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 MARCH 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM_________TO _________ COMMISSION FILE NUMBER: 0-22689 ---------------------------------- SCM MICROSYSTEMS, INC (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0444317 STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER) 131 ALBRIGHT WAY, 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 May 8, 1998, 11,198,331 shares of common stock were outstanding. ================================================================================
2 PART I. FINANCIAL INFORMATION ITEM I. FINANCIAL STATEMENTS SCM MICROSYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) <TABLE> <CAPTION> Three Months Ended March 31 -------------------- 1998 1997 ------- ------- <S> <C> <C> Net sales: Security and access products $ 7,815 $ 4,202 PCMCIA peripheral products -- 163 ------- ------- Total net sales 7,815 4,365 Cost of sales 4,916 2,804 ------- ------- Gross profit 2,899 1,561 ------- ------- Operating expenses: Research and development 766 628 Sales and marketing 1,044 975 General and administrative 778 548 ------- ------- Total operating expenses 2,588 2,151 ------- ------- Income (loss) from operations 311 (590) Interest and other income, net 728 36 ------- ------- Income (loss) before income taxes 1,039 (554) Provision for income taxes 250 -- ------- ------- Net income (loss) 789 (554) Accretion on redeemable convertible preferred stock -- (160) ------- ------- Net income (loss) attributable to common stockholders $ 789 $ (714) ======= ======= Earnings (loss) per share: Basic net income (loss) $ 0.07 $ (0.49) ======= ======= Diluted net income (loss) per share $ 0.07 $ (0.49) ======= ======= Shares used to compute basic net income (loss) per share 10,794 1,468 ======= ======= Shares used to compute diluted net income (loss) per share 12,068 1,468 ======= ======= </TABLE> See accompanying notes to financial statements. 1
3 SCM MICROSYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (amounts in thousands) ASSETS <TABLE> <CAPTION> March 31, December 31, 1998 1997 -------- -------- Current assets: (unaudited) <S> <C> <C> Cash and cash equivalents $ 23,813 $ 25,552 Short-term investments 34,715 30,336 Accounts receivable 7,782 6,607 Inventories 3,441 3,392 Prepaids and other current assets 777 302 -------- -------- Total current assets 70,528 66,189 Property, equipment, and other assets, net 1,653 1,176 -------- -------- $ 72,181 $ 67,365 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Notes payable -- 9 Accounts payable 2,431 4,308 Accrued expenses 1,387 1,271 Income taxes payable 554 305 -------- -------- Total current liabilities 4,372 5,893 Stockholders' equity: Common Stock 12 11 Additional paid-in capital 75,640 69,902 Accumulated deficit (6,925) (7,714) Deferred compensation (111) (125) Cumulative translation adjustment (807) (602) -------- -------- Total stockholders' deficit 67,809 61,472 -------- -------- $ 72,181 $ 67,365 ======== ======== </TABLE> See accompanying notes to financial statements. 2
4 SCM MICROSYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (amounts in thousands) (unaudited) <TABLE> <CAPTION> THREE-MONTH PERIODS ENDED MARCH 31, ----------------------- 1998 1997 -------- -------- <S> <C> <C> Cash flows from operating activities: Net income (loss) $ 789 $ (554) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization 128 113 Amortization of deferred employee compensation 13 17 Changes in operating assets and liabilities: Accounts receivable (1,343) 495 Inventories (116) (248) Prepaid expenses (880) (194) Accounts payable (1,297) (1,082) Accrued expenses (365) 363 Income taxes payable 250 -- -------- -------- Net cash used in operating activities (2,821) (1,090) -------- -------- Cash flows used in investing activities: Capital expenditures (225) (114) Proceeds from short-term investments 9,162 -- Purchases of short-term investments (13,541) -- -------- -------- Net cash used in investing activities (4,604) (114) Cash flows from financing activities: Payments on notes payable and long-term debt (9) (1,290) Proceeds from issuance of redeemable convertible Preferred Stock -- 5,095 Proceeds from issuance of common stock, net 5,739 -- -------- -------- Net cash provided by financing activities 5,730 3,805 -------- -------- Effect of exchange rates on cash (44) (248) -------- -------- Net increase in cash (1,739) 2,353 Cash at beginnning of period 25,552 2,593 -------- -------- Cash at end of period $ 23,813 $ 4,946 ======== ======== Supplemental disclosures of cash flow information: Cash paid during the period - interest $ -- $ 25 ======== ======== Noncash financing activities: Interest accretion on redeemable convertible Preferred Stock $ -- $ 160 ======== ======== Conversion of related party and non-related party debt into redeemable convertible Preferred Stock $ -- $ 4,240 ======== ======== </TABLE> See accompanying notes to financial statements. 3
