SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

 

COMMISSION FILE NUMBER 0-29440

 

 

 

 

SCM MICROSYSTEMS, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

Registrant’s telephone number, including area code:

(510) 360-2300

 

      Securities Registered Pursuant to Section 12(b) of the Act:

None

 

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value, and associated Preferred Share Purchase Rights

 

(Title of Class)

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicated by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements or any amendment to this Form 10-K.  o

 

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 a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

Based on the closing sale price of the Registrant’s Common Stock on the NASDAQ National Market System on June 30, 2005, the last business day of the Registrant’s most recently completed second fiscal quarter, the aggregate market value of Common Stock held by non-affiliates of the Registrant was $35,006,512. For purposes of this disclosure, shares of Common Stock held by beneficial owners of more than 5% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant, have been excluded in that such persons may be deemed to be affiliates. This determination is not necessarily conclusive.

 

At March 02, 2006, the registrant had outstanding 15,592,964 shares of Common Stock.

 

 

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The Company’s Proxy Statement and Notice of Annual Meeting to be filed within 120 days after the Registrant’s fiscal year end of December 31, 2005 is incorporated by reference into Part II, Item 5 and Part III of this Report.

 

 

SCM Microsystems, Inc.

 

Form 10-K

For the Fiscal Year Ended December 31, 2005

 

TABLE OF CONTENTS

 

 

SCM, CHIPDRIVE, CIMax, EasyTAN, EuroCAM, Flashbay, MultiCAM, SmartOS, St@rKey, SwapBox, TOWITOKO, TripleCard and WorldCAM are registered trademarks and Opening the Digital World, POD Tool and SCMOS are trademarks of SCM Microsystems. Other product and brand names may be trademarks or registered trademarks of their respective owners.

 

This Annual Report on Form 10-K 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 Annual Report on Form 10-K 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 Annual Report on Form 10-K. 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 “Item 1B, Risk Factors” and elsewhere in this Annual Report on Form 10-K. These cautionary statements qualify all of the forward-looking statements included in this Annual Report on Form 10-K that are attributable to us or persons acting on our behalf.

 

Description of Business

 

SCM Microsystems, Inc. (“SCM,” the “Company,” “we” and “us”) was incorporated in 1996 under the laws of the state of Delaware. We design, develop and sell 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 secure digital access products into three market segments: Digital TV, PC Security and Flash Media Interface.

 

 

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: digital TV operators and broadcasters and conditional access providers for our conditional access modules; government contractors, systems integrators, large enterprises and computer manufacturers, as well as banks and other financial institutions for our smart card readers; and computer 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, SCM has accounted for the retail Digital Media and Video business as a discontinued operation, and statements of operations for all periods presented reflect the discontinuance of this business. (See Note 2 of Notes to Consolidated Financial Statements.)

Overview of the Market for Secure Digital Access Products

 

Individuals, businesses, governments and educational institutions increasingly rely upon computer networks, the Internet, intranets and direct broadcast systems for information, entertainment and services. The proliferation of and reliance upon electronic data and electronic transactions has created an increasing need to protect the integrity of digital data, as well as to control access to electronic networks and the devices that connect to them. For digital television operators and broadcasters and Internet service providers, there is a need to limit access to broadcast content to paying subscribers and ensure that further storage or communication of such content is secure and complies with copyright laws. For government entities and large corporate enterprises, there is a need to control access to shared networks and intranets to prevent loss of proprietary data. Increasingly, there is a need to control and monitor access to information stored on identification cards used in new government-driven programs around the world, such as electronic passports, drivers’ licenses and citizen ID and health care cards. In some cases, there may also be a need to expand the capability of electronic networks to protect or restrict access to physical facilities for corporate employees or military personnel. Finally, for consumers and online merchants or banks, there is a need to authenticate credit cardholders or bank clients for Internet transactions without jeopardizing sensitive personal account information. In all of these areas, we believe standards-based devices that easily connect to a PC or network to provide secure, controlled access to digital content or services are an easily deployed and effective solution.

 

Digital Television Market

 

Digital TV takes the form of subscriber-based direct satellite, digital cable and direct terrestrial broadcast services. The research firm In-Stat/MDR estimates that by the end of 2009, 108 million households worldwide will subscribe to digital cable television worldwide, up from 44 million households in 2005. Direct to home digital satellite is predicted by In-Stat/MDR to grow to 101 million subscriptions worldwide by the end of 2008. The rapid transition from free-to-air analog to digital pay-television is being driven by consumer demand for the very high resolution, high quality video images that digital broadcasting affords, as well as by the medium’s ability to deliver a broad range of customized, private content and interactive services.

 

A primary challenge for digital television operators and broadcasters is to limit access to their pay-TV content to the intended users, such as those who have purchased appropriate subscriptions or event specific pay-per-view privileges. Traditionally, this has been accomplished through the use of proprietary set-top boxes, which connect to the user’s television to receive the broadcast signal and utilize embedded security software, known as conditional access, to decrypt a specific operator’s content. This is still the dominant method of protecting pay-TV content in use in the world today. However, over the last several years, local country governments have endeavored to spur competition between operators and between set-top box manufacturers by mandating the availability of “open” receivers that utilize removable conditional access, rather than embedded security, to decrypt content. As a result, set-top boxes equipped with a common interface slot are now available in many areas of the world. The common interface slot accepts a conditional access security module that contains the decryption mechanisms to descramble the broadcast signal from a specific operator, and which can be easily removed and replaced with a different module to descramble a different operator’s content. Removable security has been particularly successful in Europe, where, in the 1990s, many small broadcast operators determined that it was cost prohibitive to provide proprietary set-top boxes to their subscribers. Consequently, they elected to provide their customers with less expensive and easier to deploy removable conditional access modules, which could be used with the open set-top boxes then becoming available on the market.

 

In conjunction with the regulatory push for open set-top boxes, various standards for removable security have been developed and adopted around the world. In Europe, the Digital Video Broadcasting-Common Interface, or DVB-CI standard was developed by the DVB Project, an international consortium of over 300 enterprises involved in varying aspects of digital television, including France Telecom, Deutsche Telekom, Nokia, Sony and Philips. Legislation has been enacted in Poland, Spain, Switzerland and the United Kingdom mandating that set-top receivers comply with the DVB-CI standard in order to assure broad access to digital content without requiring consumers to purchase multiple set-top boxes. In the United Kingdom, the British Digital Broadcasting Consortium has defined a reference design for set-top boxes for the British digital television market that is compliant with the DVB-CI standard. In the United States, the Federal Communications Commission has mandated the conversion of the proprietary cable infrastructure to an open environment that supports greater competition, culminating in a

cutoff of analog broadcasting by February 2009. To support this move, Cable Television Laboratories, Inc. (CableLabs^®), a research and development consortium of U.S. cable television multi-system operators, or MSOs, has developed specifications for removable security as part of its OpenCable^tm initiative. Various governments in Asia have also adopted broadcasting standards that are designed for removable security, including China, which has adopted the DVB-CI standard, and Korea, which has adopted the OpenCable standard for the digitization of cable networks. We estimate that over the next five years, the Korean digital television industry will deploy open set-top boxes requiring a removable conditional access module to between eight and twelve million households.

 

During the last decade, removable security has been used to enable pay-TV decryption with open set-top boxes connected to television sets. Since the early 2000s, television sets with embedded receiver technology, called integrated digital TVs, have begun to be available. Although these integrated digital televisions do not require a set-top box to receive the broadcast signal, in many cases they do require a conditional access module to provide the specific decryption technology for the local cable broadcasts they are receiving. Sales of integrated digital television sets are expected to grow from 5 million units in 2004 to 48.5 million units by the end of 2009, according to IMS Research.

 

Our Digital Television Products

 

We pioneered the development of removable security technology and today we offer both conditional access modules and interface chipsets to address the need for removable security for digital television pay-TV broadcasts. Through our direct sales force and select distributors, we sell our digital TV products to conditional access suppliers, digital television operators and broadcasters and distributors.

 

Conditional Access Modules.  Our conditional access modules combine smart card interface technology with the proprietary descrambling code of a digital television operator, providing a cost-effective and highly secure means of controlling access to digital broadcasts. Our conditional access modules utilize a smart card to determine if a viewer has access to a given operator’s service. If the viewer is authorized, the conditional access module descrambles the signal for viewing.

 

Our conditional access modules comply with major standards for removable security for digital television systems, including the European DVB-CI, the U.S. OpenCable and the Korean OpenCable specifications. This allows our modules to be used with any open standards television receiver — whether set-top box or integrated digital television — and enables the receiver to accept content from multiple service providers. Subscribers wishing to change service providers can do so just by removing one conditional access module and inserting another. Service providers also benefit from seamless security upgrades and reductions in fraud. Our conditional access modules also enable content providers to securely and economically deliver a variety of services including video-on-demand, pay-per-view, interactive video, home shopping, home banking and interactive games.

 

We sell our conditional access modules to a variety of customers in Europe, including distributors; OEMs; digital television operators and broadcasters such as Top Up TV in the United Kingdom, Premiere in Germany, Telefonica in Spain, Canal Digital, SVT and Boxer-TV Access in Sweden, CanalDigitaal in The Netherlands, ViaSat in Norway and Digiturk in Turkey; and conditional access security encryption system providers, such as Mindport (Irdeto), Kudelski (Nagravision), MediaGuard (Canal+Technologies), Philips (Cryptoworks), NDS (Videoguard), Viaccess and Telenor (Conax).

 

In the emerging Asian market, we have been working to leverage our relationships with global conditional access providers and to establish relationships with local suppliers in order to participate in opportunities arising from the deployment of digital television technology. To date, we have entered into agreements with local encryption system providers in China including Novel-Tongfang and DTVIA (ChinaCrypt), to assist in creating an open standards-based broadcasting infrastructure for the Chinese market. In Korea, we have entered into agreements with NDS, Nagra, Canal+Technologies, Conax and Irdeto to develop conditional access modules for the Korean market. We have also signed agreements with Korean cable operators Broadband Solutions Inc. (BSI), CJ CableNet, Jeju Broadcasting, Korea Digital Cable Media Center and Qrix Communications to deliver OpenCable conditional access modules for deployment to these operators’ subscribers.

We are actively involved in the development and adoption of conditional access modules to support removable security for open digital receivers worldwide. We are currently a key contributor to the European DVB and U.S. OpenCable standards-setting organizations for removable conditional access. We believe we are the significant supplier of the open standards-based authorized security modules for European digital TV. Based on that experience, we co-authored the specifications for the U.S. CableCARD^tm modules, which are scheduled to be deployed throughout the U.S. cable system by mid-2006 and began to be deployed in Korea in 2005. We continue to support the development of the worldwide digital TV market by working with industry standards organizations such as CableLabs in the U.S., DVB in Europe and Digital Television Group in the United Kingdom; leading consumer electronics companies; and security system providers to achieve interoperability between multiple conditional access systems, head end transmitters and end user receivers, all of which can benefit from using our conditional access modules for encryption and de-encryption.

 

CIMaX.  Our CIMaX 2.0 and CIMaX SP2 controller chips enable digital TV receiver manufacturers to quickly create equipment that can accept common interface modules, including DVB-CI and OpenCable compliant conditional access modules. Our CIMaX controllers interface with major digital TV receiver microprocessors and includes support for other systems critical to implementing removable conditional access.

