1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------- FORM 10 - Q ----------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM_________TO _________ COMMISSION FILE NUMBER: 0-22689 ----------------- SCM MICROSYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0444317 STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER) 160 KNOWLES DRIVE, LOS GATOS, CA 95032 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE) (408) 370-4888 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) N/A (FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT) ----------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [ X ] Yes [ ] No At November 9, 2000, 15,154,400 shares of common stock were outstanding. ================================================================================
2 ITEM 1. FINANCIAL STATEMENTS SCM MICROSYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited) <TABLE> <CAPTION> QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 2000 1999 2000 1999 --------- --------- --------- --------- <S> <C> <C> <C> <C> Net revenues $ 43,263 $ 36,401 $ 105,383 $ 87,145 Cost of revenues 28,997 23,048 69,187 58,298 --------- --------- --------- --------- Gross profit 14,266 13,353 36,196 28,847 --------- --------- --------- --------- Operating expenses: Research and development 3,493 2,494 9,179 6,365 Sales and marketing 6,410 3,816 14,609 9,410 General and administrative 5,230 2,892 11,457 9,410 In-process research and development 2,867 -- 2,867 900 Other acquisition-related charges -- -- -- 1,168 --------- --------- --------- --------- Total operating expenses 18,000 9,202 38,112 27,253 --------- --------- --------- --------- Income (loss) from operations (3,734) 4,151 (1,916) 1,594 Interest and other, net 1,656 1,307 5,760 4,695 --------- --------- --------- --------- Income (loss) before taxes and minority interest in earnings (2,078) 5,458 3,844 6,289 Provision for income taxes (765) (1,634) (2,553) (3,311) Minority interest in loss of consolidated subsidiaries 432 -- 223 -- --------- --------- --------- --------- Net income (loss) $ (2,411) $ 3,824 $ 1,514 $ 2,978 ========= ========= ========= ========= Net income (loss) per share: Basic $ (0.17) $ 0.27 $ 0.10 $ 0.21 Diluted $ (0.17) $ 0.26 $ 0.10 $ 0.20 Shares used in computing income (loss) per share: Basic 14,596 14,078 14,439 14,056 Diluted 14,596 14,690 15,551 14,947 Comprehensive income (loss): Net income (loss) $ (2,411) $ 3,824 $ 1,514 $ 2,978 Unrealized gain on investments, net of deferred taxes (2,264) -- (3,128) -- Foreign currency translation adjustment, net of deferred taxes (1,720) 1,069 (2,618) (1,055) --------- --------- --------- --------- Total comprehensive income (loss) $ (6,395) $ 4,893 $ (4,232) $ 1,923 ========= ========= ========= ========= </TABLE> See notes to condensed consolidated financial statements. 2
3 SCM MICROSYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited) <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 2000 1999 ------------ ------------ <S> <C> <C> ASSETS Current assets: Cash and cash equivalents $ 60,155 $ 45,662 Short-term investments 30,919 79,747 Accounts receivable, net 47,890 32,215 Inventories 26,764 15,934 Other current assets 7,370 8,836 --------- --------- Total current assets 173,098 182,394 Property and equipment, net 7,227 6,372 Long-term investments 12,129 13,945 Intangible assets, net 34,722 8,006 Other assets 269 267 --------- --------- Total assets $ 227,445 $ 210,984 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 21,208 $ 17,679 Accrued expenses 8,728 7,806 Income taxes payable 2,908 4,906 Short-term debt 405 1,512 --------- --------- Total current liabilities 33,249 31,903 Deferred tax liability -- 3,201 Minority interest 284 84 Stockholders' equity: Capital stock 15 14 Additional paid-in capital 195,218 173,048 Retained earnings (deficit) 162 (1,504) Deferred compensation -- (25) Other cumulative comprehensive income (loss) (1,483) 4,263 --------- --------- Total stockholders' equity 193,912 175,796 --------- --------- $ 227,445 $ 210,984 ========= ========= </TABLE> See notes to condensed consolidated financial statements. 3
4 SCM MICROSYSTEMS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ( in thousands ) ( unaudited ) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ------------------------- 2000 1999 -------- -------- <S> <C> <C> Cash flows from operating activities: Net income $ 1,514 $ 2,978 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Deferred income taxes 1,607 -- Depreciation and amortization 4,203 1,765 Charge off of in-process research and development 2,867 900 Write-off of impairment charge related to Dazzle acquisition -- 600 Minority interest in earnings of subsidiaries (223) -- Other 23 36 Changes in operating assets and liabilities: Accounts receivable (12,633) (3,998) Inventories (7,856) 176 Other current assets 1,904 (1,098) Accounts payable (688) (3,637) Accrued expenses 374 3,107 Income taxes payable (2,208) (603) -------- -------- Net cash (used in) provided by operating activities (11,116) 226 -------- -------- Cash flows from investing activities: Capital expenditures (3,935) (4,158) Proceeds from sale of subsidiary 39 -- Purchases of long-term investments (5,334) (4,596) Business acquired, net of cash received (17,842) 836 Proceeds from maturities of short-term investments 102,401 57,062 Purchases of short-term investments (54,003) (43,605) -------- -------- Net cash provided by investing activities 21,326 5,539 -------- -------- Cash flows from financing activities: Payments on other current debt (4,017) (30) Proceeds from issuance of equity securities, net 9,555 1,265 -------- -------- Net cash provided by financing activities 5,538 1,235 Effect of exchange rates on cash and cash equivalents (1,255) (357) -------- -------- Net increase in cash and cash equivalents 14,493 6,643 Cash and cash equivalents at beginning of period 45,662 47,177 -------- -------- Cash and cash equivalents at end of period $ 60,155 $ 53,820 ======== ======== Supplemental disclosures of cash flow information: Cash paid for income taxes $ 5,451 $ 4,566 ======== ======== Cash paid for interest $ 430 $ 238 ======== ======== </TABLE> See notes to condensed consolidated financial statements. 4
5 SCM MICROSYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2000 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three-month period and nine-month period ended September 30, 2000 are not necessarily indicative of the results that may be expected for the year ending December 31, 2000. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems' ("SCM's") December 31, 1999 annual report on Form 10-K. 2. LONG-TERM INVESTMENTS Long-term investments consist of the following (in thousands): <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 2000 1999 ------------ ----------- <S> <C> <C> Investment in SmartDisk, at fair value $ 4,845 $10,234 Investment in Spyrus, at cost 3,550 3,546 Investment in ActivCard, at fair value 2,680 -- Investment in SATUP, at cost 750 -- Other 304 165 ------- ------- Total $12,129 $13,945 ======= ======= </TABLE> The investments in SmartDisk and ActivCard represent the quoted market value of SCM's investment in their common stock. In 1999, SCM made loans to Spyrus, a privately held company which provides Internet identification and encryption solutions for e-business. In March 2000, SCM converted its loans into shares of Spyrus' Series B convertible preferred stock (see Note 8). In September 2000, SCM loaned SATUP Databroadcasting AG ("Satup"), a privately held satellite content distributor located in Weinstadt Germany, $750,000. The loan is convertible into common shares of Satup and is guaranteed by its majority investor. The loan has a term of three months and earns interest at 10% per annum which is payable at the end of the term. Satup is a customer of SCM. 3. INVENTORIES Inventories consist of (in thousands): <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 2000 1999 ------------ ------------ <S> <C> <C> Raw materials $13,154 $ 9,077 Finished goods 13,610 6,857 ------- ------- $26,764 $15,934 ======= ======= </TABLE> 5
6 4. SHORT-TERM DEBT As of September 30, 2000, short-term debt consisted of a bank loan of $401,000 related to the acquisition of 2-Tel and $4,000 in other short-term debt. The $401,000 bank loan was repaid in October 2000. Short-term debt as of December 31, 1999 consisted of $1,418,000 in notes payable and $94,000 in other short-term debt. As of December 31, 1999, Dazzle Multimedia, Inc. ("Dazzle") had convertible promissory notes of $1,418,000 with $1,358,000 of the notes payable in June 2000 and the remainder payable in July 2000. In June 2000, Dazzle repaid $1,168,000 of the notes and the remaining $190,000 of the notes along with accrued interest converted into 117,431 shares of Dazzle's Series B preferred stock. In July 2000, Dazzle repaid the convertible promissory note of $60,000 along with its accrued interest. 5. RECENT ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"), which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedge accounting when certain conditions are met. SFAS No. 133, as amended, is effective for SCM in 2001. SCM does not believe adoption of this statement will have a material impact on our consolidated financial position or results of operations. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements, which provides guidance on the recognition, presentation and disclosure of revenues in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. SAB 101 will be effective for SCM's fiscal quarter ending December 31, 2000. SCM does not believe adoption of this statement will have a material impact on our consolidated financial position or results of operations. 6. ACQUISITIONS AND DIVESTITURES Dazzle Multimedia, Inc. On June 30, 1999, SCM acquired a 51% interest in Dazzle Multimedia, Inc., a privately held company based in Fremont, California, in a transaction that was accounted for under the purchase method of accounting. The results of Dazzle have been consolidated from the date of acquisition. In September 2000, SCM acquired an additional 1.8% of Dazzle's outstanding common stock for approximately $1.2 million. The purchase of these additional shares resulted in additional intangible assets of approximately $1.0 million and approximately $0.2 million of in-process research and development costs. The in-process research and development costs were written off and are reflected in SCM's income statement for the quarter ended September 30, 2000. The other intangible assets are being amortized over an estimated life of five years. SCM has not yet completed the valuation of the additional intangibles acquired. The valuation of these intangible assets will be completed in the fourth quarter of 2000. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. Microtech International On June 27, 2000, SCM paid $7,466,000 in cash and issued approximately 98,700 shares of its common stock, valued at $91.19 per share, to the shareholders of Microtech International ("Microtech"), a privately held company in North Branford, Connecticut, in exchange for all of the outstanding share capital of Microtech. Microtech is a provider of digital photography solutions for the consumer and business markets. The transaction has been accounted for under the purchase method of accounting and the results of operations of Microtech have been included in SCM's results of operations since the date of acquisition. In connection with the acquisition, SCM incurred acquisition costs of $997,000. Additional payments of up to $5.0 million, in equal amounts of cash and 6
