPO with the following weighted-average
assumptions: 1998 -- expected dividend yield of 0.0%, risk-free interest rate of
4.57%, volatility of 96%, and expected life of 4 years; 1997 -- expected
dividend yield of 0.0%, risk-free interest rate of 6.24%, volatility of 100%,
and expected life of 4 years; 1996 -- expected dividend yield of 0.0%, risk-free
interest rate of 6.32%, and expected life of 4 years.
The fair value of purchase rights granted under the Purchase Plan is
estimated on the date of grant using the Black-Scholes option pricing model with
the following weighted-average assumptions for grants in 1998: no expected
dividends; expected volatility of 96%; risk-free interest rate of 4.91%; and
expected life of 0.5 years. The weighted-average fair value of purchase rights
granted under the Purchase Plan in 1998 was $33.17 per share.
NOTE 7. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS
The Company has adopted the provisions of SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information. SFAS No. 131 establishes
standards for the reporting by public business enterprises of information about
operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on the
way that management organizes the operating segments within the Company for
making operating decisions and assessing financial performance. The Company's
chief operating decision maker is considered to be its executive staff,
consisting of the Chief Executive Officer, Chief Operating Officer and Executive
Chairman. The executive staff reviews financial information presented on a
geographic basis for purposes of making operating decisions and assessing
financial performance.
The Company operates in one industry segment, security, access and
connectivity products for digital devices, and has operations in three primary
geographic regions. The Company's European operations are in Germany, France and
the United Kingdom, and the Company's Asia-Pacific operations are in Singapore,
F-19
<PAGE> 70
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
Japan and Taiwan. The Company's reportable geographic regions are comprised of
the United States, Europe (consisting of the U.K. and continental Europe), and
Asia-Pacific (consisting of Japan, Singapore, Taiwan, Malaysia, Korea and
surrounding countries). Each region provides products and services as further
described in Note 1. For purposes of geographic reporting, Shuttle revenues were
assigned to the region into which the products were shipped, and related costs
of revenues and operating expenses were allocated on the basis of such revenues.
All other revenues, costs of revenues and operating costs appear in the
geographic region into which the products were shipped and all related costs
were incurred. The accounting policies of the various segments are the same as
those described in the "Summary of Significant Accounting Policies" in Note 1.
The Company evaluates the performance of its segments based on the profit before
income taxes for each segment, excluding nonrecurring 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 and for the years ended December 31,
1998, 1997 and 1996 is as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
-------- ------- -------
<S> <C> <C> <C>
United States:
Revenues........................................... $ 32,686 $22,802 $15,112
Gross margin....................................... 11,781 6,950 4,861
Income before income taxes......................... 6,017 1,661 1,106
Interest income (expense).......................... 5,625 1,274 (31)
Depreciation and amortization...................... 171 131 161
Segment assets..................................... 136,003 58,085 5,096
Long-lived assets.................................. 800 560 342
Europe:
Revenues........................................... $ 35,467 $20,582 $14,234
Gross margin....................................... 13,302 8,289 4,029
Income (loss) before income taxes.................. 4,714 1,944 (2,052)
Interest expense................................... (113) (459) (278)
Foreign currency gains............................. 151 688 288
Depreciation and amortization...................... 1,440 529 350
Segment assets..................................... 34,773 19,069 12,621
Long-lived assets.................................. 2,493 2,260 741
Asia-Pacific:
Revenues........................................... $ 16,856 $ 3,039 $ 806
Gross margin....................................... 4,679 971 232
Income before income taxes......................... 506 327 17
Interest income.................................... 319 -- --
Foreign currency gains............................. 41 -- --
Depreciation and amortization...................... 1,009 -- --
Segment assets..................................... 27,220 -- --
Long-lived assets.................................. 5,692 -- --
</TABLE>
F-20
<PAGE> 71
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
A reconciliation of the Company's segment gross margin, segment profit
before income taxes, segment depreciation and amortization, and segment assets
as of and for the years ended December 31, 1998, 1997 and 1996 follows (in
thousands):
<TABLE>
<CAPTION>
1998 1997 1996
-------- ------- -------
<S> <C> <C> <C>
Segment gross margin................................. $ 29,761 $16,210 $ 9,122