 

PC Security Market

 

The proliferation of personal computers in both the home and office, combined with widespread access to computer networks and the Internet, have created significant opportunities for electronic transactions of all sorts, including business-to-business, e-government, e-commerce and home banking. In government agencies and corporate enterprises, the desire to link disparate divisions or offices, reduce paperwork and streamline operations is also leading to the adoption of more computer- and network-based programs and processes. Network-based programs are also used to track and manage data about large groups of people, for example citizens of a particular country. While the benefits of computer networks are significant, network and Internet-based transactions also pose a significant threat of fraud, eavesdropping and data theft for both groups and individuals. To combat this threat, parties at both ends of the transaction must be assured of the integrity of the transaction. Online merchants and consumers need assurances that customers are correctly identified and that the authenticity and confidentiality of information such as credit card numbers is established and maintained. Corporate, government and other networks need security systems that ensure the security of individuals’ data and protect the network from manipulation or abuse both from within and without the enterprise.

 

Increasingly, large enterprises such as corporations, government agencies and banks are adopting systems that protect the network, the information in it and the people using it by authenticating each user as they log on and off the network. Authentication of a user’s identification is typically accomplished by one of two approaches: passwords, which are codes known only by specific users; and tokens, which are user-specific physical devices that only authorized users possess. Passwords, while easier to use, are also the least secure because they tend to be short and static, and are often transmitted without encryption. As a result, passwords are vulnerable to decoding or observation and subsequent use by unauthorized persons. Tokens range from simple credit card-size objects to more complex devices capable of generating time-synchronized or challenge-response access codes. Certain token-based systems require both possession of the token itself and a personal identifier, such as a fingerprint or personal identification number, or PIN, to indicate that the token is being used by an authorized user. Such an approach, referred to as two-factor authentication, provides much greater security than single factor systems such as passwords or the simple possession of a token.

 

One example of a token used in two-factor authentication is the smart card, which contains an embedded microprocessor, memory and a secure operating system. In addition to their security capabilities, smart cards are able to store data such as account information, health care records, merchant coupons, still or video images and, in some cases, cash. Smart cards are typically about the size of a credit card and can easily be carried in a wallet or attached to a badge. Smaller cards designed for use with small devices such as mobile phones are also increasingly being used. Depending on the application for which they are being used, smart cards can be designed to insert into a reader attached to a PC or other device, or can include wireless capabilities for contactless interface. It is estimated that worldwide shipments of smart cards grew from 1.9 billion in 2003 to more than 2.5 billion in 2005, for applications ranging from mobile communications to corporate security to online banking, according to the

European smart card industry organization, Eurosmart. Demand for readers used in conjunction with those cards is also expected to grow. Research firm Frost & Sullivan have predicted that unit shipments will grow from 9.4 million in 2003 to 35.5 million in 2008, a compound annual growth rate of over 30%. We believe that the combination of smart cards and readers provides a secure solution for network access, personal identification, electronic commerce and other transactions where authentication of the user is critical.

 

To date, the largest and one of the most advanced deployments of smart cards for digital security purposes has been the U.S. Department of Defense’s Common Access Card (“CAC”) program. Between October 2000 and mid-2002, the U.S. Department of Defense distributed smart cards to approximately four million armed force personnel. These cards are being used as the standard identification credential for military personnel, and are also being used for secure authentication and network access. New deployments of the cards also include capabilities for contactless interface with security terminals at doorways and other entrances to provide secure physical access at government facilities. The U.S. government’s decision to deploy an integrated, agency-wide, common smart card platform will continue to raise the awareness of smart card technology and hence increase the demand for contactless smart card proximity readers in both public and private sectors, according to IMS Research. The firm predicts the Americas’ market for electronic physical access control equipment will reach $766.7 million in 2009, with a forecast compound annual growth rate of 9.1%.

 

Because CAC cards store and protect personnel data, they are also being used wherever a digital signature is required; for example, processing travel orders or expense claims online, electronic voting, contractor verification and in department specific programs. As a result of the success of the CAC program, other government agencies are also considering the use of smart cards as secure ID tokens. For example, the Transportation Security Administration plans to begin using smart cards beginning in 2006 for its Registered Traveler program, a voluntary program in which prescreened airline passenger are allowed to bypass some of the security procedures at U.S. airports.

 

The U.S. government is actively driving the use of smart cards outside the boundaries of the country as well, with the request in 2002 to 27 visa waiver countries to develop electronic passports that will include biometric data to authenticate the holder. Under the auspices of the International Civil Aviation Organization (ICAO), 13 countries have been working together to define and develop standards for e-passports based on contactless smart card technology. The goal of the program is to ensure that these e-passports cannot be copied or altered, and that the biometric facial image stored on the card could be used to positively identify the holder. All of ICAO’s 188 Contracting States must begin issuing only machine readable (i.e., electronic) passports no later than April 1, 2010. Some 110 States currently do so and about 40 of them plan to upgrade to e-passports with biometrics by the end of 2006 to meet the United States Visa Waiver Program requirements. The European Union, Australia, Belgium, Canada, China, Denmark, Hong Kong, Japan, Korea, Macao, Malaysia, the Netherlands, Singapore, Sweden, the United Kingdom and the U.S. have all begun implementation of plans to adopt electronic passports.

 

In many countries, governments are considering using the technology for other purposes, including new or enhanced national ID cards, storing digital certificates for online transactions, residency permits and visas, and drivers’ licenses. Other countries are also moving forward with programs to implement purely internal programs, including national ID rollouts in Thailand and China and deployment of electronic drivers’ licenses in Japan. Many of these government ID projects will utilize contactless smart card technology, according to research firm Frost & Sullivan, which predicts demand for national ID cards will reach 450 million units by 2009, up from just 12.5 million cards in 2004.

 

Many governments are also evaluating or making plans to develop electronic health care record systems, which would include smart card-based health care cards for participants. Taiwan, Puerto Rico, Germany, Italy, South Africa and other countries or regions have already deployed or are deploying health care smart cards to millions of health care users. These cards identify the user and store insurance and medical information that can be accessed by doctors and hospitals, for example. To date, the largest program actively underway is in Germany, where the government plans to distribute 82 million eHealth cards to citizens and have the corresponding network and card reader infrastructure in place for doctors, hospitals, pharmacies and other healthcare providers by 2007.

 

Outside the government sector, many corporate enterprises are adopting smart card technology to protect access to buildings and computer networks. Several smart card-based employee identification programs have

already been announced by companies such as Pfizer, Microsoft, Chevron, Nissan, Royal Dutch/Shell Group, Hitachi, Sun Microsystems and Boeing.

 

In the financial industry, major credit card companies in many parts of the world have embraced smart card technology as a more secure way to secure transactions and eliminate fraud, the cost of which can be significant. Most of the cards issued comply with the Europay Mastercard Visa (EMV) standard for securing financial transactions using a smart card. Canada, most of Europe and Asia/Pacific and some markets in the Middle East, Africa and Latin America are rapidly moving to EMV smart cards to reduce fraud. Smart cards are also expected to have a growing role in online banking. Western Europe, in particular has a high percentage of consumers banking online, and Germany is one of the first countries to coordinate e-government initiatives requiring digital signatures to leverage smart cards issued to bank customers.

 

Our PC Security Products

 

We offer a full range of smart card reader technology solutions to address the need for smart card-based security for a range of applications and environments, including PCs, networks, physical facilities and authentication programs. Our products include smart card readers, application specific integrated circuits, or ASICs, and small office productivity packages based on smart cards. We sell our readers and ASICs primarily to PC original equipment manufacturers, or OEMs, smart card solutions providers and government systems integrators to support specific internal security programs, such as secure logon for employees, secure home banking or the Common Access Card program; as well as to OEMs that incorporate our products into their devices, such as PCs or keyboards. We sell our small office productivity packages primarily to end users via retail channels and the Internet.

 

Smart Card Readers.  We are one of the world’s largest suppliers of smart card readers for security-oriented applications. Our smart card readers are hardware devices that connect either externally or internally with a computer or other processing platform to verify the identity of, or authenticate, the user, and thus control access. Much like a “lock” works with a key, our readers work with a smart card to admit or deny access to a computer or network, or to authenticate the card holder for identification and access, such as while traveling or requesting health care or other services. Our readers are used to authenticate users in order to support security programs and applications for corporations, financial institutions, governments and individuals. These security programs and applications include secure network logon; personnel identification for programs such as health care delivery, drivers’ licenses and electronic passports; secure home banking; digital signatures; and secure e-commerce.

 

Our products employ an open-systems architecture that provides compatibility across a range of hardware platforms and software environments and accommodates remote upgrades so that compatibility can be maintained as the security infrastructure evolves. We have made significant investments in software embedded in our products that enable our smart card readers and components to read the vast majority of smart cards in the world, regardless of manufacturer or application. Our smart card readers are also available with a variety of interfaces, including biometric (fingerprint), wireless/contactless, keypad, USB, PCMCIA, ExpressCard and serial port, and offer various combinations of interfaces integrated into one device in order to further increase the level of security.

 

To address the varied needs of our customers, we offer an array of smart card readers. These include readers designed for various platforms, such as desktop and notebook computers; as well as readers offering incremental levels of protection against unauthorized use, from simple PC Card reader devices to more complex PIN entry systems, which require both a smart card and a user’s personal identification number to authenticate the user. Our smart card product line includes:

 

 

 

Our readers are developed in compliance with relevant industry standards related to the applications for which they will be used. For example, many of our readers, including the SCRx31 Secure Card Reader line, conform to Europay, MasterCard and Visa (EMV) international standards for financial transactions. We typically customize our smart card readers with unique casing designs and configurations to address the specific requirements of each customer.

 

Physical Access Control Terminals.  To address the stated requirements of the U.S. government for secure access to facilities, we have developed a physical access control terminal. The terminal is designed to read the Common Access Card, a smart card currently used by four million military personnel for secure network logon as well as personal identification and authentication. Our Physical Access Control Terminal (PACT) products allow customers to combine new technologies such as contactless smart cards and biometrics with existing control systems and provide support for new connectivity options going forward. SCM’s PACT products enable a range of configurations to match different requirements across organizations as requirements evolve.

 

ASICs/Chip Sets.  Our chip sets provide smart card interface capabilities for embedded platforms, such as desktop computers or keyboards. We offer two levels of ASICs to provide both basic smart card interface capability and support for multiple interfaces and reader devices. All of our ASICs comply with all relevant security standards for applications in the smart card industry. In addition, our advanced chip allows on-board flash upgrades for future firmware and application enhancements.

 

CHIPDRIVE Productivity Solutions.  We offer several CHIPDRIVE packages, consisting of smart cards, readers and software applications, for small and medium sized businesses. These products support applications such as smart card-enabled logon to Microsoft^® Windows and smart card-based, secure electronic time recording.

 

Flash Media Interface Market

 

Digital cameras have gained rapid popularity over the last few years, resulting in more than half of U.S. households owning a digital camera at the end of 2005, according to research firm InfoTrends. InfoTrends also predicts that annual sales of digital cameras will top 100 million worldwide by the end of 2010. Research firm Gartner estimates that U.S. output of digital photo prints exceeded 8.2 billion in 2005 and will increase to nearly 29 billion by 2009. Flash media cards, which store digital images on the majority of digital cameras, are the key driver behind digital print growth. Higher capacity memory cards allow digital camera users to take more pictures before having to download images or swap out the card. As card capacities increase, more time is needed to download images. This uses more of the camera’s battery life, which is already insufficient for many camera owners. To print without draining the camera battery, the flash media card can be removed and inserted into a card reader — on a PC, printer or kiosk — to download and print images.