7 stock, can be paid to Microtech's former shareholders if Microtech meets certain financial criteria to be measured for the last six months of 2000 and the first six months of 2001. A valuation of the intangible assets related to the acquisition is currently under way and will be completed in the fourth quarter of 2000. A summary of the preliminary allocation of the purchase price is as follows (in thousands): <TABLE> <S> <C> Cash $447 Tangible assets 7,160 Trade name 1,200 Acquired workforce 1,100 Customer relationships 1,700 Non-compete agreements 700 Goodwill and other intangible assets 13,028 Assumed liabilities (7,872) ------- Total $17,463 ======= </TABLE> Intangible assets from the acquisition approximated $17,728,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The preliminary purchase price allocation is based on the assumption that the entire amount of intangible assets will have a life of five years and will be amortized on a straight-line basis over this period. SCM has not yet completed the valuation of the intangible assets acquired. When completed, certain amounts identified as intangible assets may be amortized over periods other than the five-year period. The following summary, prepared on a pro forma basis, combines SCM's consolidated results of operations with Microtech's results of operations for the three and nine months ended September 30, 2000 and 1999, as if Microtech had been acquired at January 1, 1999. The table includes the impact of certain adjustments including the elimination of intercompany profit and additional amortization relating to intangible assets acquired (in thousands, except per share data): <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------- --------------------------- 2000 1999 2000 1999 --------- --------- --------- --------- <S> <C> <C> <C> <C> Revenues $ 43,263 $ 44,242 $ 118,449 $ 105,661 Net income (loss) $ (2,411) $ 2,828 $ (2,818) $ (1,107) Net income (loss) per share: Basic $ (0.16) $ 0.20 $ (0.19) $ (0.08) Diluted $ (0.16) $ 0.19 $ (0.19) $ (0.08) Shares used in per share computations: Basic 14,695 14,177 14,537 14,155 Diluted 14,695 14,789 14,537 14,155 </TABLE> Personal Video Division of FAST Multimedia Effective July 1, 2000, Dazzle, a 53% owned subsidiary of SCM, acquired the Personal Video Division ("PVD") of FAST Multimedia AG ("FAST"), a developer of digital video production hardware and software for professional markets, headquartered in Munich, Germany. The transaction was accounted for under the purchase method of accounting and the results of operations of this division were included in SCM's results of operations since its acquisition. Under the terms of the agreement, Dazzle acquired FAST's PVD and all the assets of the PVD division, including its research and development, marketing, sales, distribution and administrative operations. Dazzle paid FAST approximately $4,000,000 in cash for the division. Up to 2.8 million shares of Dazzle common stock, presently valued at approximately $4,000,000, could be issued to PVD if the division meets certain financial performance criteria for the last six months of 2000 and the first six months of 2001. (See note 9.) Acquisition costs related to this acquisition were $245,000. A valuation of the assets acquired is currently under way and will be finalized in the fourth quarter of 2000. A 7
8 summary of the preliminary allocation of the purchase price is as follows (in thousands): <TABLE> <S> <C> Fixed assets, net $120 Trade name 373 Acquired workforce 749 In-process research and development 877 Core technology 146 Developed technology 671 Goodwill 1,783 Deferred tax liability (474) ----- Total $4,245 ====== </TABLE> Intangible assets from the acquisition approximated $4,599,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired. The in-process research and development costs of $877,000 were expensed in the third quarter of 2000. The preliminary purchase price allocation is based on the assumption that the developed technology will have a life of three years and all other intangible assets will have a life of five years and will be amortized on a straight line basis over those periods. SCM has not yet completed the valuation of the intangible assets acquired. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. 2-Tel BV On September 28, 2000, SCM paid $4,140,000 in cash and issued approximately 106,229 shares of its common stock, valued at $36.5625 per share, to the shareholders of 2-Tel BV ("2-Tel"), a privately held company in the Netherlands, in exchange for all of the outstanding share capital of 2-Tel. 2-Tel is a provider of hardware and software solutions for the chip and smart card-based electronic commerce applications. The transaction has been accounted for under the purchase method of accounting. In connection with the acquisition, SCM incurred acquisition costs of approximately $300,000. A valuation of the intangible assets related to the acquisition is currently under way and will be completed in the fourth quarter of 2000. A summary of the preliminary allocation of the purchase price is as follows (in thousands): <TABLE> <S> <C> Cash $10 Tangible assets 423 Developed technology 2,060 In-process research and development 1,790 Acquired workforce 120 Customer relations 240 Goodwill 4,317 Assumed liabilities (636) ----- Total $8,324 ====== </TABLE> Intangible assets from the acquisition approximated $8,527,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The in-process research and development costs of $1,790,000 were expensed in the third quarter of 2000. The preliminary purchase price allocation is based on the assumption that the remaining intangible assets will have a life of five years and will be amortized on a straight-line basis over this period. SCM has not yet completed the valuation of the intangible assets acquired. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. Divestiture In April 2000, SCM sold to SmartDisk its interest in Impleo, a UK-based company, for $39,000 in cash and 24,579 shares of SmartDisk common stock, resulting in a net gain of $420,000. The gain is included in interest and other, net in the statement of operations. 8
9 7. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS Summary information by segment for the three and nine months ended September 30, 2000 and 1999, is as follows (in thousands): <TABLE> <CAPTION> QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------- ---------------------- 2000 1999 2000 1999 ------- ------- ------- ------- <S> <C> <C> <C> <C> Digital TV: Revenues $18,418 $12,072 $50,285 $29,770 Gross margin 6,693 4,842 18,226 10,874 Digital Media and Connectivity: Revenues $21,013 $18,589 $42,823 $44,854 Gross margin 6,041 6,078 12,696 12,600 PC/Network Security: Revenues $ 3,832 $ 5,740 $12,275 $12,521 Gross margin 1,532 2,433 5,274 5,373 </TABLE> Geographic revenues are based on the country where the customers are located. Information regarding revenues by geographic region for the three months and nine months ended September 30, 2000 and 1999 is as follows (in thousands): <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 2000 1999 2000 1999 -------- -------- -------- -------- <S> <C> <C> <C> <C> United States $ 26,376 $ 19,657 $ 55,272 $ 40,146 Europe 12,025 10,920 35,125 34,296 Asia-Pacific 4,862 5,824 14,986 12,703 -------- -------- -------- -------- $ 43,263 $ 36,401 $105,383 $ 87,145 ======== ======== ======== ======== </TABLE> No customer exceeded 10% of total net revenues for the three and nine months ended September 30, 2000 and 1999. 8. RELATED PARTY TRANSACTIONS In 1999, SCM loaned $3,550,000 to Spyrus, Inc., a privately held company which provides Internet identification and encryption solutions for e-business. In March 2000, Spyrus consummated a $20,150,000 preferred stock financing. In this transaction, SCM acquired 35,500,000 shares of Spyrus' Series B preferred stock at a price of $0.10 per share through the conversion of the loan. This represents approximately 15.8% of Spyrus' outstanding common stock on an as converted basis. In connection with this transaction, three directors of SCM acquired additional Spyrus Series B preferred stock on the same terms as SCM. Shares held by these individuals represent approximately 3.6% of Spyrus' outstanding common stock on an as converted basis. SCM has the right to appoint a director to Spyrus' board of directors and a member of SCM's Board currently serves as SCM's appointee. 9. SUBSEQUENT EVENT In October of 2000, SCM announced its intention to acquire all of the remaining outstanding common shares of Dazzle. SCM owned approximately 53% of Dazzle as of September 30, 2000. The acquisition will involve both cash and SCM common stock and is expected to be completed in the fourth quarter of 2000. 9