5 SCM MICROSYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered for a fair presentation have been included. Operating results for the three-month period ended March 31, 1998 are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. For further information, refer to the financial statements and footnotes thereto included in the Company's December 31, 1997 annual report on Form 10-K. 2. NET INCOME (LOSS) PER SHARE Basic Earning Per Share (EPS) is computed using the weighted average number of common shares outstanding during the period. Dilutive EPS is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of common stock issuable upon exercise of stock options and warrants using the treasury stock method. The following is a reconciliation of the shares used in the computation of basic and diluted EPS for the three month periods ended March 31, 1998 and 1997 (in thousands): <TABLE> <CAPTION> Three Months Ended March 31, ------------------ 1998 1997 ------ ------ <S> <C> <C> Basic EPS - weighted average number of common shares 10,794 1,468 Effect of dilutive common equivalent shares: Stock options outstanding 983 -- Stock warrants outstanding 291 -- ------ ------ Diluted EPS - weighted average number of common shares and common equivalent shares outstanding 12,068 1,468 ====== ====== </TABLE> 3. COMPREHENSIVE INCOME In June 1997 the Financial Accounting Standards Board (FASB) issued SFAS No. 130, "Reporting Comprehensive Income" (SFAS No. 130), which establishes standards for reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and requires reclassification of financial statements for earlier periods to be provided for comparative purposes. The Company has not determined the manner in which it will present the information required by SFAS No. 130 in its annual financial statements for the year ending December 31, 1998. The Company's total comprehensive income (loss) for the three months ended March 31, 1998 and 1997 was $585,000 and $(884,000), respectively. 4
6 4. SUBSEQUENT EVENTS In April 1998, the Company completed a follow-on public offering with the sale of 3.45 million shares of Common Stock at a price to the public of $61.00 per share. Of the total number of shares sold, 2,000,000 shares were sold by shareholders and 1.45 million shares were sold by the Company. The net proceeds to the Company approximated $84 million. 5
7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company'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." OVERVIEW SCM Microsystems designs, develops and sells standards-compliant hardware, firmware and software products and technologies used in smart card and other token-based network security and conditional access systems. The Company's security and access products are targeted at OEM computer, telecommunication and digital video broadcasting ("DVB") component and system manufacturers. The Company markets, sells and licenses its products through a direct sales and marketing organization primarily to OEMs and also through distributors, VARs, system integrators and resellers worldwide. From the Company's inception through 1994, the Company focused primarily on PCMCIA peripheral products, including flash memory and fax/modem devices, which carried a significantly lower gross margin than the Company's current products. In 1994, the Company began emphasizing security and access products. The Company made the final shipment of PCMCIA peripheral products in the quarter ended March 31, 1997, completing its exit from this business. The Company experiences substantial seasonality in its business, with approximately one-third of annual net sales being realized in the first half of the year and the remaining two-thirds being realized in the second half of the year. In recent periods, this seasonality has been primarily the result of the Company's reliance on sales of its SwapBox products to OEMs that in turn are selling to U.S. government agencies. The buying pattern of U.S. government agencies tend to be substantially weighted to the third quarter and, to a somewhat lesser extent, the fourth quarter of the calendar year. The strength in net sales in the third quarter which results from the U.S. government buying patterns is somewhat offset by relatively weaker sales in Europe in the same quarter as a result of the traditional European summer vacation patterns. The Company expects that as sales of its DVB products, which are sold to OEMs mainly in Europe for the consumer market, begin to represent a larger percentage of net sales, the seasonality that the Company experiences may be further exacerbated as such sales are likely to be strongest in the fourth quarter of the year. In contrast to net sales, operating expenses tend to be spread relatively evenly across the year. As a result, the Company's operating results have tended to be weakest in first and second quarter of the year. 6
