UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10 – Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005

OR

o		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: 0-29440

SCM MICROSYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)		77-0444317 (I.R.S. EMPLOYER IDENTIFICATION NUMBER)

466 Kato Terrace, Fremont, CA 94539
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)

(510) 360-2300
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ No o

At August 3, 2005, 15,542,260 shares of common stock were outstanding.

 

 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Net revenue		$	10,241			$	11,511			$	21,023			$	24,741
Cost of revenue			6,984				9,793				14,132				17,618
Gross profit			3,257				1,718				6,891				7,123
Operating expenses:
Research and development			2,276				2,797				4,725				5,553
Selling and marketing			2,629				3,054				5,064				6,372
General and administrative			2,288				2,949				4,759				5,774
Amortization of intangible assets			174				290				350				593
Restructuring and other charges (credits)			(26	)			(149	)			163				(58	)
Total operating expenses			7,341				8,941				15,061				18,234
Loss from operations			(4,084	)			(7,223	)			(8,170	)			(11,111	)
Interest and other income			517				374				1,676				773
Loss from continuing operations before income taxes			(3,567	)			(6,849	)			(6,494	)			(10,338	)
Benefit (provision) for income taxes			90				(10	)			177				(126	)
Loss from continuing operations			(3,477	)			(6,859	)			(6,317	)			(10,464	)
Loss from discontinued operations, net of income taxes			(133	)			(79	)			(269	)			(108	)
Gain (loss) on sale of discontinued operations, net of income taxes			(40	)			(35	)			15				62
Net loss		$	(3,650	)		$	(6,973	)		$	(6,571	)		$	(10,510	)
Loss per share from continuing operations:
Basic and diluted		$	(0.23	)		$	(0.44	)		$	(0.41	)		$	(0.68	)
Loss per share from discontinued operations:
Basic and diluted		$	(0.01	)		$	(0.01	)		$	(0.01	)		$	(0.00	)
Net loss per share:
Basic and diluted		$	(0.24	)		$	(0.45	)		$	(0.42	)		$	(0.68	)
Shares used to compute basic and diluted loss per share			15,522				15,392				15,504				15,359
Comprehensive loss:
Net loss		$	(3,650	)		$	(6,973	)		$	(6,571	)		$	(10,510	)
Unrealized gain (loss) on investments			313				(75	)			209				(78	)
Foreign currency translation adjustment			(907	)			(218	)			(1,877	)			(356	)
Total comprehensive loss		$	(4,244	)		$	(7,266	)		$	(8,239	)		$	(10,944	)

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(unaudited)

		June 30,				December 31,
		2005				2004
ASSETS
Current assets:
Cash and cash equivalents		$	15,749			$	31,181
Short-term investments			20,598				14,972
Accounts receivable, net of allowances of $1,796 and $2,207 as of June 30, 2005 and December 31, 2004, respectively			6,446				8,700
Inventories			6,133				8,319
Other current assets			2,396				2,336
Total current assets			51,322				65,508
Property and equipment, net			3,770				4,597
Intangible assets, net			1,222				1,740
Other assets			1,451				1,462
Total assets		$	57,765			$	73,307
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	4,613			$	4,790
Accrued compensation and related benefits			2,523				2,670
Accrued restructuring and other charges			4,069				9,879
Accrued professional fees			1,494				2,011
Accrued royalties			1,215				1,794
Other accrued expenses			2,985				3,189
Income taxes payable			2,015				2,014
Total current liabilities			18,914				26,347
Deferred tax liability			103				131
Commitments and contingencies (see Notes 10 and 12)			—				—
Stockholders’ equity:
Common stock, $0.001 par value: 40,000 shares authorized; 15,542 and 15,484 shares issued and outstanding as of June 30, 2005 and December 31, 2004, respectively			16				15
Additional paid-in capital			227,555				227,398
Treasury stock			(2,777	)			(2,777	)
Accumulated deficit			(186,892	)			(180,321	)
Other cumulative comprehensive gain			846				2,514
Total stockholders’ equity			38,748				46,829
Total liabilities and stockholders’ equity		$	57,765			$	73,307

See notes to condensed consolidated financial statements.

		Six Months
		Ended June 30,
		2005				2004
Cash flows from operating activities:
Net loss		$	(6,571	)		$	(10,510	)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss from discontinued operations			254				46
Depreciation and amortization			1,177				1,768
Loss (gain) on disposal of fixed assets			(2	)			2
Stock compensation expense			—				22
Deferred income taxes			(28	)			—
Changes in operating assets and liabilities:
Accounts receivable			1,828				2,230
Inventories			2,005				(1,524	)
Other assets			(218	)			5,734
Accounts payable			83				(1,876	)
Accrued expenses			(5,991	)			584
Income taxes payable			1				(467	)
Net cash used in operating activities from continuing operations			(7,462	)			(3,991	)
Net cash used in operating activities from discontinued operations			(1,059	)			(600	)
Net cash used in operating activities			(8,521	)			(4,591	)
Cash flows from investing activities:
Capital expenditures			(65	)			(245	)
Proceeds from disposal of fixed assets			76				—
Maturities of short-term investments			4,704				2,692
Purchases of short-term investments			(10,338	)			(3,041	)
Net cash used in investing activities from continuing operations			(5,623	)			(594	)
Net cash provided by investing activities from discontinued operations			2				—
Net cash used in investing activities			(5,621	)			(594	)
Cash flows from financing activities:
Proceeds from issuance of equity securities, net			158				600
Net cash provided by financing activities			158				600
Effect of exchange rates on cash and cash equivalents			(1,448	)			(655	)
Net decrease in cash and cash equivalents			(15,432	)			(5,240	)
Cash and cash equivalents at beginning of period			31,181				49,382
Cash and cash equivalents at end of period		$	15,749			$	44,142
Supplemental disclosures of cash flow information:
Income tax refunds received		$	96			$	—
Income taxes paid		$	8			$	50

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005

1.

Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three- and six-month periods ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems’ (“SCM” or “the Company”) Annual Report on Form 10-K for the year ended December 31, 2004.

Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment. SFAS No. 123R is a revision of SFAS No. 123 and supersedes Accounting Principles Board (“APB”) Opinion 25. SFAS No. 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

     The Company has not yet quantified the effects of the adoption of SFAS No. 123R, but it is expected that the new standard may result in significant stock-based compensation expense. The actual effects of adopting SFAS No. 123R will be dependent on numerous factors including, but not limited to, the valuation model chosen by the Company to value stock-based awards; the assumed award forfeiture rate; the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS No. 123R.