 

Gartner predicts that home photo printing, currently the most popular location for image printing, will be surpassed by retail printing by the end of 2007. Retail photo kiosks and minilabs, which give instant, high-quality printouts of digital images, make printing photos more convenient for the consumer and typically provide higher quality prints than home printers. Shipments of photo kiosks in the U.S. are predicted to grow at an annual compounded growth rate of 12% over the forecast period between 2003 and 2008, reaching shipments of about 34,000 units in 2009, according to InfoTrends. As flash memory card capacities increase and digital cameras continue to proliferate, we believe consumers will increasingly use photo kiosks and minilabs to download and print their digital pictures. Each photo kiosk or minilab requires a variety of media card readers to download images from the various media cards in use in digital cameras on the market

Our Flash Media Interface Products

 

We offer digital media readers that provide an interface to the various formats of digital media cards to download digital images and other content. We sell our flash media interface products primarily to photo kiosk manufacturers. Our digital media readers allow photo kiosk makers and others to build flash media interface capabilities into their products. Our product offerings provide interface capabilities for all major memory card formats, including PCMCIA I and II, CompactFlash^® I and II, IBM MicroDrive, MultiMediaCard^tm, Secure Digital Card^®, SmartMedia, Sony Memory Stick^®, xD-Picture Card^tm, miniSD^tm and RS-MMC media. Our media readers leverage our interface chips to enable each reader slot to read multiple types of cards.

 

Business Segment Financial Information

 

See Note 11 to the consolidated financial statements for financial information regarding revenue and gross margin for our reported business segments through 2005. See “Management’s Discussion and Analysis of Financial Conditional and Results of Operations” for historical financial information, including revenue and gross margin, for our continuing security business.

 

Technology

 

Most of the markets in which we participate are in their early stages of development and we expect they will continue to evolve. For example, early markets such as ours typically require complete hardware solutions, but over time requirements shift to critical components such as silicon or software as OEM customers increase their knowledge and sales volumes of the technologies being provided. We are committed to developing products using standards compliant technologies. Our core technologies, listed below, leverage our development efforts to benefit customers across our product lines and markets.

 

Chip-Level Integration.  We have implemented a number of our core interface and processing technologies into silicon chips for each of our three primary product areas.

 

Silicon and Firmware.  For our PC Security and Digital TV products, we have developed interface technology that provides interoperability between PCs and smart cards from many different smart card manufacturers. Our interoperable architecture includes an International Standards Organization, or ISO, compliant layer as well as an additional layer for supporting non-ISO compliant smart cards. Through our proprietary integrated circuits and firmware, our smart card readers can be updated electronically to accommodate new types of smart cards without the need to change the reader’s hardware. For our Flash Media Interface products, we have developed interface technology that provides interoperability and compatibility between various digital appliances, computer platforms and flash memory cards.

 

Complete Hardware Solutions.  We provide complete hardware solutions for a range of secure digital access applications, and we can customize these solutions in terms of physical design and product feature set to accommodate the specific requirements of each customer. For example, we have designed and manufactured smart card readers that incorporate specific features, such as a transparent case and removable USB cable, to address the needs of specific OEM customers.

 

Customers

 

Our products are targeted at digital TV operators and broadcasters, conditional access suppliers, government contractors and systems integrators, as well as manufacturers of computers, computer components, consumer electronics and photographic equipment. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. Sales to our top 10 customers accounted for approximately 46% of our total net revenue in 2005, 40% of our total net revenue in 2004 and 56% of our total net revenue in 2003. In 2005 and 2004, no single customer accounted for more than 10% of our total net revenue. In 2003, one customer accounted for 16% and one customer for 13% of our total net revenue. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns,

or market, economic or competitive conditions in the digital information security business, could harm our business and operating results.

 

Sales and Marketing

 

We market, sell and license our products worldwide to digital television operators and broadcasters, conditional access suppliers, government contractors and systems integrators, and manufacturers of computers, computer components, consumer electronics and photographic equipment. We utilize a direct sales and marketing organization, supplemented by distributors, value added resellers, systems integrators and resellers. As of December 31, 2005, we had 40 full-time employees engaged in sales and marketing activities. Our direct sales staff solicits prospective customers, provides technical advice and support with respect to our products and works closely with customers, distributors and OEMs. In support of our sales efforts, we conduct sales training courses, targeted marketing programs, advertising, trade shows and ongoing customer and third-party communications programs.

 

Backlog

 

A significant portion of our sales are made from inventory on a current basis. Sales are made primarily pursuant to purchase orders for current delivery or agreements covering purchases over a period of time. Our customer contracts generally do not require fixed long-term purchase commitments. In view of our order and shipment patterns and because of the possibility of customer changes in delivery schedules or cancellation of orders, we do not believe that such agreements provide meaningful backlog figures or are necessarily indicative of actual sales for any succeeding period.

 

Collaborative Industry Relationships

 

We are party to collaborative arrangements with a number of third parties and are a member of several industry consortia. We evaluate, on an ongoing basis, potential strategic alliances and intend to continue to pursue such relationships. Our future success will depend significantly on the success of our current arrangements and our ability to establish additional arrangements. These arrangements may not result in commercially successful products.

 

PC/SC Workgroup.  We are an associate member of the PC/SC workgroup, a consortium of technology companies that seeks to set the standard for integrating smart cards and smart card readers into the mainstream computing environment.

 

Silicon Trust.  We are a member of Silicon Trust, an industry forum sponsored by Infineon Technologies that focuses on silicon based security solutions, including smart cards, biometrics, and trusted platforms.

 

Teletrust.  We are a member of Teletrust, a German organization whose goal is to provide a legally accepted means to adopt digital signatures. Digital signatures are encrypted personal identifiers, typically stored on a secure smart card, which allow for a high level of security through internationally accepted authentication methods. We are a member of the smart card terminal committee, which defines the standards for connecting smart cards to computers for applications such as secure electronic commerce over the Internet.

 

PCMCIA.  We are an executive member of Personal Computer Memory Card International Association, or PCMCIA, an international standards body and trade association with more than 100 member companies. We have been a member of PCMCIA since 1990. PCMCIA was founded in 1989 to establish standards for integrated circuit cards and to promote interchangeability among mobile PCs. Other executive members include Dell, Hewlett-Packard, Intel, Microsoft, Sandisk and Sony. In 1995, we introduced to PCMCIA the DVB-CI standard which was adopted as a custom interface extension for inclusion into the PC Card standard. In 1997, we proposed the adoption of the OpenCable POD interface standard for digital set-top boxes in the U.S., which was subsequently approved.

 

FINREAD.  We are a member of FINREAD, a consortium of European banks whose goal it is to create a secure online payment system based on smart cards that is affordable and easy to use, deploy and upgrade. In addition to our participation with the standards setting activities of FINREAD, we have been selected by FINREAD to provide secure smart card readers for various financial application deployments in Europe.

Smart Card Alliance.  We are a member of the Smart Card Alliance, a U.S.-based, multi-industry association of member firms working to accelerate the widespread acceptance of multiple applications for smart card technology. We are also members of Smart Card Alliance’s Leadership Council and the Physical Access Council, which focuses on issues relating to the implementation of physical access systems. We regularly contribute to Smart Card Alliance research and education materials including white papers, for example a paper defining key policy, process and technology considerations for a secure smart card-based personal ID system.

 

SmartRight.  In late 2002, we joined SmartRight, an industry consortium composed of leading companies from the consumer electronics, conditional access, integrated circuit and smart card industries — including Axalto (formerly Schlumberger), Canal+ Technologies, Gemplus, Micronas, Nagravision, Panasonic, Pioneer, STMicroelectronics and Thomson. The aim of SmartRight is to develop a worldwide framework for copy protection within a digital home network. The SmartRight system will work in combination with conditional access systems or digital rights management systems, to provide end-to-end protection of digital content from the content provider to the consumer’s presentation device and can accept content from any kind of source, including free-to-air and pre-recorded content.

 

Trusted Computing Group.  In November 2003, we joined the Trusted Computing Group, or TCG, an open industry standards organization whose specifications help vendors build products that let users protect critical data and information across a variety of computing platforms. TCG’s focus is on developing, defining and promoting hardware-enabled trusted computing and security technologies across multiple platforms, peripherals and devices.

 

Digital Video Broadcasting (DVB).  We have long been a member of the DVB consortium, which is responsible for setting the standards for the digital TV industry in Europe and other parts of the world. We were a key contributor to the development of the current DVB-CI standard for removable security modules. We remain actively involved in DVB through our participation in various subgroups of the organization, including those on copy protection and middleware technology.

 

Digital TV Group (DTG).  We are a member of DTG, the industry association for digital television in the United Kingdom whose goal is to facilitate the rapid rollout of digital television and convergence across the communications industry.

 

OpenCable.  We are a founding member of the OpenCable project, an initiative of Cable Television Laboratories, Inc., or CableLabs, a research and development consortium of cable television system operators. The OpenCable process is intended to foster competition among suppliers for key elements of digital cable networks, while ensuring interoperability of devices connected to cable networks. We have played a leading role in OpenCable, including co-authoring the OpenCable standards specifications for removable security for digital TV in the U.S.

 

European Association for the Protection of Encrypted Works and Services (AEPOC).  Since 2002, we have been a member of AEPOC, a European consortium of digital television operators, conditional access providers and hardware manufacturers whose purpose is to lobby European governments to impose tougher legislation on broadcast piracy activities.

 

Digital Living Network Alliance (DLNA).  We are a member of the Digital Living Network Alliance, a group of industry leaders that share a vision of a wired and wireless interoperable network of personal computers, consumer electronics and mobile devices in the home enabling a seamless environment for sharing and growing new digital media and content services.

 

Research and Development

 

To date, we have made substantial investments in research and development, particularly in the areas of smart card-based physical and network access devices, connectivity and interface devices and digital television broadcast encryption and decryption technologies. Our engineering design teams work cross-functionally with marketing managers, applications engineers and customers to develop products and product enhancements to meet customer and market requirements. We also strive to develop and maintain close relationships with key suppliers of components and technologies in order to be able to quickly introduce new products that incorporate the latest technological advances. Our future success will depend upon our ability to develop and to introduce new products

that keep pace with technological developments and emerging industry standards while addressing the increasingly sophisticated needs of our customers.

 

Our research and development expenses were approximately $9.3 million, $10.4 million and $9.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. As of December 31, 2005, we had 113 full-time employees engaged in research and development activities, including software and hardware engineering, testing and quality assurance and technical documentation. The majority of our research and development activities occur in India and France. We fund a small portion of our research and development activities with technology development revenues received from OEM customers in connection with design and development of specific products.

 

Manufacturing and Sources of Supply

 

Through September 2005, we manufactured our products primarily using internal resources in Singapore, supplemented by contract manufacturers in Asia. Since October 2005, we have ceased to manufacture any of our own components or products internally and have shifted these activities to a Singaporean contract manufacturer. We have implemented a global sourcing strategy that we believe enables us to achieve greater economies of scale, better gross margins and more uniform quality standards for our products. In the event any of our contract manufacturers are unable or unwilling to continue to manufacture our products, we may have to rely on other current manufacturing sources or identify and qualify new contract manufacturers. Any significant delay in our ability to obtain adequate supplies of our products from current or alternative sources would harm our business and operating results.

 

We believe that our success will depend in large part on our ability to provide quality products and services while ensuring the highest level of security for our products during the manufacturing process. We have a formal quality control program to satisfy our customers’ requirements for high quality and reliable products. To ensure that products manufactured by others are consistent with our standards, we manage all key aspects of the production process, including establishing product specifications, selecting the components to be used to produce our products, selecting the suppliers of these components and negotiating the prices for these components. In addition, we work with our suppliers to improve process control and product design. As of December 31, 2005, we had 20 full-time employees engaged in manufacturing and logistics activities, focused on coordinating product management and supply chain activities between SCM and our contract manufacturers.

 

We rely upon a limited number of suppliers of several key components of our products. For example, we currently utilize the foundry services of Atmel to produce ASICs for our digital TV modules; we utilize the foundry services of Atmel and Samsung to produce our ASICs for smart cards readers; we use chips and antenna components from Philips in our contactless smart card readers; and we use various mechanical components in our conditional access modules and smart card readers from TaiSol Electronics. Our reliance on a limited number of suppliers could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. In addition, some of the basic components we use in our products, such as flash media, may at any time be in great demand. This can result in the components not being available to us timely or at all, particularly if larger companies have ordered more significant volumes of the components; or in higher prices being charged for the components. Disruption or termination of the supply of components or software used in our products could delay shipments of our products, which could have a material adverse effect on our business and operating results. These delays could also damage relationships with current and prospective customers.