8 RESULTS OF OPERATIONS Net Sales. Net sales reflect the invoiced amount for goods shipped less estimated returns. Revenue is recognized upon product shipment. Net sales for the Company's quarter ended March 31, 1998 were $7.8 million compared to $4.4 million in the first quarter of 1997, an increase of 79%. All of the Company's sales in the first quarter of 1998 were derived from security and access products, compared to $4.2 million for the comparable periods of 1997. This represents year-over-year growth for security and access products of 86%. The increase was primarily due to a three-fold increase in the number of DVB-CAM units shipped into the European market, and a 33% increase in SwapBox revenues, primarily to OEM customers supplying U.S. government agencies. The Company made the final shipment of PCMCIA peripheral products in the quarter ended March 31, 1997, completing its exit from this business. Gross Profit. Gross profit for the first quarter of 1998 was $2.9 million, or 37% of total net sales, compared to $1.6 million, or 36% of total net sales for the first quarter of 1997. The increase in gross profit, both in absolute amount and as a percentage of total net sales, was primarily due to the aforementioned increase in shipments of DVB-CAM units which carry higher gross margins than the Company's SwapBox products. The Company believes that its gross profit in absolute dollars during 1998 will continue to be above the levels experienced in 1997. The Company's gross profit has been and will continue to be affected by a variety of factors, including competition, product configuration and mix, the availability of new products and product enhancements which tend to carry higher gross profit than older products and the cost and availability of components. Accordingly, gross profit percentages are expected to fluctuate from period to period. Research and Development. Research and development expenses consist primarily of employee compensation and prototype expenses. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, the Company has not capitalized any software development costs. Research and development expenses for the first quarter of 1998 were $766,000, compared with $628,000 in the first quarter of 1997, an increase of 22%. As a percentage of total net sales, research and development expenses were 10% and 14% in the first quarter of 1998 and 1997, respectively. The increase in absolute amounts was due primarily to higher headcount in the Company's La Ciotat, France facility and a rise in prototype and related expenses for the Company's security and access product development. The Company believes that the absolute amount of research and development expenses during the remainder of 1998 will be higher than the last three quarters of 1997 due to a higher number of personnel involved in the Company's new product development and customer projects, but that such expenses will fluctuate as a percentage of total net sales. Sales and Marketing. Sales and marketing expenses consist primarily of employee compensation and trade show and other marketing costs. Sales and marketing expenses for the first quarter of 1998 were $1.0 million, compared with $975,000 in the first quarter of 1997, an increase of 7%. As a percentage of total net sales, these expenses were 13% in the first quarter of 1998, compared with 22% in the comparable period of 1997. This increase in absolute amount 7
9 was due primarily to routine increases in personnel costs and an increase in trade show costs related to the CEBIT event held in the first quarter of each year in Hannover, Germany. The decrease in sales and marketing expenses as a percentage of total net sales in the first quarter of 1998 compared to the first quarter of 1997 was due to the 79% increase in total net sales discussed above. Sales and marketing expenses in the remainder of 1998 are expected to increase in absolute amounts as the Company continues to expand its sales and business development efforts on a worldwide basis. The Company expects these expenses as a percentage of total sales to generally remain consistent with or decline slightly from the 15.2% level reported for 1997. General and Administrative. General and administrative expenses consist primarily of compensation expenses for employees performing the Company's administrative functions. General and administrative expenses were $778,000 in the first quarter of 1998, or 10% of total net sales, compared with $548,000, or 13% of total net sales in the first quarter of 1997, an increase of 42%. This increase in absolute amount was primarily due to an increase of administrative headcount in the Company's U.S. and Pfaffenhofen, Germany offices to support higher levels of business activities, as well as costs relating to the Company operating as a public company subsequent to its IPO in October 1997. The Company believes general and administrative expenses in the remainder of 1998 will continue to increase in absolute amount for both of the aforementioned reasons, but will fluctuate as a percentage of total net sales. Interest and Other Income, Net. Interest and other income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt. In the first quarter of 1998, net interest income was $728,000, compared to net interest income of $36,000 in the first quarter of 1997. During the first six months of 