10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties including statements regarding the Company's anticipated gross profits, research and development costs, and general and administrative costs. SCM's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in this section as well as those discussed under the caption "Factors That May Affect Future Operating Results" and elsewhere in this document. OVERVIEW SCM Microsystems designs, develops and sells hardware, software and silicon that enables 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 into the Digital Television, Broadband Access, PC/Network Security and Digital Media Transfer markets. Our target customers are manufacturers in the consumer electronics, computer, digital appliance, digital media and conditional access system industries. We sell and license our products through a direct sales and marketing organization, primarily to original equipment manufacturers. We also sell through distributors, value added resellers and systems integrators worldwide. Operationally, we have organized our business around three divisions: Digital Television and Broadband Access, PC/Network Security, and Digital Media and Connectivity. We were organized in Delaware in 1996. ACQUISITIONS Dazzle On June 30, 1999, SCM acquired a 51% interest in Dazzle Multimedia, Inc., a privately held company based in Fremont, California, in a transaction that was accounted for under the purchase method of accounting. The results of Dazzle have been consolidated from the date of acquisition. In September 2000, SCM acquired an additional 1.8% of Dazzle's outstanding common stock for approximately $1.2 million. The purchase of these additional shares resulted in additional intangible assets of approximately $1.0 million and approximately $0.2 million of in-process research and development costs. The in-process research and development costs were written off and are reflected in SCM's income statement for the quarter ended September 30, 2000. The other intangible assets are being amortized over an estimated life of five years. SCM has not yet completed the valuation of the additional intangibles acquired. The valuation of these intangible assets will be completed in the fourth quarter of 2000. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. Microtech International On June 27, 2000, SCM paid $7,466,000 in cash and issued approximately 98,700 shares of its common stock, valued at $91.19 per share, to the shareholders of Microtech International ("Microtech"), a privately held company in North Branford, Connecticut, in exchange for all of the outstanding share capital of Microtech. Microtech is a provider of digital photography solutions for the consumer and business markets. The transaction has been accounted for under the purchase method of accounting and the results of operations of Microtech have been included in SCM's results of operations since the date of acquisition. In connection with the acquisition, SCM incurred acquisition costs of $997,000. Additional payments of up to $5.0 million, in equal amounts of cash and stock, can be paid to Microtech's former shareholders if Microtech meets certain financial criteria to be measured for the last six months of 2000 and the first six months of 2001. 10
11 Intangible assets from the acquisition approximated $17,728,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The preliminary purchase price allocation is based on the assumption that the entire amount of intangible assets will have a life of five years and will be amortized on a straight-line basis over this period. SCM has not yet completed the valuation of the intangible assets acquired. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. Personal Video Division of FAST Multimedia Effective July 1, 2000, Dazzle, a 53% owned subsidiary of SCM, acquired the Personal Video Division ("PVD") of FAST Multimedia AG ("FAST"), a developer of digital video production hardware and software for professional markets, headquartered in Munich, Germany. The transaction was accounted for under the purchase method of accounting and the results of operations of this division were included in SCM's results of operations since its acquisition. Under the terms of the agreement, Dazzle acquired FAST's PVD and all the assets of the PVD division, including its research and development, marketing, sales, distribution and administrative operations. Dazzle paid FAST approximately $4,000,000 in cash for the division. Up to 2.8 million shares of Dazzle common stock, presently valued at approximately $4,000,000, could be issued to PVD if the division meets certain financial performance criteria for the last six months of 2000 and the first six months of 2001. (See note 9.) Intangible assets from the acquisition approximated $4,599,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired. The in-process research and development costs of $877,000 were expensed in the third quarter of 2000. The preliminary purchase price allocation is based on the assumption that the developed technology will have a life of three years and all other intangible assets will have a life of five years and will be amortized on a straight line basis over those periods. SCM has not yet completed the valuation of the intangible assets acquired. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. At the time of the acquisition, the estimated aggregate fair value of the PVD Division's research and development efforts that had not reached technological feasibility and had no alternative future uses was estimated to be approximately $877,000. This amount was expensed in the third quarter of 2000 and represented the estimated fair value based on risk-adjusted cash flows related to incomplete research and development projects. PVD had three projects considered to be in-process technology at the time of the acquisition. These projects were DV.now AV, DV.twin and TV-Master. As of the date of acquisition, these projects are estimated to be 80%, 90% and 50% complete, respectively, and are scheduled to be complete in the fourth quarter of 2000. As of September 30, 2000, the percentage completion of these projects were estimated to be 95% for DV.now AV and DV.twin and 75% for TV-Master. The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risks adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time. The revenue projection used to value the in-process technology is based on sales forecasts for worldwide sales territories and adjusted to consider only the revenue related to development achievements completed at the acquisition date. Projected revenues for the in-process technology projects were assumed to increase from product release to 2002 and to decline significantly in 2003 and 2004. Gross margins were projected to range from 42% for the remainder of 2000 to 40% for 2001 through to 2004. Projected gross margins were based on estimated cost of revenues including component costs, tooling costs, assembly and testing costs and packaging based on PVD's experience with similar products. Estimated operating costs, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income for the in-process development projects. Operating expenses were estimated as a percentage of revenues and included sales and marketing expenses, administrative expenses and development costs to maintain the technology once it has achieved technological feasibility. In addition, net cash flow estimates were adjusted to allow a fair return on working capital and fixed assets. A 30% discount rate was used to discount the net cash flows back to their present value. If these projects are not successfully developed, we may not realize the value assigned to the in-process research and 11
12 development projects. Total costs incurred for the DV.now AV project was approximately $125,000 as of the acquisition date with an anticipated $35,000 needed for completion. Total costs incurred for the DV.twin project is approximately $36,000 as of the acquisition date with an anticipated $5,000 needed for completion. Total costs incurred for the TV-Master product is approximately $120,000 as of the acquisition date with an anticipated $120,000 needed for completion. 2-Tel BV On September 28, 2000, SCM paid $4,140,000 in cash and issued approximately 106,229 shares of its common stock, valued at $36.5625 per share, to the shareholders of 2-Tel BV ("2-Tel"), a privately held company in the Netherlands, in exchange for all of the outstanding share capital of 2-Tel. 2-Tel is a provider of hardware and software solutions for the chip and smart card-based electronic commerce applications. The transaction has been accounted for under the purchase method of accounting. In connection with the acquisition, SCM incurred acquisition costs of approximately $300,000. Intangible assets from the acquisition approximated $8,527,000 and represented the excess of the purchase price over the fair value of the tangible assets acquired less the liabilities assumed. The in-process research and development costs of $1,790,000 were expensed in the third quarter of 2000. The preliminary purchase price allocation is based on the assumption that the remaining intangible assets will have a life of five years and will be amortized on a straight-line basis over this period. SCM has not yet completed the valuation of the intangible assets acquired. The allocation of the purchase price is subject to a final valuation to be completed by an independent valuation specialist. At the time of the acquisition, the estimated aggregate fair value of 2-Tel's research and development efforts that had not reached technological feasibility and had no alternative future uses was estimated to be approximately $1,790,000. This amount was expensed in the third quarter of 2000 and represented the estimated fair value based on risk-adjusted cash flows related to incomplete research and development projects. 