Merger and acquisition-related charges............... (1,900) -- --
-------- ------- -------
Total gross margin......................... $ 27,861 $16,210 $ 9,122
======== ======= =======
Segment income (loss) before income taxes............ $ 11,237 $ 3,932 $ (929)
In-process research and development.................. (3,101) -- --
Merger and acquisition-related charges............... (10,264) -- --
Settlement of patent claim........................... -- (515) --
-------- ------- -------
Total income (loss) before income taxes.... $ (2,128) $ 3,417 $ (929)
======== ======= =======
Segment depreciation and amortization................ $ 2,620 $ 660 $ 511
Merger and acquisition-related charges............... 5,211 -- --
-------- ------- -------
Total depreciation and amortization........ $ 7,831 $ 660 $ 511
======== ======= =======
Segment assets....................................... $197,996 $77,288 $17,828
Elimination of intercompany balances................. (14,676) (1,686) (4,008)
-------- ------- -------
Total assets............................... $183,320 $75,602 $13,820
======== ======= =======
</TABLE>
Additional information regarding revenue by product groups is as follows
(in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Digital TV Access Products............................ $26,372 $16,707 $ 3,649
PC and Network Security Products...................... 18,609 10,899 12,979
Digital Media and Connectivity Products............... 40,028 18,654 8,632
PCMCIA Peripheral Products............................ -- 163 4,892
------- ------- -------
$85,009 $46,423 $30,152
======= ======= =======
</TABLE>
A summary of the net sales to major customers that exceeded 10% of total
net sales during each of the years in the three-year period ended December 31,
1998, and the amount due from these customers as of December 31, 1998, follows
(accounts receivable in thousands):
<TABLE>
<CAPTION>
ACCOUNTS
1998 1997 1996 RECEIVABLE
---- ---- ---- ----------
<S> <C> <C> <C> <C>
Customer 1.................................... 17% 27% 8% $2,468
Customer 2.................................... -- 14% -- --
</TABLE>
NOTE 8. INCOME TAXES
Income (loss) before income taxes for domestic and non-U.S. operations is
as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Income (loss) before income taxes:
U.S......................................... $(8,807) $(1,214) $ 133
Foreign..................................... 6,679 4,631 (1,062)
------- ------- -------
Total income (loss) before income
taxes............................. $(2,128) $ 3,417 $ (929)
======= ======= =======
</TABLE>
F-21
<PAGE> 72
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
The provision for income taxes consisted of the following (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------- ------ ----
<S> <C> <C> <C>
Federal:
Current................................................. $ 1,715 $ -- $--
Deferred................................................ (1,607) -- --
------- ------ ---
108 -- --
------- ------ ---
State:
Current................................................. 420 -- --
Deferred................................................ (389) -- --
------- ------ ---
31 -- --
------- ------ ---
Foreign:
Current................................................. 1,941 1,068 19
Deferred................................................ -- -- --
------- ------ ---
1,941 1,068 19
------- ------ ---
Charge in lieu of taxes attributable to incentive stock
options and employee stock purchase plan................ 765 -- --
------- ------ ---
Total provision for income taxes.......................... $ 2,845 $1,068 $19
======= ====== ===
</TABLE>
Significant items making up deferred tax assets and liabilities as of
December 31, 1998 and 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997
------- -------
<S> <C> <C>
Deferred tax assets:
Bad debt reserves......................................... $ 838 $ 32
Inventory adjustments..................................... 871 116
Net operating loss carryforwards.......................... 1,084 2,016
State taxes............................................... 258 --
Other accruals............................................ 49 36
------- -------
3,100 2,200
Less valuation allowance.................................... (1,084) (2,200)
------- -------
2,016 --
Deferred tax liabilities:
Property and equipment.................................... 20 --
------- -------
Net deferred tax asset...................................... $ 1,996 $ --
======= =======
</TABLE>
The Company's deferred tax asset as of December 31, 1997 of $2,200,000 was
fully offset by a valuation allowance due to the uncertainty of generating
future profits that would allow for the realization of such deferred tax assets
as of December 31, 1997. Management believes the realizability of the net
deferred tax asset of $1,996,000 as of December 31, 1998 is likely considering
the amounts available in carryback periods and SCM's projections of future
taxable income. The Company has provided a valuation allowance of $1,084,000 as
of December 31, 1998 due to the uncertainty of the use of the net operating loss
carryforwards due to certain limitations. The net change in the total valuation
allowance for the year ended December 31, 1998 is a decrease of $1,116,000.