1997, the Company raised $12.1 million through the sale of preferred stock, resulting in a reduction of debt and corresponding interest expense and an increase in investable cash balances. In October 1997, the Company completed its IPO with the sale of 3.8 million shares of common stock, a transaction which generated net proceeds to the Company of approximately $43.7 million. These amounts, along with the $84 million proceeds of the Company's follow-on stock sale in April 1998, will generate future net investment income in the remainder of 1998 at levels higher than experienced in 1997. Income Taxes. A provision for income taxes of $250,000 was booked in the first quarter of 1998, an effective tax rate of 24%, resulting principally from tax liabilities associated with foreign operations of the Company and minimum state income taxes. As of December 31, 1997, the Company had German net operating loss carry forwards of approximately $1.4 million available for an indefinite period to offset income from the Company's German operations. In addition, the Company had net operating loss carry forwards of approximately $3.3 million and $1.6 million for United States federal and California income tax purposes, respectively. The Company's utilization of United States federal operating loss carry forwards is limited to approximately $340,000 per year. 8
10 LIQUIDITY AND CAPITAL RESOURCES Prior to the Company's initial public stock offering, the Company had financed its operations principally through private placements of debt and equity securities and, to a lesser extent, borrowings under bank lines of credit. In October 1997, the Company completed the sale of 3.8 million shares of Common Stock in an initial public offering ("IPO"), resulting in net proceeds of $43.7 million. In April 1998, the Company completed a follow-on public offering with the sale of 3.45 million shares of Common Stock at a price to the public of $61.00 per share. Of the total number of shares sold, 2,000,000 shares were sold by shareholders and 1.45 million shares were sold by the Company. The net proceeds to the Company from the follow-on offering approximated $84 million. As of March 31, 1998, the Company's working capital was $66.1 million, compared to a working capital of $60.3 million as of December 31, 1997. Working capital increased during the first three months of 1998 due primarily to the Company's receipt of $5.7 million in net proceeds from the exercise of warrants and options. During the first three months of 1998, cash and cash equivalents decreased by $1.7 million due primarily to $4.6 million used in investing activities (which consisted of $225,000 in capital equipment expenditures and $9.2 million from proceeds from short-term investments and $13.5 million used in purchases of short-term investments) and financing activities which included proceeds from issuance of common stock of $5.7 million. Operating activities for the three months ended March 31, 1998 used $2.8 million of cash, including an increase in receivables of $1.3 million due primarily to higher revenue levels in the third month of the quarter, an increase in prepaid expenses of $880,000, consisting primarily of financing costs relating to the follow-on public offering completed in April 1998, and a $1.3 million decrease in accounts payable. The Company has revolving lines of credit with three banks in Germany providing total borrowings of up to 1.5 million DM each (approximately $2.4 million in total at March 31, 1998). Two of these lines of credit expire on September 30, 1998 and the third has no fixed expiration date. The German lines of credit bear interest at rates ranging from 7.0% to 8.75%. Borrowings under the German lines of credit are unsecured. The Company also has a $3.0 million U.S. line of credit which is secured by all assets of the Company, bears interest at the bank's prime rate, and expires in May 1999. At March 31, 1998, no amounts were outstanding under any of the Company's lines of credit. The Company presently expects that its current capital resources and available borrowings should be sufficient to meet its operating and capital requirements through at least the end of 2000. The Company may, however, seek additional debt or equity financing prior to that time. There can be no assurance that additional capital will be available to the Company on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders. 9