     As a result of the decision by the Securities and Exchange Commission (“SEC”) to delay its effective date, SFAS No. 123R will be effective for the Company’s fiscal year beginning January 1, 2006. SFAS No. 123R requires the use of the Modified Prospective Application Method. Under this method SFAS No. 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. In addition, companies may use the Modified Retrospective Application Method. This method may be applied to all prior years for which the original SFAS No. 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS No. 123.

     In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion 29. SFAS No. 153 eliminates certain differences between existing accounting standards. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June, 15, 2005. The Company does not expect adoption of this standard to have a material impact on its future results of operations and financial position.

     In November 2004, FASB issued SFAS No. 151, Inventory Costs. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that these items be recognized as current period charges. In addition, SFAS No. 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is evaluating the impact of the adoption of the new standard on its future results of operations and financial position.

     In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF No. 03-01”). EITF No. 03-01 provides guidance on recording other-than-temporary impairments of cost method investments and disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. For investments accounted for under SFAS No. 115, the disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated balance sheet or statement of operations.

2. Stock Based Compensation

     Pending the effective date of SFAS No. 123R, the Company accounts for its employee stock option plan in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (“FIN No. 44”). Accordingly, no compensation is recognized for employee stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at date of grant. If the exercise price is less than the market value at the date of grant, the difference is recognized as deferred compensation expense, which is amortized over the vesting period of the options. The Company accounts for stock options issued to non-employees in accordance with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and EITF Issue No. 96-18 under the fair value based method.

     For purposes of pro forma disclosure under SFAS No. 123, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting period, using the multiple option method. Pro forma information is as follows (in thousands, except per share amounts):

		Three months ended								Six months ended
		June 30,								June 30,
		2005				2004				2005				2004
Net loss, as reported		$	(3,650	)		$	(6,973	)		$	(6,571	)		$	(10,510	)
Add: Employee stock-based compensation included in reported net loss net of related tax effects			—				—				—				—
Less: Stock-based compensation expense determined under fair value method for all awards			(402	)			(884	)			(839	)			(1,589	)
Pro forma net loss		$	(4,052	)		$	(7,857	)		$	(7,410	)		$	(12,099	)
Net loss per share, as reported — basic and diluted		$	(0.24	)		$	(0.45	)		$	(0.42	)		$	(0.68	)
Pro forma net loss per share — basic and diluted		$	(0.26	)		$	(0.51	)		$	(0.48	)		$	(0.79	)

3. Discontinued Operations

     During 2003, the Company completed two transactions to sell its retail Digital Media and Video business. On July 25, 2003, the Company completed the sale of its digital video business to Pinnacle Systems and on August 1, 2003, the Company completed the sale of its retail digital media reader business to Zio Corporation. As a result of these sales, the Company has accounted for the retail Digital Media and Video business as a discontinued operation.

     The operating results for the discontinued operations of the retail Digital Media and Video business for the three and six months ended June 30, 2005 and during the same periods for 2004 are as follows (in thousands):

		Three Months Ended June 30,								Six Months Ended June 30,
		2005				2004				2005				2004
Net revenue		$	—			$	—			$	—			$	16
Operating loss		$	(79	)		$	(68	)		$	(185	)		$	(131	)
Net loss before income taxes		$	(133	)		$	(79	)		$	(269	)		$	(108	)
Income tax benefit (provision)		$	—			$	—			$	—			$	—
Loss from discontinued operations		$	(133	)		$	(79	)		$	(269	)		$	(108	)

4.

Short-Term Investments

     The fair value of short-term investments at June 30, 2005 and December 31, 2004 was as follows (in thousands):

		June 30, 2005
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	9,952			$	—			$	(57	)		$	9,895
U.S. government agencies			10,745				—				(42	)			10,703
Total		$	20,697			$	—			$	(99	)		$	20,598

		December 31, 2004
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	10,286			$	—			$	(276	)		$	10,010
U.S. government agencies			4,994				—				(32	)			4,962
Total		$	15,280			$	—			$	(308	)		$	14,972

     During each quarter, SCM evaluates investments for possible asset impairment by examining a number of factors, including the current economic conditions and markets for each investment, as well as its cash position and anticipated cash needs for the short and long term. For the three and six months ended June 30, 2005 and 2004, no impairment of the investments was identified based on the evaluations performed.

5.

Inventories

     Inventories consist of (in thousands):

		June 30,				December 31,
		2005				2004
Raw materials		$	2,978			$	4,604
Work in process			1,746				1,152
Finished goods			1,409				2,563
		$	6,133			$	8,319

6.

Intangible Assets

     Intangible assets consist of the following (in thousands):

						June 30, 2005												December 31, 2004
						Gross												Gross
		Amortization				Carrying				Accumulated								Carrying				Accumulated				Impairment
		Period				Value				Amortization				Net				Value				Amortization				Loss				Net
Customer relations		60 months				$	1,506			$	(938	)		$	568			$	1,937			$	(1,086	)		$	(44	)		$	807
Core technology		60 months					1,707				(1,053	)			654				3,984				(2,707	)			(344	)			933
Total intangible assets						$	3,213			$	(1,991	)		$	1,222			$	5,921			$	(3,793	)		$	(388	)		$	1,740

     SCM evaluates long-lived assets under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, only SCM’s, intangible assets relating to core technology and customer relations are subject to amortization. Amortization expense related to intangible assets was $0.4 million for the first six months of 2005 and $0.6 million for the same period of 2004.

     Estimated future amortization of intangible assets is as follows (in thousands):

Fiscal Year				Amount
2005 (remaining 6 months)				$	320
2006					637
2007					265
Total				$	1,222

7.

Restructuring and Other Charges

     Continuing Operations

     In the first six months of 2005 and 2004, SCM incurred net restructuring and other charges (credits) related to continuing operations of approximately $0.2 million and $(0.1) million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the first two quarters of 2005 and during the year ended December 31, 2004 consist of the following (in thousands):

										Asset
		Legal				Lease/Contract				Write								Other
		Settlements				Commitments				Downs				Severance				Costs				Total
Balances as of January 1, 2004		$	—			$	124			$	49			$	114			$	6,807			$	7,094
Provision for 2004			620				9				17				831				106				1,583
Changes in estimates			(19	)			20				(20	)			(6	)			(1,741	)			(1,766	)
			601				29				(3	)			825				(1,635	)			(183	)
Payments or write offs in 2004			(601	)			(101	)			(46	)			(508	)			(40	)			(1,296	)
Balances as of December 31, 2004			—				52				—				431				5,132				5,615
Provision for Q1 2005			1				—				—				16				9				26
Changes in estimates			—				7				—				(15	)			170				162
			1				7				—				1				179				188
Payments or write offs in Q1 2005			(1	)			(8	)			—				(339	)			(302	)			(650	)
Balances as of March 31, 2005			—				51				—				93				5,009				5,153
Provision for Q2 2005			—				—				—				—				12				12
Changes in estimates			—				—				—				3				(41	)			(38	)
			—				—				—				3				(29	)			(26	)
Payments or write offs in Q2 2005			—				(8	)			—				(96	)			(4,671	)			(4,775	)
Balances as of June 30, 2005		$	—			$	43			$	—			$	—			$	309			$	352