F-22
<PAGE> 73
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
The provision for taxes reconciles to the amount computed by applying the
statutory federal rate of 34% to income (loss) before income taxes as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------ ------ -----
<S> <C> <C> <C>
Computed expected tax (benefit)........................... $ (724) $1,162 $(316)
State taxes, net of federal benefits...................... 133 -- --
Foreign taxes (benefits) provided for at rates other than
U.S. statutory rate..................................... (330) (507) 380
Benefits of U.S. net operating loss carryforwards......... (389) -- --
Expenses not currently deductible for tax purposes........ 4,338
Change in the valuation allowance for deferred tax assets
at beginning of year allocated to income tax expense.... (183) 413 (45)
------ ------ -----
Provision for income taxes................................ $2,845 $1,068 $ 19
====== ====== =====
</TABLE>
The Company had net operating loss carryforwards of approximately
$2,191,000 and $923,000 for federal and California income tax purposes,
respectively. Additionally, the Company's Japanese subsidiary had net operating
loss carryforwards of approximately $600,000 as of December 31, 1998 for
Japanese tax purposes. The Japan net operating loss carryforward will expire
approximately in the years 2001 and 2002. The U.S. federal net operating loss
carryforwards will expire in the years 2008 through 2012, and the California net
operating loss carryforwards will expire in the years 1999 through 2002. Federal
and California tax laws impose significant restrictions on the utilization of
net operating loss carryforwards in the event of a shift in the ownership of the
Company, which constitutes an "ownership change" as defined by the Internal
Revenue Code, Section 382. An ownership change occurred in 1996, resulting in
the U.S. subsidiary's federal and California net operating loss carryforwards
being subject to an annual limitation of approximately $340,000. Another
ownership change resulted from the Company's IPO. Any unused annual limitations
may be carried forward to increase the limitations in subsequent years. As of
December 31, 1997, The Company's German subsidiary had net operating loss
carryforwards of approximately $1,440,000 which were fully utilized in 1998.
NOTE 9. COMMITMENTS
The Company leases its facilities, certain equipment, and automobiles under
noncancelable operating lease agreements. These lease agreements expire at
various dates during the next four years. Rent expense was $736,000, $621,000,
and $551,000 in 1998, 1997, and 1996, respectively.
Future minimum lease payments under noncancelable operating leases, net of
expected receipts under noncancelable subleases of $196,000 in 1999, $202,000 in
2000, and $176,000 in 2001, are as follows as of December 31, 1998 (in
thousands):
<TABLE>
<CAPTION>
YEARS ENDING
DECEMBER 31,
------------
<S> <C>
1999.............................................. $1,488
2000.............................................. 1,066
2001.............................................. 805
2002.............................................. 295
2003 and thereafter............................... 243
------
Total minimum lease payments.............. $3,897
======
</TABLE>
F-23
<PAGE> 74
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
NOTE 10. RELATED PARTY TRANSACTIONS
The Company purchased inventory under transactions negotiated on a basis
comparable to an arm's length basis totaling $3,379,000 and $3,294,000 in 1997
and 1996, respectively, from a supplier (ICS) that was also a stockholder.
Included in accounts payable are amounts owed this stockholder of $1,058,000 and
$396,000 as of December 31, 1997 and 1996, respectively. In June 1998, the
Company acquired ICS (see Note 2). Inventory purchased by the Company in 1998
from ICS prior to the acquisition approximated $1,300,000.
In May 1997, the Company entered into a development and supply agreement
with a less than 10% stockholder. Revenues under this agreement in 1998 and 1997
were $3,304,000 and $2,692,000, respectively, and the amounts owed the Company
by the stockholder as of December 31, 1998 and 1997 were $271,000 and $336,000,
respectively.
As discussed in Note 2, the Company acquired Memory, a company related by
common directorship, in December 1997. Prior to the acquisition, the Company,
through its Shuttle subsidiary, conducted transactions on an arm's length basis
with Memory as follows (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
------------
1997 1996
---- ----
<S> <C> <C>
Revenues to Memory.......................................... $520 $339
Purchases from Memory....................................... $433 $613
</TABLE>
Accounts receivable from Memory were $4,000 and $68,000 as of December 31,
1997 and 1996, respectively. Accounts payable to Memory were $97,000 and $73,000
as of December 31, 1997 and 1996, respectively.