 

Competition

 

The digital television decryption, PC security and flash media interface markets are intensely competitive and characterized by rapidly changing technology. We believe that competition in these markets is likely to intensify as a result of anticipated increased demand for digital access products. We currently experience competition from a number of sources, including:

 

 

 

In our Digital TV business, we are adversely affected by competition from companies that provide conditional access modules using unlicensed, emulated conditional access decryption systems. We have lost and will likely continue to lose business to these competitors and their presence causes us to implement more costly anti-piracy mechanisms on our own products to prevent their unlicensed use.

 

We anticipate competing with several companies in the secure physical access market, once our smart card terminal products for this market begin shipping in volume. These companies could include AMAG Technology, BioScript, BridgePoint Systems, HID, Indala, Integrated Engineering, Precise Biometrics and XTec.

 

We also experience indirect competition from certain of our customers who currently offer alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these and other parties that develop digital data security products based upon approaches similar to or different from those employed by us. In addition, the market for digital data security and access control products may ultimately be dominated by approaches other than the approach marketed by us.

 

We believe that the principal competitive factors affecting the market for our products include:

 

 

While we believe that we compete favorably with respect to these factors, we may not be able to continue to successfully compete due to these or other factors and competitive pressures we face could materially and adversely affect our business and operating results.

 

Proprietary Technology and Intellectual Property

 

Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights, which afford only limited protection. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable, and that any issued patent will fail to provide us with any competitive advantages.

 

There has been a great deal of litigation in the technology industry regarding intellectual property rights and from time to time we may be required to use litigation to protect our proprietary technology. This may result in our incurring substantial costs and there is no assurance that we would be successful in any such litigation. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software without authorization. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to the same extent as do the laws of the United States. Because many of our products are sold and a substantial portion of our business is conducted outside the United States, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. If we are

unsuccessful in protecting our intellectual property or our products or technologies are duplicated by others, our business could be harmed.

 

In addition, we have from time to time received claims that we are infringing upon third parties’ intellectual property rights. Future disputes with third parties may arise and these disputes may not be resolved on terms acceptable to us. As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, divert management resources, cause product shipment delays, or require us to redesign our products, accept product returns or to write off inventory. Any of these events could have a material adverse effect on our business and operating results.

 

Employees

 

As of December 31, 2005, we had 233 full-time employees, of which 113 were engaged in engineering, research and development; 40 were engaged in sales and marketing; 20 were engaged in manufacturing and logistics; and 60 were engaged in general management and administration. We are not subject to any collective bargaining agreements and, to our knowledge, none of our employees are currently represented by a labor union. To date, we have experienced no work stoppages and believe that our employee relations are generally good.

 

Foreign Operations

 

Please see Note 11 to the consolidated financial statements included in response to Item 8 for financial information about geographic areas in which we have operations.

 

Availability of SEC Filings

 

We make available through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports free of charge as soon as reasonably practicable after we electronically file such material with the Securities and Exchange Commission. Our Internet address is www.scmmicro.com. The content on our website is not incorporated by reference into this filing.

 

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.

 

Any of the risk, uncertainties and other factors could have a materially adverse effect on our business, financial condition, results of operations, cash flows or product market share and could cause the trading price of our common stock to decline substantially.

 

We have incurred operating losses and may not achieve profitability.

 

We have a history of losses with an accumulated deficit of $192.8 million as of December 31, 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 profit and operating results may fluctuate significantly from quarter to quarter due to, among other things:

 

 

 

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 operational results 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 in revenues. 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. In addition, from time to time, we may experience unexpected increases in demand for our products resulting from seasonal demand in our customers’ markets. These occurrences are not always predictable and can have a significant impact on our results in the period in which they occur.

 

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.

 

Since 2003, 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 a reduction in sales of our PC Security products, due to the slow pace of anticipated large digital security projects that we believe could utilize our products. 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. Since new target markets are still evolving, it is difficult to assess the competitive environment or the size of the market that may develop. If our target markets do not develop and create demand for our products, if we are not able to complete, sell and ship new

products into the new markets we have identified, or if we are not able to compete against new or existing competitors in those markets, 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 Nasdaq Stock Market and the Prime Standard of the Frankfurt Stock Exchange and we typically 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, European investors may react differently and more positively or negatively than investors in the United States to events such as acquisitions, dispositions, one-time charges and higher or lower than expected revenue or earnings announcements. A positive or negative reaction by investors in Europe to such events could cause our stock price to increase or decrease significantly. The European economy and market conditions in general, or downturns on the Prime Standard specifically, regardless of the Nasdaq Stock Market conditions, also could negatively impact our stock price.

 

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

 

Over the past few years, the Nasdaq Stock Market and the Prime Standard of the Frankfurt Exchange have experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. For example, during the 12-month period from January 1, 2005 to December 31, 2005, the closing prices for our common stock on the Nasdaq Stock Market ranged between $2.61 and $4.92 per share. Volatility in our stock price on either or both exchanges may result from a number of factors, including, among others:

 

 

In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

 

A significant portion of our sales typically comes from a small number of customers and the loss of one of more of these customers could negatively impact our operating results.

 

Our products are generally targeted at OEM customers in the consumer electronics, digital photography, computer and conditional access system industries, as well as digital television operators, broadcasters and distributors, the government sector and corporate enterprises. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total revenues. For example, three customers accounted for approximately 21% of our total net revenue in the year ended December 31, 2005 and three customers accounted for approximately 19% of our total net revenue in the year ended December 31, 2004. We expect that

sales of our products to a relatively small number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss of a customer or reduction of orders from a significant customer, including those due to product performance issues, changes in customer buying patterns, or market, economic or competitive conditions in our market segments, would increase our dependence on a smaller group of our remaining customers and could result in decreased revenues, decreased margins, and/or inventory or receivables write-offs and otherwise harm our business and operating results.

 

Sales of our products depend on the development of several emerging markets.

 

We sell our products primarily to emerging markets that have not yet reached a stage of mass adoption or deployment. If demand for products in these markets does not develop further and grow sufficiently, our revenue and gross profit margins could decline or fail to grow. We cannot predict the future growth rate, if any, or size or composition of the market for any of our products. The demand and market acceptance for our products, as is common for new technologies, is subject to high levels of uncertainty and risk and may be influenced by various factors, including, but not limited to, the following:

 

 

Our products may have defects, which could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in costly litigation or liability.

 

Products such as our conditional access modules and smart card readers may contain defects for many reasons, including defective design, defective material or software interoperability issues. Often, these defects are not detected until after the products have been shipped. If any of our products contain defects or perceived defects or have reliability, quality or compatibility problems or perceived problems, our reputation might be damaged significantly, we could lose or experience a delay in market acceptance of the affected product or products and we might be unable to retain existing customers or attract new customers. In addition, these defects could interrupt or delay sales or our ability to recognize revenue for products shipped. In the event of an actual or perceived defect or other problem, we may need to invest significant capital, technical, managerial and other resources to investigate and correct the potential defect or problem and potentially divert these resources from other development efforts. If we are unable to provide a solution to the potential defect or problem that is acceptable to our customers, we may be required to incur substantial product recall, repair and replacement and even litigation costs. These costs could have a material adverse effect on our business and operating results.

In addition, because our digital security customers rely on our products to prevent unauthorized access to their digital content, a malfunction of or design defect in our products (or even a perceived defect) could result in legal or warranty claims against us for damages resulting from security breaches. If such claims are adversely decided against us, the potential liability could be substantial and have a material adverse effect on our business and operating results. Furthermore, the publicity associated with any such claim, whether or not decided against us, could adversely affect our reputation. In addition, a well-publicized security breach involving smart card-based and other security systems could adversely affect the market’s perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. Any of the foregoing events could cause demand for our products to decline, which would cause our business and operating results to suffer.

 

If we do not accurately anticipate the correct mix of products that will be sold, we may be required to record charges related to excess inventories.

 

Due to the unpredictable nature of the demand for our products, we are required to place orders with our suppliers for components, finished products and services in advance of actual customer commitments to purchase these products. Significant unanticipated fluctuations in demand could result in costly excess production or inventories. In order to minimize the negative financial impact of excess production, we may be required to significantly reduce the sales price of the product to increase demand, which in turn could result in a reduction in the value of the original inventory purchase. If we were to determine that we could not utilize or sell this inventory, we may be required to write down its value, which we have done in the past. Writing down inventory or reducing product prices could adversely impact our cost of revenues and financial condition.

 

We have paid taxes related to products previously purchased by a customer for which we may not receive reimbursement.

 

In order to resolve tax liabilities related to products that we previously sold to a Digital TV customer, in April 2005 we were required to pay the French government approximately $4.7 million in Value Added Taxes (“VAT”), for which we had previously accrued the expense. In connection with this payment, we entered into an agreement with the customer that committed the customer to seek a refund from the French government for the VAT paid with respect to the products it purchased from us and then remit the refunded amount to us. On October 13, 2005 the French government refunded approximately $4.7 million to the customer. However, in December 2005 the customer filed a claim in France alleging participation by SCM Microsystems GmbH in the counterfeiting of their product and has not remitted the refunded VAT amount to us. Pending this litigation, and even after it is resolved, there is no assurance that the customer will remit to us the amount that has been refunded to it. Legal actions to defend against the claims made against us and to pursue reimbursement from or to enforce this agreement with the customer could result in significant expense, use our management’s time and resources and may not be successful. (See also “Item 3 — Legal Proceedings” for further discussion of this lawsuit.)

 

Our business could suffer if our third-party manufacturers cannot meet production requirements.

 

Our products are manufactured outside the United States by contract manufacturers. Our reliance on foreign manufacturing poses a number of risks, including, but not limited to:

 

 

 

In the second half of 2005 we shifted all product and component manufacturing that was previously performed by our employees to contract manufacturers, while continuing to manage demand planning, procurement and other related activities within SCM. The exclusive use of contract manufacturing reduces the flexibility we have in our operations and requires us to exercise strong planning and management skills in order to ensure that our products are manufactured timely, to correct specifications and to a high standard of quality. If any of our contract manufacturers cannot meet our production requirements, we may be required to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. Despite efforts to do so, we may be unable to identify or qualify new contract manufacturers in a timely manner or at all or with reasonable terms and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative manufacturers would materially and adversely affect our business and operating results. In addition, if we are not successful at managing the contract manufacturing process, the quality of our products could be jeopardized or inventories could be too low or too high, which could result in damage to our reputation with our customers and in the marketplace, as well as possible write-offs of excess inventory.

 

We have a limited number of suppliers of key component, and may experience difficulties in obtaining components for which there is significant demand.

 

We rely upon a limited number of suppliers of several key components of our products, which may expose us to various risks including, without limitation, an inadequate supply of components, price increases, late deliveries and poor component quality. In addition, some of the basic components we use in our products, such as flash memory for our conditional access modules, are in great demand. This could result in the components not being available to us in a timely manner or at all, particularly if larger companies have ordered more significant volumes of the components, or in higher prices being charged for the components. Disruption or termination of the supply of components or software used in our products could delay shipments of these products. These delays could have a material adverse effect on our business and operating results and could also damage relationships with current and prospective customers.

 

Our future success will depend on our ability to keep pace with technological change and meet the needs of our target markets and customers.