11 FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS HISTORY OF OPERATING LOSSES; POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS; SEASONALITY Although the Company was profitable for each of the four fiscal quarters ended March 31, 1998 before interest accretion on preferred stock, the Company incurred a net loss of $554,000 for the three months ended March 31, 1997 and net operating losses on an annual basis from its inception in 1993 through the year ended December 31, 1996. As of March 31, 1998, the Company had an accumulated deficit of $6.9 million. In view of the Company's loss history, there can be no assurance that the Company will be able to achieve or sustain profitability on an annual or quarterly basis in the future. The Company's quarterly operating results have in the past varied and may in the future vary significantly. Factors affecting operating results include: the level of competition; the size, timing, cancellation or rescheduling of significant orders; market acceptance of new products and product enhancements; new product announcements or introductions by the Company or its competitors; adoption of new technologies and standards; changes in pricing by the Company or its competitors; the ability of the Company to develop, introduce and market new products and product enhancements on a timely basis, if at all; hardware component costs and availability, particularly with respect to hardware components obtained from sole or limited source suppliers; the Company's success in expanding its sales and marketing organization and programs; technological changes in the market for digital information security products; levels of expenditures on research and development; foreign currency exchange rates; and general economic trends. In addition, because a high percentage of the Company's operating expenses are fixed, a small variation in revenue can cause significant variations in operating results from quarter to quarter. The Company has experienced significant seasonality in its business, and the Company's business and operating results are likely to be affected by seasonality in the future. The Company has typically experienced higher net sales in the third quarter and fourth quarter of each calendar year followed by lower net sales and operating income in the first quarter and second quarter of the following year. The Company believes that this trend has been principally due to budgeting requirements of the U.S. government which influence the purchasing patterns of OEMs which supply PCs and workstations incorporating the Company's data security products to the U.S. government. The Company expects that as sales of its DVB products, which are currently sold to OEMs mainly in Europe for the consumer market, begin to represent a larger percentage of net sales, the seasonality that the Company experiences may be further exacerbated as these sales are likely to be strongest in the fourth quarter of the year. Initial sales of the Company's products to a new customer typically involve a sales cycle which can range from six to nine months during which the Company may expend substantial financial resources and management time and effort with no assurance that a sale will ultimately result. The length of the sales cycle may vary depending on a number of factors over which the Company may have little or no control, including product and technical requirements, and the level of competition which the Company encounters in its selling activities. Any delays in the sales 10
12 cycle for new customers could have a material adverse effect on the Company's business and operating results. Based upon the factors enumerated above, the Company believes that its operating results may vary significantly in future periods and that historical results are not reliable indicators of future performance. It is likely that, in some future quarter or quarters, the Company's operating results will be below the expectations of stock market analysts and investors. In such event, the market price of the Company's Common Stock could decline significantly. 11
13 DEPENDENCE ON EMERGING PRODUCT MARKETS; UNCERTAINTY OF MARKET ACCEPTANCE OF THE COMPANY'S PRODUCTS From the Company's inception through 1994, the Company focused on PCMCIA peripheral products, including flash memory and fax/modem devices. In 1994, the Company began emphasizing security and access products. The Company made the final shipment of PCMCIA peripheral products in the quarter ended March 31, 1997, completing its exit from this business. As a result of the Company's strategic shift in product focus, the proportion of security and access product sales increased from 22.1% of total net sales in 1994 to 99.4% of total net sales in 1997, and to 100% of total net sales in the first quarter of 1998. The Company's net sales are now and will continue to be dependent upon the success of its security and access products. The Company's future growth and operating results will depend to a large extent on the successful marketing and commercial viability of the Company's security and access product families. Each of these product families addresses needs in different emerging markets. Smart card token-based security applications are able to provide protection from unauthorized access to digital information. The Company believes that smart cards are ideally suited to serve as tokens for network and electronic commerce security. Accordingly, the Company's SwapBox and SwapSmart product families are designed to provide smart card token-based security for PCs. However, there can be no assurance that the smart card will become the industry standard for network and electronic commerce security applications. The