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 SEPTEMBER 30, 2005

OR

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

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 a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

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 November 2, 2005, 15,592,964 shares of common stock were outstanding.

 

 

TABLE OF CONTENTS

				Page
PART I. FINANCIAL INFORMATION
		Item 1. Financial Statements			3
		Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations			15
		Item 3. Quantitative and Qualitative Disclosures About Market Risk			33
		Item 4. Controls and Procedures			33
PART II. OTHER INFORMATION
		Item 1. Legal Proceedings			34
		Item 4. Submission of Matters to a Vote of Security Holders			34
		Item 6. Exhibits			34
SIGNATURES					35
EXHIBIT INDEX					36
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

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								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Net revenue		$	13,312			$	10,957			$	34,335			$	35,698
Cost of revenue			8,117				7,825				22,249				25,443
Gross profit			5,195				3,132				12,086				10,255
Operating expenses:
Research and development			2,196				2,486				6,921				8,039
Selling and marketing			2,237				2,744				7,301				9,116
General and administrative			2,696				2,303				7,455				8,077
Amortization of intangible assets			163				278				513				872
Restructuring and other charges (credits)			25				(82	)			188				(140	)
Total operating expenses			7,317				7,729				22,378				25,964
Loss from operations			(2,122	)			(4,597	)			(10,292	)			(15,709	)
Interest and other income, net			467				359				2,143				1,132
Loss from continuing operations before income taxes			(1,655	)			(4,238	)			(8,149	)			(14,577	)
Benefit (provision) for income taxes			(137	)			59				40				(67	)
Loss from continuing operations			(1,792	)			(4,179	)			(8,109	)			(14,644	)
Loss from discontinued operations, net of income taxes			(166	)			(96	)			(435	)			(203	)
Gain (loss) on sale of discontinued operations, net of income taxes			(89	)			186				(74	)			248
Net loss		$	(2,047	)		$	(4,089	)		$	(8,618	)		$	(14,599	)
Loss per share from continuing operations:
Basic and diluted		$	(0.11	)		$	(0.27	)		$	(0.52	)		$	(0.95	)
Gain (loss) per share from discontinued operations:
Basic and diluted		$	(0.02	)		$	0.01			$	(0.04	)		$	0.00
Net loss per share:
Basic and diluted		$	(0.13	)		$	(0.26	)		$	(0.56	)		$	(0.95	)
Shares used to compute income (loss) per share:
Basic and diluted			15,542				15,426				15,517				15,382
Comprehensive loss:
Net loss		$	(2,047	)		$	(4,089	)		$	(8,618	)		$	(14,599	)
Unrealized gain (loss) on investments			(59	)			(25	)			150				(103	)
Foreign currency translation adjustment			(81	)			(86	)			(1,958	)			(442	)
Total comprehensive loss		$	(2,187	)		$	(4,200	)		$	(10,426	)		$	(15,144	)

See notes to condensed consolidated financial statements.

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

		September 30,				December 31,
ASSETS		2005				2004
Current assets:
Cash and cash equivalents		$	15,223			$	31,181
Short-term investments			20,585				14,972
Accounts receivable, net of allowances of $1,577 and $2,207 as of September 30, 2005 and December 31, 2004, respectively			7,057				8,700
Inventories			5,319				8,319
Other current assets			2,725				2,336
Total current assets			50,909				65,508
Property and equipment, net			3,489				4,597
Intangible assets, net			1,053				1,740
Other assets			1,454				1,462
Total assets		$	56,905			$	73,307

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	4,700			$	4,790
Accrued compensation and related benefits			2,615				2,670
Accrued restructuring and other charges			4,107				9,879
Accrued royalties			1,401				1,794
Accrued professional fees			1,923				2,011
Other accrued expenses			3,275				3,189
Income taxes payable			2,212				2,014
Total current liabilities			20,233				26,347
Deferred tax liability			111				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 September 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			(188,939	)			(180,321	)
Other cumulative comprehensive gain			706				2,514
Total stockholders’ equity			36,561				46,829
Total liabilities and stockholders’ equity		$	56,905			$	73,307