     For the three and six months ended June 2005, restructuring and other charges primarily related to changes in estimates for European tax related matters and lease commitments, which were partially offset by changes in estimates related to severance costs in connection with cost reduction actions taken by management in 2004. As of June 30, 2005, these cost reduction actions have been completed and the Company does not expect to incur further charges in 2005 related to these actions. During the three months ended June 30, 2005, the Company made a payment to the French government of approximately $4.7 million related to Value Added Tax (“VAT”) in respect of sales transactions with a former customer. In connection with this payment, the Company entered into an agreement with the customer to seek a refund from the French government for the VAT paid with respect to the products it purchased from the Company, and then remit the refunded amount to the Company. Although the Company is in the process of completing certain regulatory procedures and is attempting to recover this amount from the customer, there is no assurance that the Company will be able to recover the amount. As of June 30, 2005, the remaining balance of accrued other costs primarily relates to European tax matters.

     Discontinued Operations

     In the first six months of 2005 and 2004, SCM incurred net restructuring and other charges related to discontinued operations of approximately $0.1 and $0.8 million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the first two quarters of 2005 and during the year ended December 31, 2004 consist of the following (in thousands):

						Asset
		Lease/Contract				Write								Other
		Commitments				Downs				Severance				Costs				Total
Balances as of January 1, 2004		$	3,912			$	9			$	275			$	345			$	4,541
Provision for 2004			43				22				7				826				898
Changes in estimates			450				—				(65	)			—				385
			493				22				(58	)			826				1,283
Payments or write offs in 2004			(445	)			(31	)			(217	)			(867	)			(1,560	)
Balances as of December 31, 2004			3,960				—				—				304				4,264
Provision for Q1 2005			—				—				—				6				6
Changes in estimates			5				—				—				—				5
			5				—				—				6				11
Payments or write offs in Q1 2005			(182	)			—				—				(94	)			(276	)
Balances as of March 31, 2005			3,783				—				—				216				3,999
Provision for Q2 2005			—				—				—				52				52
Changes in estimates			(12	)			—				—				—				(12	)
			(12	)			—				—				52				40
Payments or write offs in Q2 2005			(170	)			—				—				(152	)			(322	)
Balances as of June 30, 2005		$	3,601			$	—			$	—			$	116			$	3,717

     Exit costs for the three and six months ended June 30, 2005 primarily related to changes in estimates for lease obligations and legal fees. The Company has exited its retail Digital Media and Video business and does not expect to incur further significant charges during 2005, except for legal costs relating to the Company’s defense to the complaint filed by DVDCre8. (See Note 12.)

8.

Segment Reporting, Geographic Information and Major Customers

     SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, 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 Financial Officer, Chief Operating Officer and Executive Vice President, Sales.

     SCM provides secure digital access solutions to original equipment manufacturer (“OEM”) customers in three markets: Digital TV, PC Security and Flash Media Interface. The executive staff reviews financial information and business performance along these three business segments. The Company evaluates the performance of these segments at the revenue and gross margin level. The Company’s reporting systems do not track or allocate operating expenses or assets by segment. The Company does not include intercompany transfers between segments for management purposes.

     Summary information by segment for the three and six months ended June 30, 2005 and for the same periods of 2004 is as follows (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Digital TV:
Revenue		$	4,503			$	4,446			$	8,541			$	10,325
Gross profit			1,239				(1,369	)			1,692				167
Gross profit %			28	%			(31	)%			20	%			2	%
PC Security:
Revenue		$	3,637			$	4,269			$	8,668			$	8,636
Gross profit			888				1,966				2,950				3,961
Gross profit %			24	%			46	%			34	%			46	%
Flash Media Interface:
Revenue		$	2,101			$	2,796			$	3,814			$	5,780
Gross profit			1,130				1,121				2,249				2,995
Gross profit %			54	%			40	%			59	%			52	%
Total:
Revenue		$	10,241			$	11,511			$	21,023			$	24,741
Gross profit			3,257				1,718				6,891				7,123
Gross profit %			32	%			15	%			33	%			29	%

     Geographic net revenue is based on selling location. Information regarding revenue by geographic region is as follows (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Europe		$	4,622			$	5,213			$	9,324			$	12,299
United States			2,559				3,928				5,728				7,274
Asia-Pacific			3,060				2,370				5,971				5,168
		$	10,241			$	11,511			$	21,023			$	24,741

     Customers comprising 10% or greater of the Company’s net revenue are summarized as follows:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Customer A			*				11	%			10	%			11	%

     Customers representing 10% or greater of the Company’s accounts receivable are summarized as follows:

		June 30,				December 31,
		2005				2004
Customer A			11	%			*
Customer B			*				18	%
Total			11	%			18	%

     Long-lived assets by geographic location as of June 30, 2005 and December 31, 2004, are as follows (in thousands):

		June 30,				December 31,
		2005				2004
Property and equipment, net:
United States		$	56			$	70
Europe			1,540				1,919
Asia-Pacific			2,174				2,608
Total		$	3,770			$	4,597

9.

Cumulative Adjustment to Interest Income and Other Cumulative Comprehensive Gain

     In July 2005, during a review of the Company’s investment holdings and the calculation of interest income and unrealized gains and losses on investments, the Company discovered an error in the recording of the amortization of investment premiums and discounts and the related interest income and unrealized gain (loss) on investment. As a result, interest income and unrealized loss on investment during the periods affected and the balance of unrealized loss included in other cumulative comprehensive gain have been overstated. The cumulative overstatement of interest income and unrealized loss on investment for periods prior to the three months ended June 30, 2005 was approximately $0.3 million. The effect of the error was not material to any relevant prior period and had the amounts been recorded correctly in the prior periods, there would have been no effect on reported comprehensive loss or total stockholder’s equity. To correct this error, the Company recorded the cumulative $0.3 million as a reduction in interest income in the Condensed Consolidated Statements of Operations and a decrease in unrealized loss on investments with a corresponding $0.3 million increase in Other Cumulative Comprehensive Gain for the three months ended June 30, 2005.

10.

Commitments

     The Company leases facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These lease agreements expire at various dates during the next twelve years.