Company's DVB product family provides a means of controlling access to digital television broadcasts. The Company's SwapAccess DVB-CAM product implements the DVB-CI and NRSS-B standards. To date, the Company's DVB-CAM product has been implemented in a relatively limited number of DVB set-top boxes in Europe. Although the Company believes that the DVB-CI standard will eventually become the European standard for DVB conditional access applications, there can be no assurance that the standard will be adopted, that the European DVB market will further develop or that even if such standard is adopted and the market further develops, the Company's DVB-CAM products will be widely adopted. Furthermore, the market for DVB products in the United States has only recently begun to develop. There can be no assurance whether, or to what extent, the United States DVB market will grow. In addition, the substantial installed base of analog set-top boxes in the United States may cause the market for DVB products in general, and the Company's SwapAccess products in particular, to grow slower than expected, if at all. If the market for the products described above or any of the Company's other products fails to develop or develops more slowly than expected or if any of the standards supported by the Company do not achieve or sustain market acceptance, the Company's business and operating results would be materially and adversely affected. DEPENDENCE ON SALES TO OEMs A substantial majority of the Company's products are intended for use as components or subsystems in systems manufactured and sold by third party OEMs. In 1997, almost all of the Company's sales were to OEMs and the Company expects this dependence on OEM sales to continue. In 1997, sales to BetaDigital (a division of the Kirch Group) accounted for 45% of total net sales and sales to the Company's top 10 customers (all of which are OEMs) accounted for 80% of total net sales. In the first three months of 1998, sales to BetaDigital accounted for 49% 12
14 of total net sales, sales to Telenor Conax A.S. accounted for 15% of total net sales, and sales to the Company's top 10 customers (9 of which are OEMs) accounted for 83% of total net sales. In order for an OEM to incorporate the Company's products into its systems, the Company must demonstrate that its products provide significant commercial advantages to OEMs over competing products. There can be no assurance that the Company can successfully demonstrate such advantages or that the Company's products will continue to provide any advantages. Moreover, even if the Company is able to demonstrate such advantages, there can be no assurance that OEMs will elect to incorporate the Company's products into their current or future systems. Further, the business strategies and manufacturing practices of the Company's OEM customers are subject to change and any such change may result in decisions by the customers to decrease their purchases of the Company's products, seek other sources for products currently manufactured by the Company or manufacture these products internally. The Company's OEM customers may also seek price concessions from the Company. Failure of OEMs to incorporate the Company's products into their systems, the failure of such OEMs' systems to achieve market acceptance or any other event causing a decline in the Company's sales to OEMs would have a material adverse effect on the Company's business and operating results. DEPENDENCE ON SALES TO GOVERNMENT CONTRACTORS Approximately 51%, 39%, 28% and 18% of the Company's net sales during 1995, 1996, 1997 and the first three months of 1998, respectively, were derived from sales of the Company's SwapBox product for use by the U.S. government, all of which were made under contracts between the Company and major OEMs that sell PCs to the United States Department of Defense (the "DoD"). The Company believes that indirect sales to the DoD are subject to a number of significant uncertainties, including timing and availability of funding, unforeseen changes in the timing and quantity of government orders and the competitive nature of government contracting generally. Furthermore, the DoD has been reducing total expenditures over the past few years in a number of areas and there can be no assurance that such funding will not be reduced in the future. In addition, there is no assurance that the Company will be able to modify existing products or develop new products that will continue to meet the specifications of OEM suppliers to the DoD. A significant loss of indirect sales to the U.S. government would have a material adverse effect on the Company's business and operating results. DEPENDENCE ON DEVELOPMENT OF INDUSTRY RELATIONSHIPS The Company is party to collaborative arrangements with a number of corporations and is a member of key industry consortia. The Company has formed strategic relationships, including technology sharing agreements, with a number of key industry players such as Intel, Gemplus and Telenor. The Company evaluates, on an ongoing basis, potential strategic alliances and intends to continue to pursue such relationships. The Company's future success will depend significantly on the success of its current arrangements and its ability to establish additional arrangements. There can be no assurance that these arrangements will result in commercially successful products. COMPETITION The market for digital data security and access control products is intensely competitive and characterized by rapidly changing technology. The Company believes that competition in this 13