 

The markets for our products are characterized by rapidly changing technology and the need to meet market requirements and to differentiate our products through technological enhancements, and in some cases, price. Our customers’ needs change, new technologies are introduced into the market, and industry standards are still evolving. As a result, product life cycles are often short and difficult to predict, and frequently we must develop new products quickly in order to remain competitive in light of new market requirements. Rapid changes in technology, or the adoption of new industry standards, could render our existing products obsolete and unmarketable. If a product is deemed to be obsolete or unmarketable, then we might have to reduce revenue expectations or write down inventories for that product. For example, in the first quarter of 2005 we determined that we might no longer be able to sell certain of our Digital TV and PC Security products because they contain lead, which will be banned from use in electronic and electrical products in Europe beginning in July 2006 under the directive known as RoHS (Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment), which will come into force on July 1, 2006. As a result, we wrote down some Digital TV and PC Security product inventory in the first quarter of 2005.

 

Our future success will depend upon our ability to enhance our current products and to develop and introduce new products with clearly differentiated benefits that address the increasingly sophisticated needs of our customers

and that keep pace with technological developments, new competitive product offerings and emerging industry standards. We must be able to demonstrate that our products have features or functions that are clearly differentiated from existing or anticipated competitive offerings, or we may be unsuccessful in selling these products. In addition, in cases where we are selected to supply products based on features or capabilities that are still under development, we must be able to complete our product design and delivery process on a timely basis, or risk losing current and any future revenue from those products. In developing our products, we must collaborate closely with our customers, suppliers and other strategic partners to ensure that critical development, marketing and distribution projects proceed in a coordinated manner. Also, this collaboration is important because these relationships increase our exposure to information necessary to anticipate trends and plan product development. If any of our current relationships terminate or otherwise deteriorate, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, our product development and marketing efforts may be adversely affected, and we could lose sales. We expect that our product development efforts will continue to require substantial investments and we may not have sufficient resources to make the necessary investments.

 

In some cases, we depend upon partners who provide one or more components of the overall solution for a customer in conjunction with our products. If our partners do not adapt their products and technologies to new market or distribution requirements, or if their products do not work well, then we may not be able to sell our products into certain markets.

 

Because we operate in markets for which industry-wide standards have not yet been fully set, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines. If any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected.

 

Our markets are highly competitive.

 

The markets for our products are intensely competitive and characterized by rapidly changing technology. We believe that the principal competitive factors affecting the markets for our products include:

 

 

We currently experience competition from a number of companies in each of our target market segments and we believe that competition in our markets is likely to intensify as a result of anticipated increased demand for secure digital access products. We may not be successful in competing against offerings from other companies and could lose business as a result.

 

In our Digital TV business, we are adversely affected by competition from companies that provide conditional access modules using unlicensed, emulated conditional access decryption systems. We have lost and will likely continue to lose business to these competitors and their presence causes us to implement more costly anti-piracy mechanisms on our own products to prevent their unlicensed use.

 

We also experience indirect competition from certain of our customers who currently offer alternative products or are expected to introduce competitive products in the future. For example, we sell our products to many OEMs who incorporate our products into their offerings or who resell our products in order to provide a more complete solution to their customers. If our OEM customers develop their own products to replace ours, this would result in a loss of sales to those customers, as well as increased competition for our products in the marketplace. In addition, these OEM customers could cancel outstanding orders for our products, which could cause us to write down inventory already designated for those customers. We may in the future face competition from these and other parties that develop digital data security products based upon approaches similar to or different from those

employed by us. In addition, the market for digital information security and access control products may ultimately be dominated by approaches other than the approach marketed by us.

 

Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products and may be able to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, new competitors, or alliances among competitors, may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share.

 

Sales of our smart card readers to the U.S. government are impacted by uncertainty of timelines and budgetary allocations, as well as by the delay of standards for information technology (IT) projects.

 

Historically, we have sold a significant proportion of our smart card reader products to the U.S. government and we anticipate that some portion of our future revenues will also come from the U.S. government. The timing of U.S. government smart card projects is not always certain. For example, while the U.S. government has announced plans for several new smart card-based security projects, none have yet reached a stage of sustained high volume card or reader deployment, in part due to delays in reaching agreement on specifications for a new federally mandated set of identity credentials. In addition, government expenditures on IT projects have varied in the past and we expect them to vary in the future. As a result of shifting priorities in the federal budget and in the Department of Homeland Security, U.S. government spending may be reallocated away from IT projects, such as smart card deployments. The slowing or delay of government projects for any reason could negatively impact our sales.

 

We may have to take back unsold inventory from our customers.

 

Although our contractual obligations to accept returned products from our distributors and OEM customers are limited, if demand is less than anticipated, these customers may ask that we accept returned products that they do not believe they can sell. We may determine that it is in our best interest to accept returns in order to maintain good relations with our customers. While we have experienced few product returns to date, returns may increase beyond present levels in the future. Once these products have been returned, we may be required to take additional inventory reserves to reflect the decreased market value of slow-selling returned inventory, even if the products are in good working order.

 

Large stock holdings outside the U.S. make it difficult for us to achieve quorum at stockholder meetings and this could restrict, delay or prevent our ability to implement future corporate actions, as well as have other effects, such as the delisting of our stock from the Nasdaq Stock Market.

 

To achieve quorum at a regular or special stockholder meeting, at least one-third of all shares of our stock entitled to vote must be present at such a meeting in person or by proxy. As of April 25, 2005, the record date for our 2005 Annual Meeting of Stockholders, more than two-thirds of our shares outstanding were held by retail stockholders in Germany, through German banks and brokers. Securities regulations and customs in Germany result in very few German banks and brokers providing our proxy materials to our stockholders and in very few stockholders voting their shares even when they do receive such materials. In addition, the absence of a routine “broker non-vote” in Germany typically requires the stockholder to return the proxy card to us before the votes it represents can be counted for purposes of establishing a quorum.

 

We expect that a significant percentage of our shares will continue to be held by retail stockholders in Germany through German banks and brokers. As a result, it is difficult and costly for us, and requires considerable management resources, to achieve a quorum at annual and special meetings of our stockholders, if we are able to do so at all. For example, because of the large pool of shares in Germany that were not voted, we were obliged to adjourn our 2005 Annual Meeting of Stockholders twice after its original date of June 23, 2005, until October 20, 2005, in order to solicit enough votes to achieve quorum. This resulted in significant cost and diversion of

management resources from our operations. We cannot assure you that we will be successful in obtaining proxies from a sufficient number of our stockholders to constitute a quorum in the future. If we are unable to achieve a quorum at a future annual or special meeting of our stockholders, corporate actions requiring stockholder approval could be restricted, delayed or even prevented. These include, but are not limited to, actions and transactions that may be of benefit to our stockholders, part of our strategic plan or necessary for our corporate governance, such as corporate mergers, acquisitions, dispositions, sales or reorganizations, financings, stock incentive plans or the election of directors. Even if we are able to achieve a quorum for a particular meeting, some of these actions or transactions require the approval of a majority of the total number of our shares then outstanding, and we cannot assure you that we will be successful in obtaining such approval.

 

The future failure to hold an annual meeting of stockholders may result in our being out of compliance with Delaware law and the qualitative listing requirements of the Nasdaq National Market, each of which requires us to hold an annual meeting of our stockholders. Our inability to obtain a quorum at any such meeting may not be an adequate excuse for such failure. In accordance with Section 211 of the Delaware General Corporation Law, if there has been a failure to hold an annual meeting, the Court of Chancery may order a meeting to be held upon the application of any stockholder or director. Lack of compliance with the qualitative listing requirements of the Nasdaq National Market could result in the delisting of our common stock on the Nasdaq Stock Market. Either of these events would divert management’s attention from our operations and would likely be costly and could also have an adverse effect on the trading price of our common stock.

 

We have global operations, which require significant financial, managerial and administrative resources.

 

Our business model includes the management of three separate product lines that address three disparate market opportunities that are geographically dispersed. While there is some shared technology across our products, each product line requires significant research and development effort to address the evolving needs of our customers and markets. To support our development and sales efforts, we maintain company offices and business operations in several locations around the world. Managing our various development, sales and administrative operations places a significant burden on our financial systems and has resulted in a level of operational spending that is disproportionately high compared to our current revenue levels. Based on our business model and geographic structure, if we do not grow revenues, we will likely not reach profitability.

 

Operating in diverse geographic locations also imposes significant burdens on our managerial resources. In particular, our management must:

 

 

Any failure to effectively manage our operations globally could have a material adverse effect on our business and operating results.

 

The restructuring of our business could result in significant cost and disruptions in our operations.

 

Over the past several years, we have periodically made changes in our organizational structure in an effort to improve efficiencies in our business or otherwise strengthen our ability to operate competitively. In the future, we may from time to time pursue additional restructurings of our businesses and operations. There is no assurance, however, that any such restructurings will yield the benefits we contemplate or any benefits at all. In fact, any restructuring is likely to require us to incur significant expense and cost, including in connection with severance

payments to employees, lease write-offs or other facility reduction or closure costs. In addition, restructurings could have other negative consequences on our business and operations, including the following:

 

 

Any of the foregoing events could have a material and adverse effect on our business.

 

We conduct a significant portion of our operations outside the United States. Economic, political, regulatory and other risks associated with international sales and operations could have an adverse effect on our results of operation.

 

We conduct a substantial portion of our business in Europe and Asia. Approximately 73% and 69% of our revenues for the twelve months ended December 31, 2005 and 2004, respectively, were derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to risks associated with foreign operations, any of which could impact our sales and/or our operational performance. These risks include, but are not limited to:

 

 

Fluctuations in the valuation of foreign currencies could result in currency transaction losses.

 

A significant portion of our business is conducted in foreign currencies, principally the euro. Fluctuations in the value of foreign currencies relative to the U.S. dollar will continue to cause currency transaction gains and losses. We cannot predict the effect of exchange rate fluctuations upon future quarterly and annual operating results. We may experience currency losses in the future. To date, we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations.

 

Our key personnel are critical to our business, and such key personnel may not remain with us in the future.

 

We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel were to leave and not be replaced, our business could be adversely affected.

 

We also believe that our future success will depend in large part on our ability to attract and retain highly qualified technical and management personnel. However, competition for such personnel is intense. We may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future.

 

Likewise, as a small, dual-traded company, we are challenged to identify, attract and retain experienced professionals with diverse skills and backgrounds who are qualified and willing to serve on our Board of Directors. The increased burden of regulatory compliance under the Sarbanes-Oxley Act of 2002 creates additional liability and exposure for directors and financial losses in our business and lack of growth in our stock price make it difficult for us to offer attractive director compensation packages. If we are not able to attract and retain qualified board members, our ability to practice a high a level of corporate governance could be impaired.

 

We are subject to a lengthy sales cycle and additional delays could result in significant fluctuations in our quarterly operating results.

 

Our initial sales cycle for a new customer usually takes a minimum of six to nine months. During this sales cycle, we may expend substantial financial and managerial resources with no assurance that a sale will ultimately result. The length of a new customer’s sales cycle depends on a number of factors, many of which we may not be able to control. These factors include the customer’s product and technical requirements and the level of competition we face for that customer’s business. Any delays in the sales cycle for new customers could delay or reduce our receipt of new revenue and could cause us to expend more resources to obtain new customer wins. If we are unsuccessful in managing sales cycles, our business could be adversely affected.

 

We face risks associated with strategic transactions.

 

A component of our business strategy has been and is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. We have in the past acquired or made, and from time to time in the future may acquire or make, investments in companies, products and technologies that we believe are complementary to our existing businesses, products and technologies. Any future acquisition could expose us to significant risks, including, without limitation, the use of our limited cash balances or potentially dilutive stock offerings to fund such acquisitions; costs of any necessary financing, which may not be available on reasonable terms or at all; accounting charges we might incur in connection with such acquisitions; the difficulty and expense of integrating personnel, technologies, marketing efforts and facilities acquired through acquisitions; diversion of our management resources; failure to realize anticipated benefits; costly fees for legal and transaction-related services and the unanticipated assumption of liabilities. Any of the foregoing could have material adverse effect on our financial condition and results of operations. We cannot assure you that any such acquisition will be successful.