     Purchases for inventories are highly dependent upon forecasts of the customers’ demand. Due to the uncertainty in demand from customers, the Company may have to change, reschedule, or cancel purchases or purchase orders from suppliers. These changes may lead to vendor cancellation charges on these purchases or contractual commitments. As of June 30, 2005, purchase and contractual commitments were $2.9 million.

     The Company provides warranties on certain product sales, which range from twelve to twenty-four months, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. The Company currently establishes warranty reserves based on historical warranty costs for each product line combined with liability estimates based on the prior twelve months’ sales activities. If actual return rates and/or repair and replacement costs differ significantly from the Company’s estimates, adjustments to recognize additional cost of sales may be required in future periods.

     Components of the reserve for warranty costs for the six months ended June 30, 2005 and 2004 were as follows (in thousands):

		2005				2004
Balances at January 1		$	244			$	326
Additions related to sales during the period			158				71
Warranty costs incurred during the period			(63	)			(70	)
Adjustments to accruals related to prior period sales			(200	)			(63	)
Balance at June 30		$	139			$	264

11.

Related Party Transactions

     During the three months ended June 30, 2004, SCM recognized no revenue from sales to Conax AS, a company engaged in the development and provision of smart-card based systems. During the six months ended June 30, 2004, SCM recognized revenue of approximately $0.3 million from sales to Conax. As of December 31, 2004, no accounts receivable were due from

Conax. Oystein Larsen served as Executive Vice President, Business Development and New Business of Conax through December 31, 2004 and as a board member of SCM Microsystems until July 2005. Mr. Larsen was not directly compensated for revenue transactions between the two companies.

12.

Legal Proceedings

     From time to time the Company could be subject to claims arising in the ordinary course of business or could be a defendant in lawsuits. While the outcome of any such claims or other proceedings can not be predicted with certainty, management expects that any such liabilities, to the extent not provided for by insurance or otherwise, will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

     In April 2005, Cybercard Corporation (“Cybercard”), a Canadian corporation, filed a patent infringement claim against the Company in the Southern District of Illinois (Case No. 05-CV-274-MJR). The claim alleged infringement of U.S. Patent No. 5,497,411, entitled “Telecommunications Card – Access System,” by the Company’s CHIPDRIVE® Smartcard Office product. In the same lawsuit, Cybercard sued six other defendants. No specific damages have been specified in the claim. To date, no sales of the allegedly infringing product have been made in the United States. The Company is investigating the claim, which it expects to vigorously defend, if necessary, or otherwise resolve, as appropriate, of any allegations of infringement.

     In September 2003, we and Pinnacle Systems, Inc. (“Pinnacle’) were served with a complaint in YOUCre8, Inc. a/k/a DVDCre8, Inc. v. Pinnacle Systems, Inc., Dazzle Multimedia, Inc., and SCM Microsystems, Inc. (Superior Court of California, Alameda County Case No. RG03114448). The complaint was filed by a software company whose software was distributed by Dazzle Multimedia, now SCM Multimedia (“Dazzle”). The complaint alleges that in connection with our sale of certain assets of our former Dazzle video products business to Pinnacle, Dazzle breached the Software License Agreement between the Plaintiff and Dazzle. The complaint further alleges that we and Pinnacle tortiously interfered with DVDCre8’s commercial relationships, engaged in acts to restrain competition in the DVD software market, misappropriated DVDCre8’s trade secrets, and engaged in unfair competition. In December of 2003, Dazzle filed a Cross-Complaint against the Plaintiff seeking $600,000 in damages for alleged breach of the Software License Agreement between the Plaintiff and Dazzle. In June of 2004, Plaintiff filed a First Amended Complaint asserting additional claims against Pinnacle. In July of 2004 and January of 2005, the parties participated in settlement discussions before a private mediator which were unsuccessful. In March of 2005, Plaintiff filed a Second Amended Complaint, which dropped contract claims and a claim for injunctive relief against Pinnacle, as well as the misappropriation of trade secrets claim against all defendants, and added new allegations against Dazzle and SCM Microsystems, including a claim for damages in excess of $5.8 million. Trial has been set for January 20, 2006. Pursuant to the Asset Purchase Agreement between SCM and Pinnacle, we and Pinnacle are seeking indemnification from each other, respectively, for all or part of the damages and the expenses incurred to defend the Plaintiff’s claims. We believe the claims by DVDCre8 are without merit and intend to vigorously defend the action, but we cannot predict the final outcome of this lawsuit, nor accurately estimate the amount of time and resources that we may need to devote to defending ourselves against it. If we were to be unsuccessful in our defense of this lawsuit, and if the Plaintiff were to be able to establish substantial damages, we could be forced to pay an amount, currently unknown, which could have an adverse effect on our business. In addition, although we believe that we are entitled to indemnification in whole or in part for any damages and costs of defense and that Pinnacle’s claim for indemnification is without merit, there can be no assurance that we will be successful on the indemnification claim or recover all or a portion of any damages assessed or expenses incurred, and we may even be forced to pay Pinnacle an amount, currently unknown, which could have an adverse effect on our business.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     This Quarterly Report on Form 10-Q contains forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. For example, statements, other than statements of historical facts regarding our strategy, future operations, financial position, projected results, estimated revenues or losses, projected costs, prospects, plans, market trends, competition and objectives of management constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “will,” “believe,” “could,” “should,” “would,” “may,” “anticipate,” “intend,” “plan,” “estimate,” “expect,” “project” or the negative of these terms or other similar expressions. Although we believe that our expectations reflected in or suggested by the forward-looking statements that we make in this Quarterly Report on Form 10-Q are reasonable, we cannot guarantee future results, performance or achievements. You should not place undue reliance on these forward-looking statements. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our expectations change, whether as a result of new information, future events or otherwise. We also caution you that such forward-looking statements are subject to risks, uncertainties and other factors, not all of which are known to us or within our control, and that actual events or results may differ materially from those indicated by these forward-looking statements. We disclose some of the important factors that could cause our actual results to differ materially from our expectations under the heading “Factors That May Affect Future Results” and elsewhere in this Quarterly Report.

     The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto set forth in Item 1 of this Quarterly Report on Form 10-Q. We also urge readers to review and consider our disclosures describing various factors that could affect our business, including the disclosures under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Factors That May Affect Future Results” and the audited financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 31, 2005.

Overview

     SCM Microsystems designs, develops and sells hardware, software and silicon solutions that enable people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We sell our digital access products into three markets segments: PC Security, Digital TV and Flash Media Interface.