2-Tel had three projects considered to be in-process technology at the time of the acquisition. These projects were E-Gate 2000, Retail Application Terminal and the Transmobile Wallet. The E-Gate 2000 and Retail Application Terminal projects are due to be completed in the fourth quarter of 2000 while the Transmobile Wallet is scheduled for completion in the second quarter of 2001. As of the date of the acquisition and September 30, 2000, the percentage completion of these projects were estimated to be 79% for the E-Gate 2000, 81% for the Retail Application project and 31% for the Transmobile Wallet. The fair value assigned to purchased in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risks adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. The completion percentages were estimated based on cost incurred to date, importance of completed development tasks and the elapsed portion of the total project time. The revenue projection used to value the in-process technology is based on sales forecasts for worldwide sales territories and adjusted to consider only the revenue related to development achievements completed at the acquisition date. Since the projected debt-free cash flow for the E-Gate 2000 product was considered to be slightly negative, no in-process technology value was ascribed to this product. Projected revenues for the two remaining in-process technology projects were assumed to increase from product release to 2003 and to decline significantly in 2004 and 2005. Gross margins were projected to range from 62% in the first few years to 54% in 2004 and 2005 for the Retail Application Terminal and 41% in 2001 to 46% for the following years for the Transmobile Wallet. Projected gross margins were based on estimated cost of revenues including component costs, tooling costs, assembly and testing costs and packaging based on 2-Tel's experience with similar products. Estimated operating costs, income taxes and capital charges to provide a return on other acquired assets were deducted from gross profit to arrive at net operating income for the in-process development projects. Operating expenses were estimated as a percentage of revenues and included sales and marketing expenses, administrative expenses and development costs to maintain the technology once it has achieved technological feasibility. In addition, net cash flow estimates were adjusted to allow a fair return on working capital and fixed assets. A 45% discount rate was used to discount the net cash flows back to their present value for the Retail Application Terminal while a 50% rate was used for the Transmobile Wallet. The higher rate for the Transmobile Wallet relates to the additional risk related to technological similarity to existing products and its stage of completion. If these projects are not successfully 12
13 developed, we may not realize the value assigned to the in-process research and development projects. The calculated value of the in-process technology for the Retail Application Terminal is $1,560,000 and $230,000 for the Transmobile Wallet. Total costs incurred for the E-Gate 2000 project is approximately $360,000 as of the acquisition date and September 30, 2000 with an anticipated $120,000 needed for completion. Total costs incurred for the Retail Application Terminal is approximately $324,000 as of the acquisition date and September 30, 2000 with an anticipated $108,000 needed for completion. Total costs incurred for the Transmobile Wallet is approximately $180,000 as of the acquisition date and September 30, 2000 with an anticipated $420,000 needed for completion. RESULTS OF OPERATIONS Net Revenues. Net revenues reflect the invoiced amount for goods shipped less an allowance for estimated returns. Revenue is recognized upon product shipment. Net revenues for the quarter ended September 30, 2000 were $43.3 million compared to $36.4 million in 1999, an increase of 19%. For the first nine months of 2000, net revenues were $105.4 million, an increase of 21% over the $87.1 million for the same period of 1999. The increase in revenues in the first nine months of 2000 over the same period in 1999 was due primarily to an increase in sales of our Digital TV and Broadband Access products of $20.5 million, offset by decreases in sales of Digital Media and Connectivity products of $2.0 million and in sales of PC/Network Security products of $0.2 million. The increase in the third quarter of 2000 compared to the same quarter in 1999 was primarily due to an increase in sales of our Digital TV and Broadband Access products of $6.3 million and a $2.4 million increase in sales of Digital Media and Connectivity products, offset by a decrease of $1.9 million in sales of PC/Network Security products. The increases in Digital TV and Broadband Access sales primarily consisted of shipments of Dazzle products to its customers, including a new MPG-2 digital video product. No Dazzle product sales were included in the first six months of 1999 since Dazzle was acquired on June 30, 1999. The increase in Digital Media and Connectivity sales in the third quarter of 2000 compared to the same quarter in 1999 was primarily due to sales to the retail channel by Microtech, which was acquired on June 27, 2000, and to increased sales of our Digital Media Reader/Writers. The decrease in Digital Media and Connectivity sales in the first nine months of 2000 compared to the same period in 1999 was primarily due to the lack of availability of multimedia flash memory cards for the digital music player market in the first six months of 2000. The decrease in PC/Network Security shipments was primarily due to a reduction of demand for our legacy SwapBox products. In the third quarter, PC Security revenues came primarily from smart card reader products. Gross Profit. Gross profit for the third quarter of 2000 was $14.3 million, or 33% of total net revenues, compared to $13.4 million, or 37% for the same quarter of 1999. Gross profit for the first nine months of 2000 was $36.2 million, or 34% of total net revenues compared to $28.8 million, or 33% of total net revenues for the same period of 1999. The increase in gross profit in absolute dollars for the third quarter and first nine months of 2000 was primarily due to the aforementioned increase in shipments of Digital TV and Broadband Access products in both periods. Digital Media and Connectivity margins in the nine months ended September 30, 1999 also included a $1.1 million charge resulting from the write down of excess inventory in that division and costs associated with the ramp up of production of certain Digital Media and Connectivity products in the second quarter of 1999. The write down of inventory resulted from a review of SCM's products in the Digital Media and Connectivity division, which was conducted following a slow down in sales of certain products. These declining sales were attributed to an overlap in SCM's product lines. The decrease as a percentage of total net revenues for the quarter ended September 30, 2000 compared to the same period in 1999 was primarily due to lower margins in our Digital TV and Digital Media and Connectivity products as a result of as change in product mix within those product groups. We believe that our gross profit in absolute dollars during 2000 will continue to be above the levels experienced in 1999. Our gross profit has been and will continue to be affected by a variety of factors, including competition, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to fluctuate from period to period. Research and Development. Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are primarily related to hardware and chip development, and to a lessor degree software development. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, SCM has not capitalized any software 13
14 development costs. For the third quarter of 2000, research and development expenses were $3.5 million, compared with $2.5 million in the same quarter of 1999, an increase of 40%. For the first nine months of 2000, research and development expenses were $9.2 million, compared with $6.4 million, an increase of 44%. As a percentage of total net revenues, research and development expenses were 8% in the third quarter of 2000, 9% for the first nine months of 2000 and 7% for the corresponding 1999 periods. The increase in absolute amounts was primarily due to increased engineering headcount and related product development costs at our development centers in France and India, and to research and development expenses of Dazzle. Personnel related expenses increased by $1.1 million in the third quarter of 2000 compared to the same quarter in 1999. Personnel related expenses increased by $2.4 million and prototype expenses increased by $0.4 million in the first nine months of 2000 compared to the same period in 1999. We believe that the absolute amount of research and development expenses during 2000 will be higher than in 1999 due to a higher number of personnel involved in our new product development and customer projects, but that such expenses will fluctuate as a percentage of total net revenues. Sales and Marketing. Sales and marketing expenses consist primarily of employee compensation, trade show and other marketing costs. Sales and marketing expenses for the third quarter of 2000 were $6.4 million, or 15% of revenues, compared with $3.8 million in the third quarter of 1999, or 10% of revenues, an increase of 68%. Sales and marketing expenses for the first nine months of 2000 were $14.6 million, or 14% of revenues, compared with $9.4 million, or 11% of revenues, in the same period of 1999, an increase of 55%. These increases in absolute amounts in 2000 were primarily due to the acquisition of Dazzle and Microtech which incur relatively higher marketing costs because of their retail sales strategy and an increase in sales and marketing costs in the U.S. and Germany. The increases in the third quarter of 2000 compared to the same period in 1999 consisted primarily of personnel related expenses of $1.1 million and marketing program costs of $1.7 million. In the first nine months of 2000 compared to the same period in 1999, increases in spending were primarily from personnel related expenses of $2.0 million, marketing program costs of $2.3 million, external and internal sales commissions of $0.6 million and depreciation expenses of $0.3 million. We expect sales and marketing expenses in 2000 to increase in absolute amounts as we continue to expand our sales and business development efforts on a worldwide basis. General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing SCM's administrative functions, professional fees such as legal, audit, tax and consulting fees, and the amortization of intangible assets. In the third quarter of 2000, general and administrative expenses were $5.2 million, an increase of 81% compared with $2.9 million in the third quarter of 1999, and representing 12% and 8% of