 

Our business strategy also contemplates divesting portions of our business from time to time, if and when we believe we would be able to realize greater value for our stockholders in so doing. We have in the past sold, and may from time to time in the future sell, all or one or more portions of our business. Any such divestiture or disposition could expose us to significant risks, including, without limitation, costly fees for legal and transaction-related services; diversion of management resources; loss of key personnel; and reduction in revenue. In addition, we may be required to retain or indemnify the buyer against certain liabilities and obligations in connection with any such divestiture or disposition and we may also become subject to third party claims arising out of divestiture or disposition. For example, following the sale and disposition of our retail Digital Media and Video business in 2003, we were the recipient of a claim filed by DVDCre8, for which our defense has required significant expenditure of financial and management resources. In addition, any such divestiture or disposition could result in our recognition of an operating loss to the extent that the proceeds received by us in the divestiture or disposition are less than the book value of the assets sold. Any of the foregoing could have a material adverse effect on our financial condition and results of operations. Furthermore, we cannot assure you that we would be able to complete any such divestiture or disposition on reasonable terms or at all.

 

We may be exposed to risks of intellectual property infringement by third parties.

 

Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights, which afford only limited protection. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable or that any issued patent will fail to provide us with any competitive advantages.

There has been a great deal of litigation in the technology industry regarding intellectual property rights, and from time to time we may be required to use litigation to protect our proprietary technology. This may result in our incurring substantial costs and there is no assurance that we would be successful in any such litigation.

 

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software without authorization. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to the same extent as do the laws of the United States. Because many of our products are sold and a significant portion of our business is conducted outside the United States, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. If we are unsuccessful in protecting our intellectual property or our products or technologies are duplicated by others, our business could be harmed.

 

Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

 

We prepare our financial statements to conform with generally accepted accounting principles, or GAAP, in the United States. These accounting principles are subject to interpretation by the Financial Standards Accounting Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various other bodies formed to interpret and create appropriate accounting rules and policies. A change in those rules or policies could have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. For example, under the recently issued Financial Accounting Standard Board Statement No. 123R, as of January 1, 2006 we are required to apply certain expense recognition provisions to share-based payments to employees using the fair value method. This new accounting policy and any other changes in accounting policies in the future may result in significant accounting charges. We believe that the adoption of SFAS 123R will have a material effect on our results of operations; however, we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosure under FAS No. 123. See Note 1 to the Consolidated Financial Statements for the pro forma expense disclosure under SFAS No. 123.

 

We face costs and risks associated with maintaining effective internal controls over financial reporting.

 

Under Section 302 of the Sarbanes-Oxley Act of 2002, on a quarterly basis our management is required to certify that effective internal controls are in place over financial reporting. The process of maintaining and evaluating the effectiveness of these controls is expensive, time-consuming and requires significant attention from our management and staff. We have found material weakness in our internal controls in the past and we cannot be certain in the future that we will be able to report that our controls are without material weakness or complete our evaluation of those controls in a timely fashion.

 

If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, we may discover material weaknesses that we would then be required to disclose. We may not be able to accurately or timely report on our financial results, and we might be subject to investigation by regulatory authorities. As a result, the financial position of our business could be harmed; current and potential future shareholders could lose confidence in SCM and/or our reported financial results, which may cause a negative effect on the trading price of our common stock; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

 

In addition, all internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to the preparation and presentation of financial statements. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

 

We face risks from litigation.

 

From time to time, we may be subject to litigation, which could include claims regarding infringement of the intellectual property rights of third parties, product defects, employment-related claims, and claims related to acquisitions, dispositions or restructurings. Any claims or litigation may be time-consuming and costly, divert

management resources, cause product shipment delays, require us to redesign our products, require us to accept return of product and to write off inventory, or have other adverse effects on our business. Any of the foregoing could have a material adverse effect on our results of operations and could require us to pay significant monetary damages.

 

For example, in December 2005, a complaint was filed in France against SCM Microsystems GmbH, one of our wholly-owned subsidiaries, by Aston France S.A.S. alleging participation by SCM Microsystems GmbH in the counterfeiting of Aston’s conditional access modules and claiming damages in the amount of 57 million EUR. Our defense of such claim may result in our incurrence of significant expense and cost and demand significant use of our management’s limited time and resources. We cannot assure you that we will be successful in defending ourselves against Aston’s claims in a timely manner or at all. If these claims are decided against us, the result may have a material and adverse effect on our company.

 

We expect the likelihood of intellectual property infringement and misappropriation claims may increase as the number of products and competitors in our markets grows and as we increasingly incorporate third-party technology into our products. As a result of infringement claims, we could be required to license intellectual property from a third party or redesign our products. Licenses may not be offered when we need them or on acceptable terms. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments or we may be required to license some of our intellectual property to others in return for such licenses. If we are unable to obtain a license that is necessary for us or our third party manufacturers to manufacture our allegedly infringing products, we could be required to suspend the manufacture of products or stop our suppliers from using processes that may infringe the rights of third parties. We may also be unsuccessful in redesigning our products. Our suppliers and customers may be subject to infringement claims based on intellectual property included in our products. We have historically agreed to indemnify our suppliers and customers for patent infringement claims relating to our products. The scope of this indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney’s fees. We may periodically engage in litigation as a result of these indemnification obligations. Our insurance policies exclude coverage for third-party claims for patent infringement.

 

We are exposed to credit risk on our accounts receivable. This risk is heightened in times of economic weakness.

 

We distribute our products both through third-party resellers and directly to certain customers. A substantial majority of our outstanding trade receivables are not covered by collateral or credit insurance. While we seek to monitor and limit our exposure to credit risk on our trade and non-trade receivables, we may not be effective in limiting credit risk and avoiding losses. Additionally, if the global economy and regional economies deteriorate, one or more of our customers could experience a weakened financial condition and we could incur a material loss or losses as a result.

 

Factors beyond our control could disrupt our operations.

 

We face a number of potential business interruption risks that are beyond our control. For example, in past periods, the State of California experienced intermittent power shortages and interruption of service to some business customers. Additionally, we may experience natural disasters that could disrupt our business. For example, our corporate headquarters are located near a major earthquake fault. Power shortages, earthquakes or other disruptions could affect our ability to report timely financial statements.

 

Provisions in our agreements, charter documents, Delaware law and our rights plan may delay or prevent our acquisition by another company, which could decrease the value of your shares.

 

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us or enter into a material transaction with us without the consent of our Board of Directors. These provisions include a classified Board of Directors and limitations on actions by our stockholders by written consent. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, our Board of Directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.

We have adopted a stockholder rights plan. The triggering and exercise of the rights would cause substantial dilution to a person or group that attempts to acquire us on terms or in a manner not approved by our Board of Directors, except pursuant to an offer conditioned upon redemption of the rights. While the rights are not intended to prevent a takeover of our company, they may have the effect of rendering more difficult or discouraging an acquisition of us that was deemed to be undesirable by our Board of Directors.

 

Although we believe the above provisions and the adoption of a rights plan may provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions will apply even if the offer were to be considered adequate by some of our stockholders. Also, because these provisions may be deemed to discourage a change of control, they could decrease the value of our common stock.

 

SCM has no unresolved comments from the Securities and Exchange Commission.

 

Our corporate headquarters are in Fremont, California where we lease approximately 18,300 square feet pursuant to a lease agreement that expires on April 30, 2006. Our European headquarters are located in Ismaning, Germany, where we lease approximately 35,000 square feet pursuant to a lease agreement that expires November 15, 2008. We also lease approximately 69,000 square feet at a facility in Guilford, Connecticut, where the lease term expires February 2011. During 2003, we discontinued operations at the Guilford facility and we are currently attempting to sublease the unused space. We also lease small sales and marketing facilities in Japan and a sales and marketing facility of approximately 4,600 square feet in Singapore. We own research and development facilities in La Ciotat, France and Chennai, India.

 

In December 2005, a complaint was filed in France against SCM Microsystems GmbH, one of our wholly-owned subsidiaries, by Aston France S.A.S., a current competitor of ours in the conditional access modules market, alleging participation by SCM Microsystems GmbH in the counterfeiting of Aston’s conditional access modules. Aston was one of our Digital Television customers until November 2002, when we entered into a settlement agreement (the “2002 Settlement”) with Aston that included our agreement to cancel binding orders made by Aston and the return by Aston of unsold inventory to us. In April 2005, we entered into an agreement with Aston where by Aston agreed to (i) seek a refund from the French government for approximately $4.7 million in value added taxes that we paid to the French government with respect to products that Aston purchased from us prior to November 2002 and (ii) remit the refunded amount to us. On October 13, 2005 the French government refunded approximately $4.7 million (the “VAT Refund”) to Aston, but Aston has not remitted such amount to us.

 

In its complaint filed in France, Aston claims damages in the amount of 57 million EUR. We believe, however, that Aston’s allegations made in their complaint are in contradiction to the statements made by Aston as part of the 2002 Settlement. On February 2, 2006, we filed a counterclaim against Aston in Germany alleging damages in the amount of 11.5 million EUR resulting from Aston’s fraudulent misrepresentation and breach of contract in connection with the 2002 Settlement.

 

In November 2005, Aston succeeded in obtaining a preliminary injunction in France to stay our claim for recovery of the VAT Refund and on February 21, 2006, the court that issued the injunction revised its order such that only 1.0 million EUR of VAT Refund amount is still covered by the injunction.

 

We believe that the claims by Aston in its complaint against us and in the preliminary injunction in France are without merit and are for the sole purpose of preventing or delaying our recovery of the VAT Refund. We intend to vigorously defend ourselves against the claims by Aston and prosecute our counterclaims against Aston. Such efforts, however, may result in our incurrence of significant expense and cost and demand significant use of our management’s limited time and resources. We cannot assure you that we will be successful in defending ourselves against Aston’s claims, prosecuting our counterclaim against Aston or recovering the amount of the VAT Refund, in each case, in a timely manner, in full or at all. If these claims are decided against us, the result may have a material and adverse effect on our company.

On December 9, 2005, the Company and its wholly owned subsidiary, SCM Multimedia, Inc. fka Dazzle Multimedia, Inc., entered into a settlement of litigation originally filed by YouCre8, Inc. aka DVD Cre8, Inc. in August of 2003, entitled YouCre8, Inc. v. Pinnacle Systems, Inc., Dazzle Multimedia, Inc., and SCM Microsystems, Inc. et al., Alameda Superior Court Case No. RG 03114448. Pursuant to the terms of the settlement agreement, the Company paid YouCre8 $1.7 million, and all claims between the Company, SCM Multimedia, and YouCre8 were dismissed with prejudice. In a related settlement, Pinnacle and the Company agreed to release their respective cross-claims for indemnity against each other arising from the litigation with YouCre8, without any payment by one to the other.

 

For information related to matters submitted to a vote of our security holders at our annual meeting held on October 30, 2005, please see Part II, Item 4 of our quarterly report on Form 10-Q for the quarter ended September 30, 2005, filed with the Securities and Exchange Commission on November 11, 2005.

 

Price Range of Common Stock; Number of Holders; Dividends

 

Our common stock is quoted on the Nasdaq Stock Market’s National Market under the symbol “SCMM” and on the Prime Standard of the Frankfurt Stock Exchange under the symbol “SMY.” According to data available at March 14, 2006, we estimate we had approximately 16,237 stockholders of record and beneficial stockholders. The following table sets forth the high and low closing prices of our common stock for the periods indicated.