	•		For the PC Security market, we offer smart card reader technology that enables secure access to PCs, networks and physical facilities.
	•		For the Digital TV market, we offer conditional access modules that provide secure decryption for digital pay-TV broadcasts.
	•		For the Flash Media Interface market, we offer digital media readers that are used to transfer digital content to and from various flash media.

     We sell our products primarily to original equipment providers, or OEMs, who typically either bundle our products with their own solutions, or repackage our products for resale to their customers. Our OEM customers include: government contractors, systems integrators, large enterprises and computer manufacturers as well as banks and other financial institutions for our smart card readers; digital TV operators and broadcasters and conditional access providers for our conditional access modules; and consumer electronics and photographic equipment manufacturers for our digital media readers. We sell and license our products through a direct sales and marketing organization, as well as through distributors, value added resellers and systems integrators worldwide.

     Until the middle of 2003, our operations included a retail Digital Media and Video business that accounted for approximately half of our sales. We sold this business in the third quarter of 2003, so that we are now solely focused on our core OEM Security business. As a result of this sale and divestiture, beginning in the second quarter of fiscal 2003, we have accounted for the retail Digital Media and Video business as a discontinued operation.

     In our continuing operations, we have experienced a significant drop in revenues in the period from January 2003 through June 2005, which has resulted in continued operational losses in our business in recent quarters. This decline in our revenues is primarily related to our Digital TV product sales, which have been adversely affected by competition since the middle of 2003, as well as ongoing weakness in the overall digital television market. Sales of our PC Security products were relatively unchanged in 2004 compared with 2003, and sales for the first six months of 2005 were relatively unchanged compared with the first six months of 2004. We believe that growth in sales of our PC Security products has been curtailed by the slow pace at which new

smart card programs reach a stage requiring high volumes, which directly drives demand for our readers. Sales of our Flash Media Interface products were relatively unchanged in 2004 compared with 2003, but declined in the first six months of 2005 when we discontinued sales of certain digital media products. In all three of our primary product segments, sales are dependent on a small number of customers, which can result in fluctuations in sales levels from one quarter to another.

     We have adopted a strategy to address our declining revenue that is based on introducing new Digital TV and PC Security products to offset the rate of decline of our legacy Digital TV product sales and to address new market opportunities. To date, this strategy has been only partially successful. Delays in the certification process for our digital TV security modules in South Korea have limited shipment of our modules to the Korean digital TV market, which remains an important focus for us. We have also experienced delays in the development of new products designed to take advantage of new market opportunities, including our mobile smart card readers, physical access control terminals and dual reader conditional access modules.

     We have taken measures to reduce operating expenses over the last several quarters, including reducing headcount, reducing the use of outside contract personnel and limiting certain expenses such as travel. While we have been successful in reducing expenses overall, expense reductions have been partially offset by the devaluation of the U.S. dollar related to foreign currencies. More than half of our expenses are denominated in currencies other than the U.S. dollar, such as the euro, Singapore dollar, Indian rupee and Japanese yen. In addition to the unfavorable effect of foreign currency exchange, in recent periods we have also increased spending on audit and other services related to compliance with the Sarbanes-Oxley Act of 2002.

Critical Accounting Policies and Estimates

     Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses SCM’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, bad debts, inventories, asset impairment, deferred tax assets, accrued warranty reserves, restructuring costs, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     Management believes the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

	•		We recognize product revenue upon shipment provided that risk and title have transferred, a purchase order has been received, collection is determined to be probable and no significant obligations remain. Maintenance revenue is deferred and amortized over the period of the maintenance contract. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
	•		We write down inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Based on such judgments, we had net inventory writedowns of approximately $0.8 million and $3.1 million in the first six months of 2005 and 2004, respectively.
	•		We record an investment impairment charge when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investment that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. In each of the first six months of 2005 and 2004, we recognized no impairment charges related to investments.
	•		In assessing the recoverability of our other intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded.

	•		The carrying value of our net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. Management evaluates the realizability of the deferred tax assets quarterly. The deferred tax assets are still available for us to use in the future to offset taxable income, which would result in the recognition of a tax benefit and a reduction in our effective tax rate. The divestiture of our retail Digital Media and Video business to Pinnacle Systems and Zio Corporation as well as future changes to the operating structure of our Security business may limit our ability to utilize our deferred tax assets.
	•		We accrue the estimated cost of product warranties during the period of sale. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by actual warranty costs, including material usage or service delivery costs incurred in correcting a product failure. If actual material usage or service delivery costs differ from our estimates, revisions to our estimated warranty liability would be required.
	•		On January 1, 2003, we adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires that a liability for a cost associated with an exit or disposal activity initiated after December 31, 2002 be recognized when the liability is incurred and that the liability be measured at fair value. During 2002, the accounting for restructuring costs required us to record provisions and charges when we had a formal and committed plan. In connection with plans we had adopted, we recorded estimated expenses for severance and outplacement costs, lease cancellations, asset write-offs and other restructuring costs. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.

Recent Accounting Pronouncements

     In December 2004, FASB issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R is a revision of SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

     We have not yet quantified the effects of the adoption of SFAS No. 123R, but it is expected that the new standard may result in significant stock-based compensation expense. The actual effects of adopting SFAS No. 123R will be dependent on numerous factors including, but not limited to, the valuation model that we choose to value stock-based awards; the assumed award forfeiture rate; the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS No. 123R.

     As a result of a decision by the Securities and Exchange Commission to delay the effective date of SFAS No. 123R, SFAS No. 123R will be effective for our fiscal year beginning January 1, 2006. SFAS 123R requires the use of the Modified Prospective Application Method. Under this method SFAS No. 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. In addition, companies may use the Modified Retrospective Application Method. This method may be applied to all prior years for which the original SFAS No. 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS No. 123.

     In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion 29. SFAS No. 153 eliminates certain differences between existing accounting standards. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June, 15, 2005. We do not expect adoption of this standard to have a material impact on our future results of operations and financial position.

     In November 2004, FASB issued SFAS No. 151, Inventory Costs. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that these items be recognized as current period charges. In addition, SFAS No. 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. We are evaluating the impact of the adoption of the new standard on our future results of operations and financial position.

     In March 2004, the EITF reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF No. 03-01”). EITF No. 03-01 provides guidance on recording other-than-temporary impairments of cost method investments and disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. For investments accounted for under SFAS No. 115, the disclosures are effective in annual financial statements for fiscal years ending after December 15, 2003. The adoption of this standard did not have a material impact on our consolidated balance sheet or statement of operations.