total net revenues in the third quarter of 2000 and 1999, respectively. For the first nine months of 2000, general and administrative expenses totaled $11.5 million, an increase of $2.0 million from the same period of 1999. Increases in the third quarter of 2000 as compared to the same period in 1999 related primarily to $0.9 million for personnel related expenses, $1.1 in amortization expense and $0.2 million in investor relations costs. The increase in amortization expenses relates to our recent acquisitions. The increase in investor relations costs relates to expenses associated with our annual meeting, including the identification of shareholders and solicitation of proxies. Increases in expenses in the first nine months of 2000 as compared to the same period of 1999 were $1.6 million for personnel related expenses, $1.6 million for amortization expense, $0.6 million for professional fees, and $0.2 million for investor relations, offset by the $2.0 million charge taken in the second quarter of 1999. The increases in professional fees were primarily related to tax consulting and the rollout of our SAP software worldwide. The increases in intangible asset amortization and in personnel expenses were primarily due to the acquisition of Dazzle and Microtech. We believe general and administrative expenses in 2000 will continue to increase in absolute amounts as we continue to improve our infrastructure, but will fluctuate as a percentage of total net revenues. In-Process Research and Development. In-process research and development costs of $2.9 million were included in our third quarter results for 2000 as one-time charges for the development efforts that had not reached technological feasibility within our recently acquired companies. Of this expense, $1.8 million related to the acquisition of 2-Tel, $0.9 million related to the acquisition of the PVD division of FAST by Dazzle and the remaining $0.2 million related to SCM's purchase of additional Dazzle common stock during the quarter. The $0.9 million recorded in the second quarter of 1999 related to our purchase of 51% of Dazzle's outstanding common stock. Other Acquisition-Related Charges. In connection with the acquisition of a majority interest in Dazzle in the second quarter of 1999, SCM incurred a non-recurring charge of $0.6 million resulting from the write down of the Dazzle investment at the date of the acquisition, headcount termination costs of $0.3 million and other costs of $0.2 million. Interest Income and Other, Net. Interest income and other, net consists primarily of interest earned on invested cash, offset by interest paid or accrued on outstanding debt and foreign currency gains or losses. Interest income and other, net for the third quarter of 2000 was $1.5 million and foreign currency gains of $0.2 million, compared to $1.5 million for interest income and other, net and a foreign currency loss of $0.2 million in the same period in 1999. For the first nine 14
15 months of 2000, the net gain on sale of investments was $0.4 million, interest income and other, net was $4.7 million and the foreign currency gain was $0.7 million compared to interest income and other, net of $4.7 million in the same period of 1999. Income Taxes. The provision for income taxes in the first nine months of 2000 was $2.6 million, or 66% of net income before tax, compared to $3.3 million, or 53% of net income before tax for the same period in 1999. SCM's tax rate is affected by the mix of taxable income among the various tax jurisdictions in which we do business and the non-deductibility of various one-time charges and the amortization of intangibles. Minority interest. Minority interest reflects the proportional profits or losses that are attributable to the minority shareholders in two of SCM's majority owned subsidiaries. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2000, our working capital was $139.8 million, compared to working capital of $150.5 million as of December 31, 1999. The decrease in working capital as of September 30, 2000 related primarily to lower short-term investment levels. During the first nine months of 2000, cash and cash equivalents increased by $14.5 million due primarily to $21.3 million provided by investing activities and $5.5 million by financing activities being offset by a use of cash of $11.1 million in operations. The cash provided by investing activities was primarily from net proceeds of $48.4 million from short-term investments, offset by $17.8 million (net of cash acquired) paid to purchase Microtech, PVD and 2-Tel, the purchase of $5.3 million of long-term investments and $3.9 million of capital expenditures. The $5.5 million of cash was primarily provided by financing activities from proceeds for the exercise of stock options of $9.6 million being offset by $4.0 million of debt repayment. Cash used in operations of $11.1 million was primarily from increases of accounts receivable of $12.6 million and inventories of $7.9 million, and decreases in accounts payable of $0.7 million and income taxes payable of $2.2 million, more than offsetting a decrease of other current assets of $1.9 million and income from operations of $10.2 million after adding back depreciation and amortization of $4.2 million, in process research and development costs of $2.9 million and deferred income taxes of $1.6 million. SCM has revolving lines of credit with two banks in Germany providing total borrowings of up to DM 3,000,000 (approximately $1,356,000 as of September 30, 2000). Neither line has an expiration date. The German lines of credit bear interest at rates ranging from 7.25% to 10.00%, and borrowings under these lines of credit are unsecured. In France, we have a FF2,000,000 line of credit (approximately $269,000 as of September 30, 2000) bearing interest at 5.59%. This line has an expiration date of August 2001 and is unsecured. In the United States, we have an unsecured $3,000,000 line of credit which bears interest at 8.5% and expires in May 2001. In addition, we have a Singapore overdraft facility with a local bank of S$1,200,000 (approximately $690,000 as of September 30, 2000) due on demand. The Singapore line is secured by a U.S. $380,000 fixed deposit and has a base interest rate of 6.5%. Japan also has a 67 million yen line of credit (approximately $621,000 as of September 30, 2000) with a local bank that is renewed annually for one year each June. The Japanese line has an interest rate of 1.625% and is secured by a 67 million yen deposit. At September 30, 2000, no amounts were outstanding under any of the above lines of credit. SCM did have a $401,000 bank loan as of September 30, 2000 related to our acquisition of 2-Tel. This loan was repaid in October 2000. We believe that our current capital resources and available borrowings should be sufficient to meet our operating and capital requirements through at least the end of 2000. We may, however, seek additional debt or equity financing prior to that time. We can not assure you that additional capital will be available to SCM on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing SCM. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. 15
16 If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment. SEASONAL TRENDS IN SALES OF OUR PRODUCTS MAY AFFECT OUR QUARTERLY OPERATING RESULTS. Our business and operating results reflect seasonal trends. We have typically experienced lower net revenue and operating income in the first quarter and second quarter and higher net revenue in the third quarter and fourth quarter of each calendar year. We believe that the seasonal trends in our business and operating results are primarily due to the retail selling cycles of our OEM and retail customers in our Digital Media Transfer, Digital TV and Broadband Access markets, which are typically stronger in the second half of the calendar year. SCM sells readers for digital cameras and Internet music players in the U.S. and digital video broadcasting products in Europe. Because OEMs typically bundle our devices into their consumer products, and because the market for consumer products is stronger in the second half of the year, our business is impacted as well. We expect that our sales to consumer-oriented OEMs and the retail channel will increase, and the seasonal trends that effect our business and operating results will continue. OUR TARGET MARKETS MAY NOT DEVELOP AS QUICKLY AS EXPECTED, AND THEY MAY NOT ACCEPT OUR PRODUCTS AS THEIR PREFERRED SOLUTIONS. SCM's future growth and operating results will depend on whether our products are commercially successful. As described below, each of our product families address needs in different emerging markets. These markets may not develop as quickly as or in the ways that we expect them to, which could limit demand for our products. For example, widespread use of smart cards requiring readers depends upon the successful implementation of user applications such as credit card programs in the U.S. or home banking in Europe. If new applications are not timely or effective, then the market for smart card-based services requiring readers might not develop further. SCM sells security and connectivity products across four target markets: Digital TV, Broadband Access, PC/Network Security and Digital Media Transfer. In the Digital Media Transfer market, our reader and connectivity products provide easy to use, high-speed connections between digital platforms, such as PCs and digital cameras, and electronic media, such as copyright-protected music from the Internet. If the benefits of rapid transfer of digital photographs or music are not perceived as sufficient, or if alternative technologies are more widely adopted than the use of a media reader, then demand for products such as ours may not grow. In the PC/Network Security market, smart card-based security applications are beginning to be adopted by computer makers and software providers. Smart card token-based security applications provide protection from unauthorized access to digital information. Our smart card reader products are designed to provide security for PCs and other platforms, such as point of sale (POS). However, the market for network and electronic commerce security applications is still emerging and the smart card may not become the industry standard; hence other token architectures or other security approaches may be selected for these applications. In the Digital TV market, our products provide a means of controlling access to digital television broadcasts. Our DVB-CAM products provide conditional access decryption functionality while adhering to the European DVB-CI and U.S. NRSS-B standards. To date, our DVB-CAM products have been implemented in a relatively limited number of Digital TV set-top boxes in Europe. The European standard for Digital TV conditional access applications is still emerging. Although we believe that the DVB-CI standard will eventually become the European standard for Digital TV conditional access applications, this standard may not be adopted and the European Digital TV market may fail to develop further. In the United States, the Federal Communications Commission has mandated the transition to open standards-based Digital cable TV products by 2005. However, no products are currently available in the market. The substantial base of proprietary analog set-top boxes already installed in the U.S. may cause the market for Digital TV conditional access products in general, and our products in particular, to grow more slowly than expected or not at all. 16