 

 

We have never declared or paid cash dividends on our common stock or other securities. We currently anticipate that we will retain all of our future earnings for use in the expansion and operation of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

The disclosure required by Item 201(d) of Regulation S-K is included in Item 12 and incorporated by reference to our 2006 Proxy Statement.

 

Recent Sales of Unregistered Securities

 

None.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

None.

 

The table below has been restated to account for the retail Digital Media and Video business as a discontinued operation.

 

SCM MICROSYSTEMS, INC.

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

 

 

 

 

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 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: digital TV operators and broadcasters and conditional access providers for our conditional access modules; government contractors, systems integrators, large enterprises, computer manufacturers, as well as banks and other financial institutions for our smart card readers; and computer 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, and statements of operations for all periods presented have been restated to reflect the discontinuance of this business. For comparability, certain 2002 figures have been reclassified, where appropriate, to conform to the financial statement presentation used in 2003, 2004 and 2005, including the adjustments necessary to conform to the discontinued operations presentation of the retail Digital Media and Video business during 2002. (See Note 2 of Notes to Consolidated Financial Statements.)

 

In our continuing operations, we have experienced a significant drop in revenues during the three year period from 2003 to 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 of our PC Security products were relatively unchanged in 2004 compared with 2003 levels, but in 2005 declined somewhat due to variability in the size and timing of orders received. Sales of our Flash Media Interface products have remained relatively steady over the past two years from 2003 levels. 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. Through September 2005, we manufactured our products primarily using internal resources in

Singapore, supplemented by contract manufacturers in Asia. Since October 2005, we have ceased to manufacture any of our own components or products internally and have shifted these activities to a Singaporean contract manufacturer, 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 second half of 2005, however, due to the recent strengthening of the dollar. In the last two years 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 our 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.

 

Our significant accounting policies are outlined in Note 1 to the Consolidated Financial Statements, which appear in Part II, Item 8 of this Annual Report on Form 10-K. Some of those accounting policies require us to make estimates and assumptions that affect the amounts reported by us. 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.

 

 

 

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. 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, 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).

 

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 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 the decision by the Securities and Exchange Commission to delay its effective date, SFAS No. 123R will be effective for our 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. We expect to adopt SFAS 123R using the modified prospective method and the Black-Scholes-Merton pricing model effective January 1, 2006. We believe that the adoption of SFAS 123R will have a material effect on our results of operations; however, we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosure under FAS No. 123.

 

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.

Results of Operations

 

The following table sets forth our statements of operations as a percentage of net revenue for the periods indicated:

 

 

We sell our secure digital access products into three market segments: Digital TV, PC Security and Flash Media Interface.

 

 

Revenue

 

The following table sets forth our annual revenues and year-to-year change in revenues by product segment for the fiscal years ended December 31, 2005, 2004 and 2003:

 

 

Fiscal 2005 Revenue Compared with Fiscal 2004 Revenue

 

Net revenue for the year ended December 31, 2005 was $48.7 million, relatively unchanged from $49.1 million in 2004. Sales of our Digital TV products accounted for 43%, PC Security products for 36% and Flash Media Interface for 21% of total revenue in 2005.

 

In our Digital TV product line, sales were $20.8 million in 2005, up 9% from $19.1 million in 2004. 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. Historically, sales primarily have been to small European operators or broadcasters or to distributors and conditional access suppliers serving these operators and broadcasters. Beginning in the third quarter of 2003 and continuing to the present period, our Digital TV products sales were significantly adversely impacted by new 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. We are pursuing, and in some cases have already obtained, legal injunctions against these suppliers. However, we do not expect to be able to regain the market share we have lost. Beginning in 2004, we adopted a strategy to replace lost Digital TV revenue by targeting new customer segments, including mid-sized operators and broadcasters in Europe; operators in markets with integrated digital TVs; and digital cable operators in South Korea, where the government has mandated the use of conditional access modules to secure broadcast content as this country converts its broadcasting operations to digital technology. We experienced some success in forming relationships with new customers on our target segments in 2004 and in 2005 we shipped significant volumes of product to several of these customers.

 

Sales of our PC Security products decreased 13%, to $17.4 million in 2005, compared with $20.0 million in 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 people in order to control access to computers, computer networks and buildings or other facilities. Revenue in this product line is subject to significant variability based on the size and timing primarily of product orders. In 2005, lower revenue levels were primarily the result of fluctuations in order levels, as well as some impact from continued competition for business in Europe, based on price. In particular, 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. 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.

 

Revenues from our Flash Media Interface product line increased 5%, from $10.0 million in 2004 to $10.5 million in 2005. Flash Media Interface revenue consists of sales of digital media readers and related ASIC

technology used to provide an interface for flash memory cards in computer printers and digital photography kiosks, which are used to download and print digital photos, and in consumer electronics products such as televisions to download and view digital photos. During the first half of 2005, we ceased to sell certain products within this business, which reduced our revenue base significantly. Beginning in the third quarter, we introduced a new category of digital media reader products designed to be embedded in televisions, which helped us to offset this revenue loss and stabilize revenue levels.

 

Fiscal 2004 Revenue Compared with Fiscal 2003 Revenue

 

Net revenue for the twelve months ended December 31, 2004 was $49.1 million, compared to $66.5 million in 2003, a decrease of 26%. This decline was primarily related to lower revenues from our Digital TV products. PC Security and Flash Media Interface product revenues also decreased slightly year to year. Sales of our Digital TV products accounted for 39%, PC Security products for 41% and Flash Media Interface for 20% of total revenue in 2004.

 

In our Digital TV product line, sales decreased 46%, from $35.3 million in 2003 to $19.1 million in 2004. Beginning in the third quarter of 2003 and continuing through fiscal 2004, our Digital TV products sales were significantly adversely impacted by new 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. Our strategy in 2004 was to target new mid-sized operators and broadcasters in Europe and to sign agreements with operators in South Korea, where the government has mandated the use of conditional access modules to secure broadcast content as this country converts its broadcasting operations to digital technology. While we did experience some success with this strategy in 2004, we did not ship significant volumes of product to these target customers.

 

Sales of our PC Security products decreased 3%, from $20.7 million in 2003 to $20.0 million in 2004. In 2004 our readers were purchased for the U.S. Department of Defense’s Common Access Card personal identification program, various on-line banking programs in Europe, employee identification at oil field operations and other smart card-based security programs. While market research firms, the U.S. and other governments and our customers continue to communicate to us that they expect a significant increase in the volume of secure access projects requiring readers such as ours over the next few years, during 2004 there was no significant increase in the number of smart card readers being deployed in these projects.

 

Revenues from our Flash Media Interface product line decreased 4%, from $10.5 million in 2003 to $10.0 million in 2004. Our customer base and product offers remained relatively unchanged versus the prior year.

Gross Profit

 

The following table sets forth our gross profit and year-to-year change in gross profit by product segment for the fiscal years ended December 31, 2005, 2004 and 2003:

 

 

Gross profit for 2005 was $17.6 million, or 36% of total revenue. Gross profit was positively impacted by approximately $3.5 million in releases of reserves for inventory, primarily in our Digital TV business, which was sold as a result of higher than expected customer demand and changes in the technological application of our products. These releases were offset by inventory write-downs of approximately $1.2 million and $1.3 million in our Digital TV and PC security segments, severance costs for manufacturing personnel in our Singapore facility of $0.5 million, as well as by pricing pressure, mix of products sold and tooling costs.

 

Gross profit for 2004 was $14.9 million, or 30% of total net revenue. Gross profit was adversely impacted by a write-down of inventory of $5.4 million, of which $4.0 million related to Digital TV product inventory, $0.7 million related to PC Security product inventory and $0.7 million related to Flash Media Interface product inventory.

 

Gross profit for 2003 was $26.8 million, or 40% of total net revenue. Gross profit was adversely impacted by a write-down of inventory of $0.8 million for a European Digital TV customer whose sales did not meet forecast.

 

Our gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, inventory write-downs and the cost and availability of components. Accordingly, gross profit percentages are expected to continue to fluctuate from period to period.

 

Operating Expenses

 

Research and Development

 

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.

 

Research and development expenses were $9.3 million in 2005, or 19% of revenue, compared with $10.4 million in 2004, or 21% of revenue, a decrease of 11%. This decrease was primarily due to lower headcount and contract service costs and to the offsetting effects of customer funded development contributions of $0.4 million.

 

Research and development expenses increased 9% in 2004 as compared to 2003, primarily due to an increase in development activity to finalize and launch new products, as well as to higher costs associated with the effect of foreign currency exchange related to the payment of European employees in euros.

 

We expect our research and development expenses to vary based on future project demands.

 

Selling and Marketing

 

 

Selling and marketing expenses consist primarily of employee compensation as well as tradeshow participation and other marketing costs. Selling and marketing expenses were $9.7 million in 2005, or 20% of total revenue, compared with $11.5 million, or 23% of revenue in 2004, a decrease of 16%. This decrease was primarily due to reductions in headcount and in trade show expenditures. We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

 

During 2004, selling and marketing expenses increased in the first half of the year as part of our strategy to launch new products and enter new markets and then decreased in the second half of the year to better align with actual revenue levels. While there was an overall decrease in spending, this decrease was offset by increased costs associated with the effect of foreign currency exchange related to the payment of European employees in euros. For the year as a whole, sales and marketing expenses remained at the same level in 2004 as 2003.

 

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

 

 

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 2005, general and administrative expenses were $9.9 million, or 20% of revenue, compared with $10.4 million, or 21% of revenue in 2004, a decrease of 4%.

 

General and administrative expenses decreased 10% in 2004 as compared with 2003 primarily as a result of cost reduction measures taken by SCM in the second half of 2004, including a small reduction in headcount and a reduction in expenditures for third-party professional fees, including investor relations and legal services. These cost reduction measures were partially offset by increased costs associated with the effect of foreign currency exchange related to the payment of European employees in euros and increased spending related to Sarbanes-Oxley compliance.

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 Intangibles

 

 

Amortization of intangible assets in 2005 was $0.7 million, compared with $1.1 million in 2004. Lower amortization in 2005 reflects a lower level of intangible assets on our balance sheet.

 

Impairment of Goodwill and Intangibles

 

As required under SFAS No. 142, SCM evaluates the carrying value of goodwill and indefinite-lived intangible assets on our balance sheet from time to time and we will record a charge for impairment whenever events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable.

 

In 2005, no charge for impairment was recorded.

 

In 2004 we concluded that the carrying value of customer relations and core technology relating to a past acquisition was not supportable because the estimate of future cash flows related to these intangible assets was not sufficient to recover the carrying value of such intangibles. Accordingly, we took a charge of $0.4 million under SFAS No. 144 for intangible asset impairment.

 

In 2003, no charge for impairment was recorded.

 

Restructuring and Other Charges (Credits)

 

During 2005, we incurred restructuring and other charges of $0.8 million, which included $0.2 million of severance costs related to a reduction in force of non-manufacturing personnel at our Singapore facility, resulting from our decision to outsource manufacturing operations to contract manufacturers. Severance costs for manufacturing personnel of $0.5 million were recorded in cost of revenue. (See Note 7 to Consolidated Financial Statements.) Restructuring and other charges in 2005 also included $0.1 million primarily related to changes in estimates for European tax related matters.

 

During 2004, we incurred restructuring and other credits related to continuing operations of $0.2 million, which resulted primarily from restructuring costs related to cost reduction actions taken by management during the second half of the year that included employee severance charges of $0.8 million and legal and professional costs of $0.1 million; other costs of $0.6 million, primarily related to settlement costs of claims asserted by a European customer, as well as other legal settlements and related legal costs; and offsetting credits of $1.7 million resulting from changes in estimates to European tax related matters.