Results of Operations

     Net Revenue. Summary information by product segment for the three- and six-month periods ended June 30, 2005 and 2004 is as follows (in thousands):

										% change												% change
		Three months ended								period to				Six months ended								period to
		June 30,								period				June 30,								period
		2005				2004								2005				2004
Digital TV
Revenue		$	4,503			$	4,446				1	%		$	8,541			$	10,325				(17	)%
Gross profit			1,239				(1,369	)							1,692				167
Gross profit %			28	%			(31	)%							20	%			2	%
PC Security
Revenue		$	3,637			$	4,269				(15	)%		$	8,668			$	8,636				0	%
Gross profit			888				1,966								2,950				3,961
Gross profit %			24	%			46	%							34	%			46	%
Flash Media Interface
Revenue		$	2,101			$	2,796				(25	)%		$	3,814			$	5,780				(34	)%
Gross profit			1,130				1,121								2,249				2,995
Gross profit %			54	%			40	%							59	%			52	%
Total:
Revenue		$	10,241			$	11,511				(11	)%		$	21,023			$	24,741				(15	)%
Gross profit			3,257				1,718								6,891				7,123
Gross profit %			32	%			15	%							33	%			29	%

     Net revenue for the three months ended June 30, 2005 was $10.2 million, compared to $11.5 million for the same period in 2004, a decrease of 11%. This decrease in revenue resulted from lower sales of our Flash Media Interface and PC Security products, while sales levels of our Digital TV products remained unchanged. For the six months ended June 30, 2005, net revenue was $21.0 million, down 15% from revenue of $24.7 million in the first six months of 2004. The decrease in revenue in the six month period resulted from lower sales of our Flash Media Interface and Digital TV products, while sales levels of our PC Security products remained unchanged.

     Revenue from our Flash Media Interface product line decreased 25% to $2.1 million in the second quarter of 2005 from $2.8 million in the second quarter of 2004. This decrease was primarily due to the cessation of sales of certain products within this business, as well as lower sales related to the timing of orders. In addition, sales were also adversely impacted by delays in shipments of a newly released product. For the first six months of 2005, sales

were $3.8 million, a decrease of 34% compared with $5.8 million in the first six months of 2004. The decrease in the six-month comparative period was primarily due to the cessation of certain products within this business. Flash Media Interface revenues consist of sales of digital media readers to provide an interface for flash memory cards in computer printers and digital photography kiosks, which are used to download and print digital photos.

     In our Digital TV product line, sales in the second quarter of 2005 were $4.5 million, relatively unchanged from sales of $4.4 million in the second quarter of 2004. For the first six months of 2005, sales were $8.5 million, a decrease of 17% compared with $10.3 million in the first six months of 2004. This decrease was primarily the result of weaker demand and greater competition for our products, primarily in Europe, offset slightly by increased sales of new products in Asia. Beginning in the third quarter of 2003 and continuing through the second quarter of 2005, our Digital TV products sales have been significantly adversely impacted by competition from suppliers that have emulated the conditional access decryption software for pay-TV content on conditional access modules that may be used to provide unauthorized access to that content (further discussed in “Factors that May Affect Operating Results – Our Markets are highly competitive, and our customers may purchase products from our competitors.”). We have pursued, and in some cases have obtained, legal injunctions against these suppliers. However, we do not expect to be able to regain the market share we have lost. The majority of our Digital TV sales come from shipments of conditional access modules, which are used in conjunction with set-top boxes or integrated digital televisions to decrypt digital pay-television broadcasts.

     In our PC Security product line, sales were $3.6 million in the second quarter of 2005, a decrease of 15% from sales of $4.3 million in the second quarter of 2004. Revenue in this product line is subject to significant variability based on the size and timing primarily of product orders. In the second quarter of 2005 we experienced significantly lower sales in the U.S. compared with the prior year period due to the timing of orders for smart card readers for U.S. government security projects, as well as continued competition for business in Europe based on price. For the first six months of 2005, sales were $8.7 million, relatively unchanged from $8.6 million in the first six months of 2004. This product line consists of smart card readers and related chip technology that are utilized principally in security programs where smart cards are used to identify and authenticate the identity of people in order to control access to computers, computer networks and buildings or other facilities.

     Gross Profit. Gross profit for the second quarter of 2005 was $3.3 million, or 32% of revenue, compared to $1.7 million, or 15% of revenue in the same period of 2004. During the second quarter of 2005, our gross profit was adversely affected by approximately $0.3 million of tooling costs for new chip production, as well as by pricing pressure and the mix of products sold during the period. In particular, we experienced higher sales of lower margin ASICs as well as price declines for our conditional access modules in our Digital TV business; we experienced a shift towards higher volumes of lower margin orders in our PC Security business; and we introduced a new, lower margin product in Europe and experienced lower sales of higher margin products in the U.S. in our Flash Media Interface business. During the second quarter of 2004, our gross profit was adversely affected by an inventory write-down of approximately $2.9 million primarily related to our Digital TV products. Increasing competition and the sharp decline in demand for our conditional access modules during the quarter brought into doubt our ability to sell these products, and as a result we wrote down the value of inventory for components and finished goods.

     For the first six months of 2005, gross profit was $6.9 million, or 33% of revenue, compared with $7.1 million, or 29% of revenue for the prior year period. During the first six months of 2005, gross profit was adversely impacted by approximately $1.9 million related to inventory write-downs primarily taken during the first quarter of 2005 as well as by pricing pressure, mix of products sold and tooling costs of $0.3 million in the second quarter of 2005. These inventory write-downs were partially offset by sales of products that previously had been written down, with positive effects to cost of sales of $1.1 million. During the first six months of 2004, our gross profit was adversely affected by the Digital TV inventory write-down of $2.9 million taken in the second quarter as well as an inventory write-down of $0.2 million taken in the first quarter of 2004, both related primarily to Digital TV products that we determined we could not sell.

     Our gross profit has been and will continue to be affected by a variety of factors, including, without limitation, competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to continue to fluctuate from period to period.

     Research and Development.

										% change												% change
		Three months ended June 30								period to				Six months ended June 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,276			$	2,797				(19	)%		$	4,725			$	5,553				(15	)%
Percentage of total revenues			22	%			24	%							22	%			22	%

     Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are primarily related to hardware and chip development. For the second quarter of 2005, research and development expenses were $2.3 million, or 22% of revenue, compared with $2.8 million, or 24% of revenue in the second quarter of 2004. For the first six months of 2005, research and development expenses were $4.7 million, or 22% of revenue, compared with $5.6 million, or 22% of revenue for the first six months of 2004. The decrease of $0.8 million in the first six months of 2005 compared with the prior year period was primarily due to lower headcount and contract service costs and to a customer funded development contribution of $0.1 million in the second quarter of 2005. The decrease in expenses was partially offset by the devaluation of the U.S. dollar compared with foreign currencies in which all of our research and development expenses are paid. We expect our research and development expenses to vary based on future project demands.