17 In the market for Broadband Access, our products provide a means of accessing high-bandwidth content on the PC utilizing the broadband satellite, terrestrial and cable networks. If other solutions address this demand more quickly, more cost effectively or more conveniently than our products, or if we are unable to development sufficient relationships with partners to distribute our products, then our Broadband Access business may not grow. If the market for the products described above or any of our other products fail to develop or develop more slowly than expected, or if any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected. WE DEPEND UPON SALES TO ORIGINAL EQUIPMENT MANUFACTURERS AND TO DISTRIBUTORS. Many of our products are intended for use as components subsystems or value-added devices in systems manufactured and sold by third party original equipment manufacturers, or OEMs. In order to convince an OEM to incorporate our products into its systems, we must demonstrate that our products provide significant commercial advantages over alternative solutions. We may fail to successfully demonstrate these advantages or our products may cease to provide any advantages. Even if we are able to demonstrate that our products are superior, OEMs may still choose not to incorporate our products into their systems. OEMs may also change their business strategies and manufacturing practices, which could cause them to purchase fewer units of our products, find other sources for products we currently manufacture or manufacture these products internally. Our OEM customers may also seek price concessions from us. Failure of OEMs to incorporate our products into their systems, the failure of such OEMs' systems to achieve market acceptance or any other event causing a decline in our sales to OEMs would have a material adverse effect on our business and operating results. We also sell some of our Digital Media and Connectivity and PC/Network Security products through two-tiered distribution channels that include distributors, systems integrators, value-added resellers, and retailers, who maintain inventories of our products. We work closely with our distributors and resellers to monitor inventory levels and ensure that appropriate levels of products are available to end-users. Notwithstanding such efforts, if channel partners attempt to reduce their levels of inventory or if they do not maintain sufficient levels to meet customer demand, our sales could be negatively impacted. In addition, delays in shipments by and payments to our distribution customers by their customers may have a material adverse effect on our business and operating results. A SIGNIFICANT PORTION OF OUR SALES COMES FROM A SMALL NUMBER OF CUSTOMERS. Sales to a relatively small number of OEM consumer electronics, computer, digital appliance, digital media and conditional access system manufacturers historically have accounted for a significant percentage of our total sales. Sales to our top 10 customers accounted for approximately 45% of our total net revenues in the third quarter of 2000. No customer exceeded 10% of our revenues in the third quarter and for the first nine months of 2000. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business, could harm our business and operating results. OUR MARKETS ARE HIGHLY COMPETITIVE. The market for our products is intensely competitive and characterized by rapidly changing technology. We believe that competition in this market is likely to intensify as a result of increasing demand for digital data security, access control and connectivity products. We currently experience competition from a number of sources, including: - Motorola/General Instrument, PubliCard and Scientific Atlanta in DVB-CAM modules; - Pinnacle Systems in digital video creation; - Broadlogic, Harmonic, Motorola, Terayon and Thomson Multimedia in broadband PC receivers; - ActionTec, Carry Computer Engineering, Greystone and Litronic in PC Card adapters; 17
18 - Gemplus, Litronic, PubliCard and Towitoka in smart card readers and universal smart card reader interfaces; and - Carry Computer Engineering, DataFab, Lexar and SmartDisk for digital media readers and connectivity. We also experience indirect competition from some of our customers which sell alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these competitors and new competitors, such as Motorola, that develop digital information security products. In addition, the market for digital data security, access control and connectivity products may ultimately include technological solutions other than ours. Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources. As a result, our competitors may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products, and may be able to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share. Any of these factors could have a material adverse effect on our business and operating results. We believe that the principal competitive factors affecting the market for digital data security and connectivity products include: - the extent to which products comply with existing industry standards; - technical features; - ease of use; - quality and reliability; - level of security; - strength of distribution channels; and - price. We may not be able to successfully compete as to these or other factors and the competitive pressures may cause our business and operating results to suffer. THE MARKETS FOR OUR PRODUCTS MAY UNDERGO RAPID TECHNOLOGICAL CHANGE AND OUR FUTURE SUCCESS WILL DEPEND ON OUR ABILITY TO MEET THE SOPHISTICATED NEEDS OF OUR CUSTOMERS. The markets for our products are characterized by rapidly changing technology. Our customers' needs change and product requirements change frequently. Product life cycles are short and industry standards are still evolving. For example, in the broadband datacasting market, applications are constantly evolving as companies strive to create sustainable and profitable business models for their products or services. This impacts the features and functions we must incorporate into our St@rKey broadband access products. Rapid changes in technology or technology requirements could render our existing products obsolete and unmarketable. Therefore, our future success will depend upon our ability to successfully develop and introduce new and enhanced products that meet our customers' evolving expectations and incorporate the latest technology. Product development is risky because it is difficult to foresee developments in technology, coordinate technical personnel and identify and eliminate design flaws. Any significant delay in releasing new products could have a material adverse effect on the ultimate success of our products and could reduce sales of predecessor products. We may not be able to introduce new products on a timely basis. In addition, new products introduced by us may fail to achieve a significant degree of market acceptance or, once accepted, may fail to sustain viability in the market for any significant period. These factors could have a material adverse effect on our business and operating results. 18
19 WE RELY ON OUR STRATEGIC RELATIONSHIPS TO GENERATE REVENUE. SCM collaborates with a number of corporations and is a member of key industry consortia. Our future success will depend significantly on the success of our current arrangements and our ability to establish additional arrangements. We have formed strategic relationships, including technology-sharing agreements, with a number of key industry players such as Intel, Microsoft, Ericsson, Nokia and SanDisk. We evaluate, on an ongoing basis, potential strategic alliances and intend to continue to pursue such relationships. These arrangements may not result in commercially successful products. OUR SALES TO GOVERNMENT CONTRACTORS ARE SUBJECT TO UNCERTAINTIES AND MAY DECREASE. Approximately 1%, 8%, 12% and 17% of our net revenues for the nine months ended September 30, 2000 and the years ended 1999, 1998 and 1997, respectively, were derived from sales of our SwapBox PC Card reader product for use by the U.S. government. These sales were made under contracts between SCM and major OEMs that sell PCs to the United States Department of Defense ("DOD"). We believe that indirect sales to the DOD are subject to a number of significant uncertainties, including timing and availability of funding, unpredictable changes in the timing and quantity of orders and the generally competitive nature of government contracting. In addition, the U.S. Government is planning to transition to smart card-based security systems, and has reduced the number of new PC Card reader products it purchases. While we are actively competing for this new business, we may not be successful in securing new contracts for smart card readers with the DOD or other government suppliers. In addition, we cannot assure you that our products will meet new specifications of OEM suppliers to the DOD. A significant loss of indirect sales to the U.S. government would have a material adverse effect on our business and operating results. For