 

During 2003, we recorded restructuring and other charges of $4.7 million related to the closure and relocation of SCM facilities following the planned and subsequently completed sale of our Digital Media and Video business and the restructuring of our organization. The greatest proportion of restructuring costs related to employee severance. Other charges consisted of legal, accounting and professional fees related to the announced separation of our retail Digital Media and Video business and to tax related costs. The greatest proportion of other charges was for a change in estimate to tax provisions recorded in the previous year.

 

Loss from Investments

 

From time to time, we may make strategic investments in both private and public companies. During each quarter, we evaluate our investments for possible asset impairment. We examine 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.

We had no strategic investments in 2005 or in 2004 and therefore did not record a loss or gain related to investments during these periods.

 

During 2003, we recorded a loss of $0.4 million from our investment in Cryptovision. This was offset by a gain of $0.2 million from the sale of our investment in ActivCard. The result was a loss on investments of $0.2 million for the year.

 

Interest Income, Net

 

Interest income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt.

 

In each of the years 2005, 2004 and 2003, interest income resulting from invested cash balances was $0.8 million. The 2005 period includes a cumulative adjustment to interest income taken in the second quarter for the correction of an error in accounting for the amortization of premiums and discounts on investments. The correction of the error resulted in a reduction of interest income in the second quarter and twelve months of 2005 of approximately $0.3 million.

 

Reductions in investable cash balances in 2005 compared with 2004, and in 2004 compared with 2003, were offset by higher rates of return on invested funds. During 2003, cash balances declined for part of the year, resulting in a decrease in interest income from cash. This was offset by additional interest income recorded for a tax refund that we received in the third quarter of 2003.

 

Foreign Currency Gains and Losses and Other Income and Expenses

 

Foreign currency transaction gains and other income were $1.8 million in 2005, compared with foreign currency losses and other expenses of $1.2 million in 2004 and foreign currency gains and other income of $0.7 million in 2003.

 

Foreign currency transaction gains and losses during 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 net monetary balances in an entity where the euro is the functional currency, while the losses in 2004 resulted primarily from the revaluation of U.S. denominated intercompany balances to the functional currency of the subsidiary.

 

During 2005, foreign currency gains were $1.7 million, due primarily to the revaluation of dollar holdings in an entity where the euro is the functional currency. Other income was $0.1 million, primarily attributable to the settlement of transactional tax issues in Europe.

 

During 2004, net foreign currency losses resulted from foreign currency losses of $1.5 million, due primarily to the decrease in the value of the U.S. dollar as compared with the euro, offset by other income of $0.3 million, primarily attributable to the settlement of transactional tax issues in Europe.

 

During 2003, a weakening U.S. dollar negatively impacted foreign currency exchange rates. However, we did record a small gain for the year on foreign currency transactions, which was augmented by other income of $0.5 million resulting from a settlement on an investment that had previously been written off.

 

Income Taxes

 

In 2005 and 2004, we recorded net benefits for income taxes of approximately $33,000 and $178,000, respectively, primarily due to changes in estimates for taxes related to foreign tax jurisdictions.

 

In 2003, we recorded a net benefit for income taxes of $1.4 million, which consisted of a $2.1 million refund for taxes paid in the U.S., offset by a tax provision of $0.7 million for other tax jurisdictions.

Discontinued Operations

 

During 2003, we completed two transactions to sell our retail Digital Media and Video business. On July 25, 2003, we completed the sale of our digital video business to Pinnacle Systems and on August 1, 2003, we completed the sale of our retail digital media reader business to Zio Corporation.

 

Net revenue for the retail Digital Media and Video business in 2005, 2004 and 2003 was $0, $16,000 and $24.8 million, respectively. Operating loss for the same periods was $0.3 million, $0.3 million and $15.1 million, respectively. Net loss for the periods were was $0.5 million, $0.2 million and $14.3 million, respectively.

 

During 2005, our net loss on disposal of the retail Digital Media and Video business was $2.2 million, of which the majority related to the settlement of litigation with DVD Cre8, Inc. and related legal costs (see Note 14 of the Consolidated Financial Statements).

 

During 2004, our net gain on disposal of the retail Digital Media and Video business was $0.4 million and included $1.6 million of inventory and asset recoveries, offset by changes in estimate of lease commitments of $0.4 million and legal costs of $0.8 million.

 

During 2003, net loss on disposal of the retail Digital Media and Video business was $15.1 million and included net inventory write-downs of $0.5 million; asset write-downs of $3.1 million; increased liabilities of $0.2 million; severance of $2.8 million; contract settlements and lease commitments of $4.5 million; transactional costs to sell the businesses of $2.6 million; and other costs of $1.4 million that related to the write-down of the cumulative translation adjustment for those subsidiaries considered to be substantially liquidated.

 

Liquidity and Capital Resources

 

As of December 31, 2005, our working capital, which we have defined as current assets less current liabilities, was $27.3 million, compared to $39.2 million as of December 31, 2004. Working capital decreased in 2005 by approximately $11.9 million, due primarily to a decrease in cash, cash equivalents and short-term investments of $13.7 million, a decrease in accounts receivable of $1.8 million, a decrease in inventory of $2.3 million and a decrease in other current assets of $0.3 million, partially offset by a decrease in current liabilities of $6.0 million. The decrease in current liabilities includes the payment of $4.7 million related to VAT matters for a former customer. We are in the process of seeking recovery of this amount from the customer. See Item 3. Legal Proceedings and Note 14 to the Consolidated Financial Statements for further discussion of this matter.

 

In 2005, cash and cash equivalents decreased by $17.5 million, primarily due to cash used in operating activities of $12.8 million, cash used in investing activities of $3.5 million and the effect of exchange rates on cash and cash equivalents of $1.5 million, partially offset by cash provided by financing activities of $0.3 million.

 

Cash used in continuing operations of $9.2 million was primarily due to a net loss before discontinued operations and depreciation and amortization of $8.0 million. The remaining $1.2 cash used in continuing operations was from the net effect of changes in working capital. Cash used in operating activities from discontinued operations was $3.6 million and consisted of approximately $2.3 million for the litigation settlement with DVD Cre8, Inc. (see Note 14 of the Consolidated Financial Statements) as well as the payment of accrued liabilities.

 

Cash used in investing activities from continuing operations was primarily for capital expenditures of $0.1 million and net purchases of short-term investments of $3.8 million, partially offset by $0.4 million from the proceeds from the sale of fixed assets.

 

Cash provided by financing activities was primarily from the issuance of common stock of $0.3 million related to the Company’s employee stock purchase and stock option programs. At December 31, 2005, our outstanding stock options as a percentage of outstanding shares were 18%, compared to 19% at December 31, 2004.

 

During the fourth quarter of 2002, our Board of Directors authorized a stock repurchase program in which up to $5 million may be used to purchase shares of our stock on the open market in the United States or Germany from time to time over two years, depending on market conditions, share prices and other factors. Such repurchases could be used to offset the issuance of additional shares resulting from employee stock option exercises and the sale of

shares under the employee stock purchase plan. No shares were repurchased under the stock repurchase program during fiscal 2004 and the program ended in the fourth quarter of 2004. During 2002, we spent approximately $0.7 million and during 2003 we spent approximately $2.1 million to repurchase an aggregate of 618,400 shares.

 

During 2005, we used $9.2 million in cash to fund continuing operations. 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 through at least the end of 2006. 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.

 

Off-Balance Sheet Arrangements

 

We have not entered into off-balance sheet arrangements, or issued guarantees to third parties.

 

Contractual Obligations

 

The following summarizes expected cash requirements for contractual obligations as of December 31, 2005 (in thousands):

 

 

Foreign Currencies

 

We transact business in various foreign currencies, primarily in certain European countries, Singapore, India and Japan. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated sales and operating expenses in Europe, Singapore, India and Japan, where we conduct business in both local currencies and U.S. dollars. We assess the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis.

 

Our foreign currency transactions gains and losses are primarily the result of the revaluation of intercompany receivables/payables (denominated in U.S. dollars) and trade receivables (denominated in a currency other than the functional currency) to the functional currency of the subsidiary. We have performed a sensitivity analysis as of December 31, 2005 and 2004 using a modeling technique which evaluated the hypothetical impact of a 10% movement in the value of the U.S. dollar compared to the functional currency of the subsidiary, with all other variables held constant, to determine the incremental transaction gains or losses that would have been incurred. The foreign exchange rates used were based on market rates in effect at December 31, 2005 and 2004. The results of this hypothetical sensitivity analysis indicated that a hypothetical 10% movement in foreign currency exchange rates would result in increased foreign currency gains or losses of $1.0 million and $1.8 million for 2005 and 2004, respectively.

 

Fixed Income Investments

 

We do not use derivative financial instruments in our investment portfolio. We do, however, limit our exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. At the present time, the maximum duration of any investment in our portfolio is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria we have established, our exposure to market and credit risk is not expected to be material.

At December 31, 2005, we had $13.7 million in cash and cash equivalents and $18.8 million in short-term investments. Based on our cash and cash equivalents and short term investments as of December 31, 2005, a hypothetical 10% change in interest rates along the entire interest rate yield curve would not materially affect the fair value of our financial instruments that are exposed to changes in interest rates.

 

The information required by this Item is incorporated by reference to pages F-1 through F-26 of this Form 10-K.

 

None.

 

Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of December 31, 2005. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective, such that the information relating to our business and operations, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

Report on Internal Control over Financial Reporting

 

For the year ended December 31, 2005, we were not an accelerated filer, and therefore we are not required to make the annual report over financial reporting required by Item 308(a) of Regulation S-K and our independent auditors are not required to issue a separate attestation on management’s assessment of our internal control over financial reporting under Item 308(b).

 

Changes in Internal Control Over Financial Reporting

 

In connection with our continued monitoring and maintenance of our controls procedures in relation to the provisions of Sarbanes-Oxley, we continue to review, revise and improve the effectiveness of our internal controls. We made no significant changes to our internal control over financial reporting during the fourth quarter of 2005 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

 

Not applicable.

 

The information required by Item 10 concerning our directors and officers will be set forth under the captions “Election of Directors” and “Matters Relating to the Board of Directors” in our Proxy Statement relating to our 2006 Annual Meeting of Stockholders, referred to as the “Proxy Statement,” which we expect will be filed within

120 days of the end of our fiscal year pursuant to General Instruction G(3) of Form 10-K. Such information is incorporated herein by reference. The information required by this item concerning compliance with Section 16(a) of the Exchange Act is incorporated by reference to the section captioned “Section 16(a) Beneficial Ownership Compliance” that will be set forth in the Proxy Statement. The information required by this item concerning our code of ethics is incorporated by reference to the section captioned “Code of Conduct and Ethics” that will be set forth in the Proxy Statement.

 

The information required by Item 11 will be set forth under the sections captioned “Executive Compensation” and “Performance Graph” contained in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 12 will be set forth under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 13 will be set forth under the caption “Certain Relationships and Related Transactions” in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 14 will be set forth under the caption “Principal Accounting Fees and Services” in the Proxy Statement, which information is incorporated herein by reference.

 

(a) Documents Filed with Report

 

1. Financial Statements

 

The following Consolidated Financial Statements and Independent Auditors’ Reports are incorporated by reference to pages F-1 through F-26 of this Form 10-K.

 

a. The consolidated balance sheets as of December 31, 2005 and 2004, and the consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2005, together with the notes thereto.

 

b. The report of our Independent Registered Public Accounting Firm.

 

2. Financial Statement Schedule

 

The following financial statement schedule should be read in conjunction with the consolidated financial statements and the notes thereto.

 

Schedule II — Valuation and Qualifying Accounts

 

 

3. Exhibits

 

 

 

 

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Registrant

 

SCM MICROSYSTEMS, INC.

 

Robert Schneider

Chief Executive Officer and Director

 

March 16, 2006

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.