As discussed in Note 2, the Company acquired ICS, a Singapore-based
contract manufacturer, in June of 1998. Prior to the acquisition, ICS had made
an investment of approximately $350,000 in one of its customers, a company that
designs and markets video editing and conversion products for PC and internet
applications (the ICS Customer). During 1998, revenue from the ICS Customer
amounted to $3,609,000, and the amount receivable from this customer was
$1,608,000 as of December 31, 1998. During the fourth quarter, the Company made
an additional investment in the ICS Customer in the form of a convertible note
in the amount of $2,500,000. This note, which is included with other assets on
the accompanying consolidated balance sheet as of December 31, 1998, is secured
by all assets of the ICS Customer and automatically converts to preferred stock
upon the closing of at least $5,000,000 in additional equity by the ICS Customer
on or before June 30, 1999. In the event that the ICS Customer is unable to
obtain at least $5,000,000 in equity financing prior to this date, then SCM has
the right to acquire, for an incremental payment of approximately $100,000,
additional equity of the ICS Customer which would result in SCM having a
controlling interest of the ICS Customer. The ICS Customer is currently in
negotiations with third parties regarding the raising of additional equity
financing through private or public means, or a possible merger with another
company. In connection with their financing efforts, the ICS Customer obtained a
recent valuation of their company which indicates that the value of the ICS
Customer is approximately $12,000,000.
NOTE 11. LEGAL PROCEEDINGS
The Company was notified by Smith Corona Corporation (Smith Corona) that
Smith Corona believes that the "SCM" in the Company's name, logo and a certain
product name infringe on a trademark held by Smith Corona and that the Company
has engaged in unfair competition. The Company believes that it has defenses to
Smith Corona's claim and has so notified Smith Corona. In the event that Smith
Corona were to
F-24
<PAGE> 75
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
initiate legal proceedings against the Company with respect to this matter, the
Company would vigorously defend the action. Defending any action can be costly
and time consuming regardless of the outcome and, as with any litigation matter,
there can be no assurance that the outcome of any such dispute would be
favorable to the Company. An unfavorable outcome in the matter could subject the
Company to monetary damages and may result in the Company having to change its
name and logo, which would require the Company to incur costs related thereto
and may result in a loss of the goodwill associated with its name and logo.
In April 1997, Gemplus served the Company with a complaint alleging that
certain of the Company's products infringe certain claims of a French patent
held by Gemplus. In September 1997, the Company entered into a license agreement
and memorandum of understanding and settled this dispute with Gemplus. In
connection with these transactions, the Company agreed to sell 200,000 shares of
its common stock to Gemplus at a purchase price of $9.00 per share.
Additionally, the Company issued warrants to Gemplus to purchase up to 200,000
shares of the Company's common stock at an exercise price of $13.00 per share
and up to 200,000 shares of common stock at an exercise price of $14.00 per
share. The fair value of these warrants approximated $450,000 and such cost,
along with related legal fees, was charged to operations as patent claim
settlement expense in the third quarter of 1997.
F-25
<PAGE> 76
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------- -----------------------
<C> <S>
3.1* Fourth Amended and Restated Certificate of Incorporation.
3.2* Bylaws, as amended, of Registrant.
4.1* Form of Registrant's Common Stock Certificate.
9.1* Form of Director and Officer Indemnification Agreement.
9.2* 1997 Stock Plan.
10.1* 1997 Employee Stock Purchase Plan.
10.4* 1997 Director Option Plan.
10.5* 1997 Stock Option Plan for French Employees.
10.6* 1997 Employee Stock Purchase Plan for Non-U.S. Employees.
10.7** Revolving Credit Loan and Security Agreement, dated
September 26, 1997, between Registrant and Comerica Bank.
10.8* Line of Credit, dated October 23, 1996, between Registrant
and Deutsche Bank.
10.9* Line of Credit, dated December 3, 1996, between Registrant
and BHF Bank.
10.10* Line of Credit, dated November 11, 1996, between Registrant
and Stadtsparkasse Munchen.
10.11* Lease, dated September 29, 1994, between Registrant and Los
Gatos Business Park.
10.12* Sublease Agreement, dated December 17, 1996, between
Intermart Systems, Inc. and Registrant.
10.13* Lease, dated September 30, 1994, between Registrant and
Olbrich Franz.
10.14* Amended and Restated Stockholders' Agreement, dated April
11, 1997, between Registrant and certain investors.
10.15* Form of Employment Agreement between SCM GmbH and Messrs.
Schneider and Meier.
10.16* Employment Agreement, dated May 15, 1995, between Registrant
and Jean-Yves Le Roux.