example, in the quarters ended September 30, 2000 and June 30, 2000, sales of our SwapBox product were impacted by a reduction in orders from OEMs selling to the U.S. DOD. ANY DELAYS IN OUR NORMALLY LENGTHY SALES CYCLE COULD RESULT IN SIGNIFICANT FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS. When we obtain a new OEM customer, our initial sales to that customer usually take six to nine months. During this sales cycle, we may expend substantial financial resources and our management's time and effort with no assurance that a sale will ultimately result. The length of a new OEM customer's sales cycle depends on a number of factors that we may not be able to control. These factors include the customer's product and technical requirements and the level of competition we face for that customer's business. Any delays in the sales cycle for new customers could have a material adverse effect on our business and operating results. WE HAVE EXPERIENCED SIGNIFICANT GROWTH IN OUR BUSINESS IN RECENT PERIODS AND WE MAY NOT BE ABLE TO MANAGE THIS GROWTH OR ANY FUTURE GROWTH. Our business has grown substantially in recent periods, with net revenues increasing from $10.9 million in 1994 to $127.3 million 1999 and revenues of $105.4 million in the first nine months of 2000. We have expanded our focus from the PC/Network Security market to include Digital TV, Digital Media Transfer and more recently Broadband Access. Managing business in each of these markets requires skilled management, significant attention and substantial resources. To address our need for additional resources and because of acquisitions, we have increased in size from 67 employees at December 31, 1995 to 530 employees as of September 30, 2000. The growth of our business places a significant strain on our management and operations. If we are successful in achieving our growth plans, our growth is likely to continue to place a significant burden on our operating and financial systems and increased responsibility for senior management and other personnel. Existing management or any new members of management may not be able to improve existing systems and controls or implement new systems and controls in response to anticipated growth. Our failure to do so could have a material adverse effect on our business and operating results. 19
20 WE MAY NOT BE ABLE TO SUCCESSFULLY INTEGRATE ACQUIRED COMPANIES. We continually evaluate potential acquisitions of complementary businesses, products and technologies. SCM acquired Microtech International, based in North Branford, Connecticut in July 2000, 2-Tel BV based in The Netherlands, in September 2000, and announced intentions to complete the acquisition of Dazzle Multimedia, based in Fremont, California, by December 2000. In addition, Dazzle acquired the consumer products division of FAST Multimedia, based in Munich, Germany, effective July 2000. We may not realize the benefits of these recent and planned transactions or of future transactions. Products we acquire in connection with acquisitions may not gain acceptance in our markets, or may, because of similarities to our own products, cause confusion in our markets. We may not be able to integrate acquired technologies with our own products, and technologies we acquire may not be sufficient to address market requirements. In order to successfully integrate acquired companies, we must, among other things: - continue to attract and retain key management and other personnel; - integrate the acquired technologies and products; - minimize any impact to productivity of our research and development and marketing groups; - establish a common corporate culture; and - integrate geographically distant facilities and employees. If we fail to achieve these goals, or if our management's attention to day-to-day operations is diverted to integrating acquired companies or if problems in the integration process arise, this could result in an adverse effect on our business and operating results. OUR GLOBAL LOCATIONS MUST WORK TOGETHER EFFECTIVELY. SCM has its global headquarters in Los Gatos, California, as well as a significant-sized facility in North Branford, Connecticut. European headquarters are located in Pfaffenhofen, Germany, and the company maintains divisional offices in Munich, Germany and Heeswijk-Dinther, The Netherlands. We also have sales offices in Wokingham, England, and research and development facilities in La Ciotat, France and Chennai, India. In Asia, we have manufacturing facilities in Singapore and sales offices in Taiwan and Tokyo, Japan. Operating in diverse geographic locations imposes a number of risks and burdens on us, including the need to manage employees and contractors from diverse cultural backgrounds and who speak different languages, and difficulties associated with operating in a number of time zones. Although these difficulties can be reduced through the use of electronic mail and teleconferencing, unforeseen difficulties or logistical barriers in operating in diverse locations may occur. Operating in widespread geographic locations requires us to implement and operate complex information and operational systems. Although we believe that our systems are adequate, in the future we may have to implement new systems. Implementation of new information systems, in particular, may be costly. Any failure or delay in implementing needed systems, procedures and controls on a timely basis or in expanding current systems in an efficient manner could have a material adverse effect on our business and operating results. WE HAVE A LIMITED NUMBER OF SUPPLIERS OF KEY COMPONENTS. We rely upon a limited number of suppliers of several key components of our products. For example, SCM purchases mechanical components for use in our smart card reader product exclusively from Stocko, a German-based supplier. Our reliance on only one supplier could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of these components could delay shipments of our products, which could have a material adverse effect on our business and operating results. These delays could also damage relationships with current and prospective customers. 20
21 OUR BUSINESS COULD SUFFER IF WE OR OUR CONTRACT MANUFACTURERS CANNOT MEET PRODUCTION REQUIREMENTS. We are designing and manufacturing new products and technologies to address emerging markets that are early in their life cycles. In many cases our products are the first of their kind to address the evolving business requirements of our customers. While we perform initial beta testing on all our products, in certain cases we are unable to test the efficacy of the design or functionality of our products for mass production. If we are successful in securing large contracts for our products, we cannot be certain that we will be able to produce them in sufficient quantities and that they will meet customer specifications. In addition, most of our products are manufactured outside the United States because we believe that global sourcing enables us to achieve greater economies of scale, improve gross margins and maintain uniform quality standards for our products. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative sources would materially and adversely affect our business and operating results. In an effort to reduce our manufacturing costs, SCM has shifted volume production of many of our product components to our wholly owned subsidiary in Singapore. In addition, we utilize contract manufacturers in Europe and Asia. Foreign manufacturing poses a number of risks, including transportation delays and interruptions, difficulties in staffing, currency fluctuations, potentially adverse tax consequences and unexpected changes in regulatory requirements, tariffs and other trade barriers, and political and economic instability. If we or any of our contract manufacturers cannot meet our production requirements, we may have to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. Despite efforts to do so, we may not be able to identify or qualify new contract manufacturers in a timely manner and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements. WE MAY BE EXPOSED TO RISKS OF INTELLECTUAL PROPERTY INFRINGEMENT. SCM's success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights. Our software, documentation and other written materials are protected under trade secret and copyright laws, which afford only limited protection. SCM generally enters into confidentiality and non-disclosure agreements with our employees and with key vendors and suppliers. For example, our SwapBox and SwapSmart trademarks are registered in the United States. We continuously evaluate the registration of additional trademarks as appropriate. We currently have seven United States patents issued and five European patents issued. We also have nineteen patent applications pending worldwide. In addition, we have exclusive licenses under four other United States patents, and licenses for two United States patents associated with our products. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable, and that any issued patent will fail to provide us with any competitive advantages. There has been a great deal of litigation in the technology industry regarding intellectual property rights. Litigation may be necessary to protect our proprietary technology. SCM has from time to time received claims that it is infringing upon third parties' intellectual property rights and future disputes with third parties may not be resolved on terms acceptable to us. As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, cause product shipment delays, or require us to redesign our products or require us to enter into royalty or licensing agreements. Any of these events could have a material adverse effect on our business and operating results. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. 21