See notes to consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

		Nine Months
		Ended September 30,
		2005				2004
Cash flows from operating activities:
Net loss		$	(8,618	)		$	(14,599	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Loss (gain) from discontinued operations			509				(45	)
Deferred income taxes			(20	)			(1	)
Depreciation and amortization			1,603				2,719
Loss on disposal of fixed assets			—				47
Stock compensation expense			—				32
Changes in operating assets and liabilities:
Accounts receivable			1,152				2,950
Inventories			2,810				(155	)
Other assets			(741	)			6,080
Accounts payable			175				(3,244	)
Accrued expenses			(4,784	)			(512	)
Income taxes payable			129				(612	)
Net cash used in operating activities from continuing operations			(7,785	)			(7,340	)
Net cash used in operating activities from discontinued operations			(1,363	)			(608	)
Net cash used in operating activities			(9,148	)			(7,948	)
Cash flows from investing activities:
Capital expenditures			(65	)			(279	)
Proceeds from disposal of fixed assets			76				1
Maturities of short-term investments			6,768				4,127
Purchases of short-term investments			(12,399	)			(11,009	)
Net cash used in investing activities from continuing operations			(5,620	)			(7,160	)
Net cash provided by investing activities from discontinued operations			2				—
Net cash used in investing activities			(5,618	)			(7,160	)
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			(1,350	)			(472	)
Net decrease in cash and cash equivalents			(15,958	)			(14,980	)
Cash and cash equivalents at beginning of period			31,181				49,382
Cash and cash equivalents at end of period		$	15,223			$	34,402
Supplemental disclosures of cash flow information:
Income tax refunds received		$	96			$	—
Cash paid during the period for income taxes		$	34			$	126
Non-cash investing activities:
Purchases of property and equipment included in accounts payable at period end		$	11			$	—

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 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 nine-month periods ended September 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 May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, Accounting Changes and Error Corrections, which is a replacement of Accounting Principles Board (APB) Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, and is required to be adopted in the first quarter of 2006. The Company does not expect the adoption of SFAS No. 154 to have a material effect on its results of operations or financial position.

     In December 2004, the 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).

     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 or 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								Nine months ended
		September 30,								September 30,
		2005				2004				2005				2004
Net loss, as reported		$	(2,047	)		$	(4,089	)		$	(8,618	)		$	(14,599	)
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			(333	)			(685	)			(1,172	)			(2,274	)
Pro forma net loss		$	(2,380	)		$	(4,774	)		$	(9,790	)		$	(16,873	)
Net loss per share, as reported — basic and diluted		$	(0.13	)		$	(0.26	)		$	(0.56	)		$	(0.95	)
Pro forma loss per share — basic and diluted		$	(0.15	)		$	(0.31	)		$	(0.63	)		$	(1.10	)

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 nine months ended September 30, 2005 and during the same periods for 2004 are as follows (in thousands):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2005				2004				2005				2004
Net revenue		$	—			$	—			$	—			$	16
Operating loss		$	(59	)		$	(68	)		$	(244	)		$	(199	)
Loss before income taxes		$	(96	)		$	(96	)		$	(365	)		$	(203	)
Income tax benefit (provision)		$	(70	)		$	—			$	(70	)		$	—
Loss from discontinued operations		$	(166	)		$	(96	)		$	(435	)		$	(203	)

     The income tax provision for the three months ended September 30, 2005 primarily reflects an increase in the income tax contingency reserves for income tax filing positions taken by the Company for various subsidiaries in foreign jurisdictions.

4. Short-Term Investments

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

		September 30, 2005
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	9,962			$	—			$	(51	)		$	9,911
U.S. government agencies			10,732				—				(58	)			10,674
Total		$	20,694			$	—			$	(109	)		$	20,585

		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

     In addition to the above investments as of December 31, 2004, the Company also held a restricted investment having an unrealized gain of $49,000. During the three months ended September 30, 2005, the restriction on this investment was removed and the maturity of such investment resulted in the Company receiving the related cash proceeds.

     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 nine months ended September 30, 2005 and 2004, no impairment of the investments was identified based on the evaluations performed.

5. Inventories

     Inventories consist of (in thousands):

		September 30,				December 31,
		2005				2004
Raw materials		$	2,373			$	4,604
Work in process			1,807				1,152
Finished goods			1,139				2,563
		$	5,319			$	8,319

6. Intangible Assets

     Intangible assets consist of the following (in thousands):

						September 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				$	1,496			$	(1,007	)		$	489			$	1,937			$	(1,086	)		$	(44	)		$	807
Core technology		60 months					1,696				(1,132	)			564				3,984				(2,707	)			(344	)			933
Total intangible assets						$	3,192			$	(2,139	)		$	1,053			$	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 $0.5 million for the first nine months of 2005 and $0.9 million for the same period of 2004.