10.17*+ Commitment Instrument, dated August 7, 1996, among France
Telecom, Matra Communication, Registrant and Matra MHS.
10.18*+ Teaming Agreement, dated October 6, 1995, between
Temic/Matra MHS, Matra Communication and Registrant.
10.19*+ Development Agreement, dated March 6, 1997, between Intel
Corporation and Registrant.
10.20*+ Technology Development and License Agreement, dated
September 27, 1996, between Registrant and Sun Microsystems,
Inc.
10.21* Cooperation Contract, dated March 25, 1996, between
Registrant and Stocko Metallwarenfabriken Henkels and Sohn
GmbH & Co.
10.22*+ Development and Supply Agreement, dated October 9, 1996,
between BetaDigital Gesellschaft fur digitale Fernsehdienste
mbH and Registrant.
10.23* Framework Contract, dated December 23, 1996, between Siemens
Nixdorf Informationssysteme AG and Registrant.
10.24* B-1 License and Know-How Contract, dated September 4, 1996,
between Deutsche Telekom AG and Registrant, as amended.
10.25* Technology Option Agreement, dated January 31, 1997, between
Wolfgang Neifer and Registrant.
10.26*+ Development and Supply Agreement, dated May 15, 1997,
between Telenor Conax and Registrant.
</TABLE>
<PAGE> 77
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------- -----------------------
<C> <S>
10.27*+ Manufacturer's Sales Representative Agreement, dated
December 8, 1994, between Registrant and AGM.
10.28* License Agreement, dated September 5, 1997, between the
Registrant and Gemplus.
10.29* Warrant Issuance and Common Stock Agreement, dated September
5, 1997, between the Registrant and Gemplus.
10.30* Common Stock Purchase Warrant dated September 5, 1997,
issued to Gemplus.
10.31* Common Stock Purchase Warrant dated September 5, 1997,
issued to Gemplus.
10.32* Waiver and Amendment to Amended and Restated Stockholders'
Agreement dated September 5, 1997.
21.1* Subsidiaries of the Registrant.
23.1 Consent of KPMG LLP, Independent Certified Public
Accountants .
27.1 Financial Data Schedule.
</TABLE>
- ---------------
* Filed previously as an exhibit to SCM's Registration Statement on Form S-1
(SEC Registration No. 333-29073).
** Filed previously as an exhibit to SCM's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1997 (See File No. 000-22689).
+ Certain information in these exhibits has been omitted pursuant to a
confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83
and 230.46.
<PAGE> 1
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998, 1997 AND 1996
EXHIBIT 23.1
INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULE
The Board of Directors
SCM Microsystems, Inc.:
The audits referred to in our report dated February 23, 1999, included the
related financial statement schedule for each of the years in the three-year
period ended December 31, 1998, as listed in Item 14 herein. This consolidated
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audits. In our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth
therein.
We consent to incorporation by reference in the registration statements
(Nos. 333-45795, 333-45791, 333-45789, 333-66397 and 333-73061) on Form S-8 of
SCM Microsystems, Inc. of our reports dated February 23, 1999, relating to the
consolidated balance sheets of SCM Microsystems, Inc. and subsidiaries as of
December 31, 1998 and 1997, and the related consolidated statements of
operations and comprehensive income (loss), stockholders' equity (deficit) and
cash flows for each of the years in the three-year period ended December 31,
1998, and related schedule, which reports appear herein.
KPMG LLP
Mountain View, California
March 30, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 47,177
<SECURITIES> 82,741
<RECEIVABLES> 28,331
<ALLOWANCES> 2,796
<INVENTORY> 12,159
<CURRENT-ASSETS> 171,491
<PP&E> 7,539
<DEPRECIATION> 3,476
<TOTAL-ASSETS> 183,320
<CURRENT-LIABILITIES> 24,541
<BONDS> 0
0
0
<COMMON> 14
<OTHER-SE> 158,765
<TOTAL-LIABILITY-AND-EQUITY> 183,320
<SALES> 85,009
<TOTAL-REVENUES> 85,009
<CGS> 57,148
<TOTAL-COSTS> 57,148
<OTHER-EXPENSES> 36,013
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (6,024)
<INCOME-PRETAX> (2,128)
<INCOME-TAX> 2,845
<INCOME-CONTINUING> (4,973)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,973)
<EPS-PRIMARY> (0.38)
<EPS-DILUTED> (0.38)
</TABLE>