     Selling and Marketing.

										% change												% change
		Three months ended June 30								period to				Six months ended June 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,629			$	3,054				(14	)%		$	5,064			$	6,372				(21	)%
Percentage of total revenues			26	%			27	%							24	%			26	%

     Selling and marketing expenses consist primarily of employee compensation as well as tradeshow participation and other marketing costs. Selling and marketing expenses in the second quarter of 2005 were $2.6 million, or 26% of revenue, compared with $3.1 million, or 27% of revenue in the second quarter of 2004. For the first six months of 2005, sales and marketing expenses were $5.1 million, a decrease of 21% from $6.4 million in the first six months of 2004. The decrease of $1.3 million in the first six months of 2005 compared with the prior year period was primarily due to reductions in headcount and in trade show expenditures, partially offset by the devaluation of the U.S. dollar compared with foreign currencies in which the majority of our sales and marketing expenses are paid. We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

     General and Administrative.

										% change												% change
		Three months ended June 30								period to				Six months ended June 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,288			$	2,949				(22	)%		$	4,759			$	5,774				(18	)%
Percentage of total revenues			22	%			26	%							23	%			23	%

     General and administrative expenses consist primarily of compensation expenses for employees performing our administrative functions, professional fees arising from legal, auditing and other consulting services and charges for allowances for doubtful accounts receivable. In the second quarter of 2005, general and administrative expenses were $2.3 million, or 22% of revenue, compared with $2.9 million, or 26% of revenue in the second quarter of 2004. For the first six months of 2005, general and administrative expenses were $4.8 million, compared with $5.8 million in the first six months of 2004. The decrease of $1.0 million in the first six months of 2005 compared with the prior year period was primarily due to reductions in headcount, partially offset by increased spending on audit and other services related to compliance with the Sarbanes-Oxley Act of 2002, and by the devaluation of the U.S. dollar compared with foreign currencies in which the majority of our general and administration expenses are paid. We expect that our general and administrative costs will remain high as a percentage of revenue relative to other companies our size, as our global operations make it necessary to maintain our current business infrastructure.

     Amortization of Goodwill and Intangibles.

										% change												% change
		Three months ended June 30								period to				Six months ended June 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	174			$	290				(40	)%		$	350			$	593				(41	)%
Percentage of total revenues			2	%			3	%							2	%			2	%

     Amortization of intangible assets in the second quarter of 2005 was $0.2 million, compared with $0.3 million for the same period of 2004. For the first six months of 2005, amortization of intangible assets was $0.4 million, down 41% from $0.6 million for the first six months of 2004.

     Restructuring and Other Charges (Credits). We recorded restructuring and other credits of $26,000 in the second quarter of 2005 and for the six months ended June 30, 2005, we recorded restructuring and other charges of $0.2 million primarily related to changes in estimates for European tax related matters. In the second quarter of 2004, we recorded a credit to restructuring and other charges of $0.1 million for the adjustment of charges taken in 2003 related to European taxation issues. In the first six months of 2004, we recorded a gain to restructuring and other charges of $58,000, which reflects the adjustment noted above, offset by charges related to a legal settlement and associated legal costs taken in the first quarter of 2004.

     Interest and Other Income: Interest and other income consists of interest earned on invested cash, other income net of other expense and foreign currency gains or losses. In the second quarter of 2005, we recorded an adjustment to interest income for the correction of an error in accounting for the amortization of premiums and discounts on investments. The cumulative correction of the error resulted in a reduction of interest income in the second quarter of 2005 of approximately $0.3 million. (See Note 9 to Condensed Consolidated Financial Statements for additional discussion of this adjustment). In the second quarter of 2004, we recorded interest income of $0.2 million. In the first six months of 2005, interest income, including the reduction of $0.3 million for the correction referred to above, was $0.2 million compared to $0.3 million in the first six months of 2004. Foreign currency transaction gains and other income were $0.6 million in the second quarter of 2005, compared with $0.2 million in the second quarter of 2004. In the first six months of 2005, foreign currency transaction gains and other income were $1.4 million compared to $0.5 million in the first six months of 2004. Gains in both the second quarter and the first six months of 2005 and 2004 were primarily a result of exchange rate movements between the U.S. dollar and the euro. The gains in 2005 resulted primarily from the revaluation of dollar holdings in an entity where the euro is the functional currency, while the gains in 2004 resulted primarily from the revaluation of U.S. denominated intercompany balances to the functional currency of the subsidiary.

     Income Taxes. We recorded tax benefits of $90,000 and $177,000 for the three and six months ended June 30, 2005, respectively. The tax benefits resulted from the recognition of Research and Development tax credits in foreign jurisdictions. For the three and six months ended June 30, 2004, we recorded tax provisions of $10,000 and $126,000 respectively. The provisions for income taxes in 2004 resulted from taxes payable in foreign jurisdictions which are not offset by operating loss carryforwards.

     Discontinued Operations. During 2003, we completed two transactions to sell our retail Digital Media and Video business. Net revenue for the retail Digital Media and Video business was $0 in the second quarter of 2005 and 2004, respectively, and $0 and $16,000 in the first six months of 2005 and 2004, respectively. Operating loss was $0.1 million in each of the second quarters of 2005 and 2004 and $0.3 million and $0.1 million in the first six months of 2005 and 2004, respectively.

     During the second quarter of 2005 and 2004, we recorded a net loss on the disposal of the retail Digital Media and Video business of approximately $40,000 and $35,000, respectively. For the first six months of 2005 and 2004, we recorded net gains of $15,000 and $62,000, respectively, primarily resulting from asset recoveries and changes in estimates related to the sale transaction.

     Liquidity and Capital Resources

     As of June 30, 2005, our working capital, which we have defined as current assets less current liabilities, was $32.4 million compared to $39.2 million as of December 31, 2004, a decrease of approximately $6.8 million. The reduction in working capital for the first six months of 2005 primarily reflects a decrease in accounts receivable of $2.3 million, a decrease in inventory of $2.2 million and decreases in current liabilities of $7.4 million.

     Cash, cash equivalents and short-term investments were $36.3 million as of June 30, 2005, a decrease of approximately $9.8 million compared to the balance of $46.2 million as of December 31, 2004.