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

Fiscal Year				Amount
2005		(remaining 3 months)		$	159
2006					631
2007					263
Total				$	1,053

7. Restructuring and Other Charges

     Continuing Operations

     Accrued liabilities related to restructuring actions and other activities during the first three 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
Provision for Q3 2005			—				—				—				228				3				231
Changes in estimates			—				—				—				—				—				—
			—				—				—				228				3				231
Payments or write offs in Q3 2005			—				(5	)			—				(4	)			(8	)			(17	)
Balances as of September 30, 2005		$	—			$	38			$	—			$	224			$	304			$	566

     For the three months ended September 30, 2005, SCM incurred net restructuring and other charges of approximately $231,000, of which $228,000 primarily related to severance costs in connection with a reduction in force resulting from the Company’s decision to transfer all manufacturing operations in its Singapore facility to contract manufacturers. Approximately $0.2 million of the restructuring amount relates to severance for manufacturing personnel and is therefore recorded in cost of revenue. The remaining $25,000 primarily relates to severance for non-manufacturing personnel and is therefore recorded in operating expenses. The Company expects to substantially complete its restructuring activity by the end of the fourth quarter of 2005 and to incur further costs of approximately $0.5 million.

     For the nine months ended September 30, 2005, restructuring and other charges, excluding severance for Singapore manufacturing personnel discussed above and recorded in cost of revenue, were approximately $188,000. This includes the $25,000 severance costs for non-manufacturing personnel discussed above, as well as 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 the latter half of 2004. The 2004 cost reduction actions have been completed and the Company does not expect to incur further charges related to these actions in 2005.

     In addition, in April 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 September 30, 2005, the remaining balance of accrued other costs primarily relates to European tax matters.

     Discontinued Operations

     Accrued liabilities related to exit costs, restructuring actions and other activities during the first three 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
Provision for Q3 2005			—				—				—				149				149
Changes in estimates			(61	)			—				—				—				(61	)
			(61	)			—				—				149				88
Payments or write offs in Q3 2005			(159	)			—				—				(105	)			(264	)
Balances as of September 30, 2005		$	3,381			$	—			$	—			$	160			$	3,541

     Exit costs for the three and nine months ended September 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 within these three business segments. The Company evaluates the performance of these segments at the revenue and gross profit 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 internal reporting purposes.

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Digital TV:
Revenue		$	5,260			$	4,032			$	13,801			$	14,357
Gross profit			1,962				733				3,654				900
Gross profit %			37	%			18	%			26	%			6	%
PC Security:
Revenue		$	3,898			$	4,547			$	12,566			$	13,183
Gross profit			1,518				2,050				4,468				6,011
Gross profit %			39	%			45	%			36	%			46	%
Flash Media Interface:
Revenue		$	4,154			$	2,378			$	7,968			$	8,158
Gross profit			1,715				349				3,964				3,344
Gross profit %			41	%			15	%			50	%			41	%
Total:
Revenue		$	13,312			$	10,957			$	34,335			$	35,698
Gross profit			5,195				3,132				12,086				10,255
Gross profit %			39	%			29	%			35	%			29	%

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Europe		$	6,697			$	5,313			$	16,021			$	17,612
United States			4,145				3,549				9,873				10,822
Asia-Pacific			2,470				2,095				8,441				7,264
		$	13,312			$	10,957			$	34,335			$	35,698

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Customer A			16	%			*				12	%			10	%
Customer B			15	%			13	%			*				*
Customer C			10	%			*				*				*
			41	%			13	%			12	%			10	%

     * Revenue derived from customer represented less than 10% for the period.

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

		September 30,				December 31,
		2005				2004
Customer A			14	%			*
Customer B			12	%			*
Customer D			*				18	%
Total			26	%			18	%

     * Customer’s accounts receivable represented less than 10% for the periods presented.

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

		September 30,				December 31,
		2005				2004
Property and equipment, net:
United States		$	42			$	70
Europe			1,463				1,919
Asia-Pacific			1,984				2,608
Total		$	3,489			$	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 investments. As a result, interest income and unrealized loss on investments 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 investments 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 during the three-month period ended June 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 eleven years.

     Purchases for inventories are highly dependent upon forecasts of customers’ demand. Due to the uncertainty in demand from customers, the Company may have to change, reschedule, or cancel purchases or purchase orders from its suppliers. These changes may lead to vendor cancellation charges on these purchases or contractual commitments. As of September 30, 2005, the purchase and contractual commitments were $4.0 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 nine months ended September 30, 2005 and 2004 were as follows (in thousands):

		2005				2004
Balances at January 1		$	244			$	326
Additions related to sales during the period			288				71
Warranty costs incurred during the period			(95	)			(91	)
Adjustments to accruals related to prior period sales			(266	)			(66	)
Balance at September 30		$	171			$	240

11. Related Party Transactions

     During the three months ended September 30, 2004, SCM recognized approximately $0.2 million of revenue from sales to Conax AS, a company engaged in the development and provision of smart-card based systems of which Oystein Larsen, a former member of SCM’s board of directors, was then an officer. During the nine months ended September 30, 2004, SCM recognized revenue of approximately $0.5 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, the Company 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 and unspecified amount of punitive damages. Jury 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 market 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, primarily digital photos, to and from various flash media.