22 MANY OF OUR CUSTOMERS ARE LOCATED IN OTHER COUNTRIES WHICH EXPOSES OUR BUSINESS TO RISKS RELATED TO INTERNATIONAL SALES AND CURRENCY FLUCTUATIONS. SCM was originally a German corporation and continues to conduct a substantial portion of our business in Europe. Approximately 48%, 52%, 62%, and 51% of our revenues for the nine months ended September 30, 2000 and the years ended 1999, 1998, and 1997, 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 certain risks, including: - tariffs and other trade barriers; - difficulties in staffing and managing disparate branch operations; - currency exchange risks; - exchange controls; and - potential adverse tax consequences. These factors may have a material adverse effect on our business and operating results. We conduct operations and sell products in several different countries. Over the last two and one-half years, we have acquired companies in Japan, Singapore, Great Britain, India and The Netherlands. Therefore, our operating results may be impacted by the fluctuating exchange rates of foreign currencies, especially the German mark, the Japanese yen, the Singapore dollar, the British pound and the Indian rupee, in relation to the U.S. dollar. We do not currently engage in hedging activities with respect to our foreign currency exposure. We continually monitor our exposure to currency fluctuations and may use financial hedging techniques when appropriate to minimize the effect of these fluctuations. Even so, exchange rate fluctuations may still have a material adverse effect on our business and operating results. In the future, we could be required to denominate our product sales in other currencies, which would make the management of currency fluctuations more difficult and expose us to greater currency risks. WE MAY FACE PRODUCT LIABILITY RISKS. Customers rely on our token-based security products to prevent unauthorized access to their digital information. A malfunction of or design defect in our products could result in legal or warranty claims. Although we place warranty disclaimers and liability limitation clauses in our sales agreements and maintain product liability insurance, we cannot assure you that these measures will be effective in limiting our liability. Liability for damages resulting from security breaches could be substantial and could have a material adverse effect on our business and operating results. In addition, a well-publicized security breach involving token-based and other security systems could adversely affect the market's perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. In that event, the demand for our products could decline, which would cause our business and operating results to suffer. OUR KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS AND SUCH KEY PERSONNEL MAY NOT REMAIN WITH SCM IN THE FUTURE. We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel leave and are not adequately replaced, our business would be adversely affected. In particular, we depend on the continued service of Steven Humphreys, our Chairman of the Board, Robert Schneider, our Chief Executive Officer, Bernd Meier, our President and Chief Operations Officer, and Andrew Warner, our Chief Financial Officer. SCM provides compensation incentives such as bonuses, benefits and option grants (which are typically subject to vesting over four years) to attract and retain qualified employees. In addition, our German subsidiary has entered into substantially similar employment agreements with each of Messrs. Schneider and Meier pursuant to which each serves as a Managing Director of the subsidiary. Each of the respective agreements has no set termination date, may be terminated by the subsidiary or the officer with nine months notice, and provides that the officer cannot work for one of our competitors during the one-year period following his termination. Non-compete agreements are, however, generally difficult to enforce. Therefore, these provisions may not provide us with significant protection. 22
23 We believe that our future success will depend in large part on our continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and we may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future. WE HAVE INCURRED OPERATING LOSSES AND MAY NOT REMAIN PROFITABLE. Although SCM was profitable for the quarters ended June 30, 2000, March 31, 2000, December 31,1999, September 30, 1999 and March 31, 1999 and for the year ended December 31, 1997, we incurred net losses on an annual basis from our inception in 1993 through the year ended December 31, 1996, as well as in 1998. Although we remained profitable on a pro forma basis, we also incurred a net loss as reported in the quarters ended September 30, 2000 and June 30, 1999. In view of our loss history, we cannot assure you that we will be able to achieve or sustain profitability on an annual or quarterly basis in the future. Our quarterly operating results depend on a number of factors that are difficult to forecast. If our future quarterly operating results fall below the expectations of securities analysts or investors, the trading price of our common stock will likely drop. Our quarterly operating results have fluctuated in the past and may continue to fluctuate in the future as a result of many factors, including: - size, timing, cancellation or rescheduling of significant orders; - availability of key components or products in the market on which sales of our product depend; - new product announcements or introductions by us or our competitors; - our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all; - our success in expanding our sales and marketing organization and programs; - technological changes in the market for our products; - our level of expenditures on research and development; and - general economic trends. In addition, because a high percentage of our operating expenses are fixed, a small variation in revenue can cause significant variations in our operating results from quarter to quarter. SCM's operating results may vary significantly in future periods and our historical results may not be a reliable indicator of our future performance. OUR STOCK PRICE IS POTENTIALLY VOLATILE. The stock market has recently experienced significant price and volume fluctuations unrelated to the operating performance of particular companies. In addition, the market price of our common stock has been highly volatile and is likely to continue to be volatile. The future trading price for our common stock will depend on a number of factors, including: - variations in our financial results; - comments and forecasts by security analysts; - our ability to effectively manage our business; - expected or announced relationships with other companies; - any loss of key management; - announcements of technological innovations or new products by us or our competition; and - patents or other proprietary rights or patent litigation. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of management's attention and resources. 23
24 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK FOREIGN CURRENCIES We conduct operations and sell products in several different countries. Therefore, our operating results may be impacted by the fluctuating exchange rates of foreign currencies, especially the German mark, the Japanese yen, the Singapore dollar, the British pound and the Indian rupee, in relation to the U.S. dollar. We do not currently engage in hedging activities with respect to our foreign currency exposure. We continually monitor our exposure to currency fluctuations and may use financial hedging techniques when appropriate to minimize the effect of these fluctuations. Even so, exchange rate fluctuations may still have a material adverse effect on our business and operating results. FIXED INCOME INVESTMENTS SCM's exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments for speculative or trading purposes. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy. The policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. We do not expect any material loss with respect to our investment portfolio. We do not use derivative financial instruments in our investment portfolio to manage interest rate risk. 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 all portfolios is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria established in our investment guidelines, the exposure to market and credit risk is not expected to be material. PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Not applicable. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On June 27, 2000 and September 28, 2000, SCM acquired Microtech International, Inc. and 2-Tel BV, respectively. In connection with these acquisitions, SCM issued 99,141 shares of its common stock for Microtech and 106,229 shares of its common stock for 2-Tel. These transactions were exempt from registration requirements of Section 5 of the Securities Act pursuant to Section 4(2) thereof. The recipients of the securities represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the share certificates issued in such transaction. All recipients had adequate access to information regarding us. ITEM 3. DEFAULTS ON SENIOR SECURITIES Not applicable. 24
25 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Annual Meeting of shareholders held on July 26, 2000, the following matters were acted on by the shareholders of the Company: 1. The re-election of Bernd Meier and Andrew Vought as Class II directors for an additional three-year term: Bernd Meier Shares in Favor 5,071,626 Shares Against 6,370 Andrew Vought Shares in Favor 5,071,626 Shares Against 6,370 2. The approval of an amendment to the Company's 1997 Stock Plan to immediately increase the aggregate number of shares authorized for issuance to 750,000: Shares in Favor 3,539,625 Shares Against 228,226 3. The approval of an amendment to the Company's 1997 Stock Plan to increase the number of shares authorized under the stock plan annually to 1 million shares or 4.9%: Shares in Favor 3,533,850 Shares Against 229,421 4. The ratification of the appointment of Deloitte & Touche as the independent auditors of the company. Shares in Favor 5,073,776 Shares Against 4,220 ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. 27 Financial Data Schedule (b) Reports on Form 8-K July 11, 2000 related to the acquisition of Microtech, International. 25
26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SCM MICROSYSTEMS, INC. Date: November 14, 2000 /s/ ANDREW WARNER ------------------------------------------- Andrew Warner Vice President, Finance and Chief Financial Officer (Principal Financial and Accounting Officer) 26
27 EXHIBIT INDEX <TABLE> <CAPTION> Exhibits Description - -------- ----------- <S> <C> 27 Financial Data Schedule </TABLE> 27