     The following summarizes our cash flows for the six months ended June 30, 2005 (in thousands):

		Six Months Ended
		June 30,
		2005
Operating cash used in continuing operations		$	(7,462	)
Operating cash used in discontinued operations			(1,059	)
Investing cash usage			(5,621	)
Financing cash flow			158
Effect of exchange rate changes on cash and cash equivalents			(1,448	)
Decrease in cash and cash equivalents			(15,432	)
Cash and cash equivalents at beginning of period			31,181
Cash and cash equivalents at end of period		$	15,749

     Our primary source of cash is receipts from revenue. The primary uses of cash are payroll (salaries, bonuses, and benefits), general operating expenses (marketing, travel, office rent) and cost of product revenue. Another source of cash is the proceeds from the exercise of employee options and participation in the employee stock purchase plan.

     During the first six months of 2005, cash used by operating activities was $7.5 million and reflects a loss from continuing operations of $6.6 million, net of non-cash related expenses. The primary working capital source of cash was a reduction in accounts receivable of $1.8 million and decreases in inventory levels of $2.0 million due to lower purchases made during the quarter. These positive items were primarily impacted by payments of accrued expenses and liabilities of $6.0 million including the payment to the French government of $4.7 million related to Value Added Tax matters for a former customer. The Company is in the process of completing certain regulatory procedures in order to seek recovery of this amount from the customer (see Note 7 to Condensed Consolidated Financial Statements for further discussion). Significant commitments that will require the use of cash in future periods include obligations under operating leases, inventory purchase commitments and other contractual agreements. Total future lease obligations as of June 30, 2005 were $8.8 million, of which $2.2 million will be paid over the next 12 months. Inventory purchase commitments and other contractual obligations as of June 30, 2005 were $2.5 million and $0.4 million respectively.

     In the coming months, we expect to continue to use cash to fund operations, and we currently expect that our current capital resources and available borrowings should be sufficient to meet our operating and capital requirements for the next twelve months. We may, however, seek additional debt or equity financing prior to that time. There can be no assurance that additional capital will be available to us on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

     Cash used in investing activities was primarily for net purchases of short-term investments of $5.6 million. Cash provided by financing activities was primarily from the issuance of common stock related to our Employee Stock Option and Employee Stock Purchase programs of $0.2 million.

FACTORS THAT MAY AFFECT FUTURE RESULTS

     Our business and results of operations are subject to numerous risks, uncertainties and other factors that you should be aware of, some of which are described below. The risks, uncertainties and other factors described below are not the only ones facing our company. Additional risks, uncertainties and other factors not presently known to us or that we currently deem immaterial may also impair our business operations.

     If any of the following actually occur, our business, financial condition, results of operations, cash flows or product market share could be materially adversely affected and the trading price of our common stock could decline substantially.

We have incurred operating losses and may not achieve profitability.

     We have a history of losses with an accumulated deficit of $186.9 million as of June 30, 2005. We may continue to incur losses in the future and may be unable to achieve or maintain profitability.

Our quarterly operating results will likely fluctuate.

     Our quarterly operating results have varied greatly in the past and will likely vary greatly in the future depending upon a number of factors. Many of these factors are beyond our control. Our revenues, gross margins and operating results may fluctuate significantly from quarter to quarter due to, among other things:

	•		business and economic conditions overall and in our markets;
	•		the timing and amount of orders we receive from our customers that may be tied to budgetary cycles, product plans or equipment roll-out schedules;
	•		cancellations or delays of customer product orders, or the loss of a significant customer;
	•		our backlog and inventory levels;
	•		our customer and distributor inventory levels and product returns;
	•		competition;
	•		new product announcements or introductions;
	•		our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all;
	•		our ability to successfully market and sell products into new geographic or customer market segments;
	•		the sales volume, product configuration and mix of products that we sell;
	•		technological changes in the market for our products;
	•		reductions in the average selling prices that we are able to charge due to competition or other factors;
	•		fluctuations in the value of foreign currencies against the U.S. dollar;
	•		the timing and amount of marketing and research and development expenditures; and
	•		costs related to events such as acquisitions, organizational restructuring, litigation and write-off of investments.

     Due to these and other factors, our revenues may not increase or even remain at their current levels. Because a majority of our operating expenses are fixed, a small variation in our revenues can cause significant variations in our earnings from quarter to quarter and our operating results may vary significantly in future periods. Therefore, our historical results may not be a reliable indicator of our future performance.

It is difficult to estimate operating results prior to the end of a quarter.

     We do not typically maintain a significant level of backlog. As a result, revenue in any quarter depends on contracts entered into or orders booked and shipped in that quarter. Historically, many of our customers have tended to make a significant portion of their purchases towards the end of the quarter, in part because they believe they are able to negotiate lower prices and more favorable terms. This trend makes predicting revenues difficult. The timing of closing larger orders increases the risk of quarter-to-quarter fluctuation. If orders forecasted for a specific group of customers for a particular quarter are not realized or revenues are not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected.

Our strategy to grow revenue and become profitable depends on our ability to identify and secure new customers and market opportunities at a faster rate than the rate of decline in our sales from legacy customers and products.

     For the last several quarters, sales of our legacy Digital TV products have been significantly lower than in previous periods, primarily due to competition for our traditional customer base. We have also experienced little or no growth in sales of our PC Security products, due to the slow pace of large digital security projects which could utilize our products. We have adopted a strategy to address our declining revenue that is based on introducing new Digital TV and PC Security products to offset the rate of decline of our legacy Digital TV product sales and to address new market opportunities. To date, this strategy has been only partially successful. Delays in the certification process for our digital TV security modules in South Korea have limited shipment of our modules to the South Korean digital TV market, which remains an important focus for us. We have also experienced delays in the development of new products designed to take advantage of new market opportunities, including our mobile smart card readers, physical access control terminals and dual reader conditional access modules. Once available, our physical access control product for the U.S. government faces substantial competition, and there is no guarantee that we will be successful in securing a significant portion of this market opportunity. If we are not able to complete, sell and ship new products into the new markets we have identified, we may not be able to counter our revenue decline and our losses could increase.

Our listing on the Prime Standard of the Frankfurt Stock Exchange exposes our stock price to additional risks of fluctuation.

     Our common stock is listed both on the Prime Standard of the Frankfurt Stock Exchange and on the Nasdaq Stock Market and we currently experience a significant volume of our trading on the Prime Standard. Because of this, factors that would not otherwise affect a stock traded solely on the Nasdaq Stock Market may cause our stock price to fluctuate. For example, investors outside the United States may react differently and more negatively than investors in the United States to events such as acquisitions, one-time charges and lower than expected revenue or earnings announcements. Any negative reaction by investors in Europe to such events could cause our stock price to decrease significantly. The European economy and market conditions in general, or downturns on the Prime Standard specifically, regardless of the Nasdaq Stock Market conditions, could negatively impact our stock price. In addition, our inclusion or removal from European stock indices could impact our stock trading patterns and price.

Our stock price has been and is likely to remain volatile.