     We sell our products primarily to original equipment manufacturers, 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 September 2005, which has resulted in continued operational losses. 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 by ongoing weakness in the overall digital television market. Sales levels of our PC Security products were relatively unchanged in 2004 compared with 2003 and decreased only slightly in the first nine months of 2005 compared with the first nine 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 levels of our Flash Media Interface products were relatively unchanged in 2004 compared with 2003 and have remained relatively unchanged in the first nine months of 2005 compared with the first nine months of 2004. 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, PC Security and Flash Media Interface 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. Our target markets have not grown or developed as quickly as we had expected and we have experienced delays in the development of new products designed to take advantage of new market opportunities.

     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 tradeshow participation. In the last few months we have also taken steps to outsource all our manufacturing operations to contract manufacturers, which we believe will yield further savings and efficiencies. For the first half of 2005, our expense reductions were partially offset by the devaluation of the U.S. dollar related to foreign currencies. This did not occur in the third quarter however, due to the recent strengthening of the dollar. In recent periods we have increased spending on audit and other services related to compliance with the Sarbanes-Oxley Act of 2002. In addition, our current organizational structure requires that we support facilities and operations in several locations around the world, which limits the degree to which we can further reduce expenses.

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 our 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, our 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. Our 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.

     Our management believes the following critical accounting policies, among others, affect the 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 our management, additional inventory write-downs may be required. Based on such judgments, we had inventory write-downs of approximately $2.2 million and $4.3 million in the first nine 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 nine 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 continuing 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 May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which is a replacement of APB Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted in the first quarter of 2006. We do not expect the adoption of SFAS No. 154 to have a material effect on our results of operations or financial position.

     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 or 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 nine-month periods ended September 30, 2005 and 2004 is as follows (in thousands):

										% change												% change
		Three months ended								period to				Nine months ended								period to
		September 30,								period				September 30,								period
		2005				2004								2005				2004
Digital TV
Revenue		$	5,260			$	4,032				30	%		$	13,801			$	14,357				(4	)%
Gross profit			1,962				733								3,654				900
Gross profit %			37	%			18	%							26	%			6	%
PC Security
Revenue		$	3,898			$	4,547				(14	)%		$	12,566			$	13,183				(5	)%
Gross profit			1,518				2,050								4,468				6,011
Gross profit %			39	%			45	%							36	%			46	%
Flash Media Interface
Revenue		$	4,154			$	2,378				75	%		$	7,968			$	8,158				(2	)%
Gross profit			1,715				349								3,964				3,344
Gross profit %			41	%			15	%							50	%			41	%
Total:
Revenue		$	13,312			$	10,957				21	%		$	34,335			$	35,698				(4	)%
Gross profit			5,195				3,132								12,086				10,255
Gross profit %			39	%			29	%							35	%			29	%

     Net revenue for the three months ended September 30, 2005 was $13.3 million, compared to $11.0 million for the same period in 2004, an increase of 21%. This increase in revenue was primarily related to higher sales volumes of our Digital TV conditional access modules and Flash Media Interface readers, both driven by seasonal demand from specific customers. For the nine months ended September 30, 2005, net revenue was $34.3 million, down 4% from net revenue of $35.7 million in the first nine months of 2004. This decrease resulted from slightly lower sales across all three of our product lines, with the greatest decline occurring in PC Security.

     In our Digital TV product line, sales were $5.3 million in the third quarter of 2005 compared to $4.0 million in the third quarter of 2004, an increase of 30%. This increase was due to a larger than usual order from one customer to fulfill seasonally driven demand for new subscribers prior to the fall soccer season in Europe. We do not expect this level of demand from the same customer to be repeated in the next quarter. For the first nine months of 2005, sales were $13.8 million, a decrease of 4% compared with $14.4 million in the first nine months of 2004. Sales of our Digital TV products in the first nine months of 2005 were impacted by weak demand and increasing competition for our products, primarily in Europe, offset by increased sales of new products in South Korea and higher than expected sales due to seasonal demand in the third quarter. 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 $3.9 million in the third quarter of 2005, down 14% from $4.5 million in the third quarter of 2004. For the nine months ended September 30, 2005, sales were $12.6 million, down 5% from sales of $13.2 million in the first nine months of 2004. In both the three- and nine-month comparative periods, lower revenue levels were primarily the result of fluctuations in order levels, rather than specific market or business trends. Revenue in our PC Security product line is subject to significant variability based on the size and timing of product orders. 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. Our PC Security 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.

     Revenue from our Flash Media Interface product line was $4.2 million in the three months ended September 30, 2005, up 75% compared with $2.4 million in the third quarter of 2004. This increase was primarily due to large orders for new digital media readers that are being incorporated in consumer electronics products, which will be marketed during the 2005 holiday season. We do not expect this level of demand to be repeated in the next quarter. For the first nine months of 2005, sales were $8.0 million, a decrease of 2% compared with $8.2 million in the first nine months of 2004. The decrease in the nine-month comparative period was primarily due to the cessation of certain products within this business during the first half of 2005, partially offset by large orders for newer products in the third quarter of 2005. Flash Media Interface revenues consist of sales of digital media readers used primarily to provide an interface for flash memory cards in computer printers and digital photography kiosks, which are used to download and print digital photos.

     Gross Profit. Gross profit for the three months ended September 30, 2005 was $5.2 million, or 39% of total net revenue, compared to $3.1 million, or 29% in the same period of 2004. During the third quarter of 2005, our gross profit was positively impacted by the release of reserves for inventory previously written down of approximately $1.3 million, primarily related to our Digital TV products. This was offset by new write-downs to inventory of $0.4 million in the quarter, primarily related to PC Security products, and severance costs of $0.2 million related to the outsourcing of manufacturing operations to contract manufacturers. (See Note 7 to Condensed Consolidated Financial Statements.) The net effect of the releases, reserves and severance costs recorded in the quarter was a positive impact to gross profit of approximately $0.7 million. In addition, gross profit for our Flash Media Interface business was adversely impacted in the third quarter by product mix, as we sold significant volumes of new Flash Media Interface products that have a significantly lower margin than legacy products in this segment. During the third quarter of 2004, our gross profit was adversely affected by an inventory write-down of approximately $1.1 million, of which $0.6 million related to excess Flash Media Interface product inventory, $0.3 million related to Digital TV product inventory and $0.2 million related to a write-down in the value of digital television controller chips due to pricing pressures.

     For the nine months ended September 30, 2005, gross profit was $12.1 million, or 35% of revenue, compared with gross profit of $10.3 million, or 29% of revenue for the first nine months of 2004. Gross profit in the first nine months of 2005 was positively impacted by approximately $2.4 million in releases of reserves for inventory, which was sold during this period as a result of higher than expected customer demand and changes in the technological application of our products, primarily in our Digital TV business. These releases were offset by inventory write-downs of approximately $2.2 million, as well as by pricing pressure, mix of products sold, severance and tooling costs. Gross profit in the first nine months of 2004 was adversely impacted by inventory write-downs, including approximately $1.0 million primarily related to flash media interface and digital television products taken in the third quarter, $2.9 million related primarily to our Digital TV products taken in the second quarter and $0.2 million taken in the first quarter of 2004.

     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 September 30								period to				Nine months ended September 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,196			$	2,486				(12	)%		$	6,921			$	8,039				(14	)%
Percentage of total revenues			16	%			23	%							20	%			23	%

     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 third quarter of 2005, research and development expenses were $2.2 million, or 16% of revenue, compared with $2.5 million, or 23% of revenue in the third quarter of 2004. For the first nine months of 2005, research and development expenses were $6.9 million, or 20% of revenue, compared with $8.0 million, or 23% of revenue for the first nine months of 2004, a decrease of $1.1 million, or 14%. The decrease in the first nine months of 2005 compared with the prior year period was primarily due to lower headcount and contract service costs and to customer funded development contributions of $0.3 million. The decrease in expenses was partially offset by the devaluation of the U.S. dollar in the first half of the year compared with foreign currencies in which the majority 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 September 30								period to				Nine months ended September 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,237			$	2,744				(18	)%		$	7,301			$	9,116				(20	)%
Percentage of total revenues			17	%			25	%							21	%			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 third quarter of 2005 were $2.2 million, or 17% of revenue, compared with $2.7 million, or 25% of revenue in the third quarter of 2004. For the first nine months of 2005, sales and marketing expenses were $7.3 million, a decrease of $1.8 million, or 20% from $9.1 million in the first nine months of 2004. The decrease in the first nine 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 in the first half of the year 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 September 30								period to				Nine months ended September 30								period to
		2005				2004				period				2005				2004				period
Expenses		$	2,696			$	2,303				17	%		$	7,455			$	8,077				(8	)%
Percentage of total revenues			20	%			21	%							22	%			23	%