15 market is likely to intensify as a result of increasing demand for security products. The Company currently experiences competition from a number of sources, including: (i) ActionTec, Carry Computer Engineering, Greystone and Litronic in PC Card adapters; (ii) SmartDisk Corporation, Philips and Tritheim in smart card readers and universal smart card reader interfaces; and (iii) Gemplus in DVB-CAM modules. The Company also experiences indirect competition from certain of its customers which currently offer alternative products or are expected to introduce competitive products in the future. The Company may in the future face competition from these and other parties including new entrants, such as Motorola, that develop digital information security products based upon approaches similar to or different from those employed by the Company. In addition, there can be no assurance that the market for digital data security and access control products will not ultimately be dominated by approaches other than the approach marketed by the Company. Many of the Company's current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than the Company, and as a result, may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements, or may be able to devote greater resources to the development, promotion and sale of products, or to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Accordingly, 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 which could have a material adverse effect on the Company's business and operating results. The Company believes that the principal competitive factors affecting the market for digital data security products include: the extent to which products support industry standards and provide interoperability; technical features; ease of use; quality/reliability; level of security; strength of distribution channels; and price. There can be no assurance that the Company will be able to compete as to these or other factors or that competitive pressures faced by the Company will not materially and adversely affect its business and operating results. MANAGEMENT OF GROWTH The Company's business has grown substantially in recent periods, with net sales increasing from $6.4 million in 1994 to $27.8 million in 1997. The growth of the Company's business has placed a significant strain on the Company's management and operations. In addition, a number of key members of the Company's management, including its President and Chief Executive Officer, Chief Financial Officer, Vice President-Operations, and Vice President-Marketing have joined the Company within the past 22 months. Furthermore, in 1993 the Company commenced operations in North America which included the establishment of a U.S. management team. As a result, the Company has a limited operating history under its current U.S. management. In addition, the number of employees has grown from 50 at December 31, 1995 to 78 as of March 31, 1998. If the Company is successful in achieving its growth plans, such growth is likely to place a significant burden on the Company's operating and financial systems, resulting in increased responsibility for senior management and other personnel within the Company. There can be no 14
16 assurance that the Company's existing management or any new members of management will be able to augment or improve existing systems and controls or implement new systems and controls in response to anticipated future growth. The Company's failure to do so could have a material adverse effect on the Company's business and operating results. RISK ASSOCIATED WITH ACQUISITIONS The Company has recently entered into non-binding letters of intent with two companies (Intermart Systems K.K. in Japan and Intellicard Systems, Pte Ltd in Singapore) regarding the acquisition of such companies by the Company, and the Company's strategy is to pursue additional acquisitions and similar opportunities in the future. There can be no assurance that the two pending acquisitions will be completed on a timely basis or at all, nor that the Company will be able to identify additional acquisition opportunities or complete any future acquisition transactions. Future acquisitions by the Company may result in potentially dilutive issuances of equity securities, the incurrence of debt, write-off of purchased in-process research and development and amortization of goodwill and other intangible assets, which could materially adversely affect the Company's operating results. In addition, completed acquisitions present a number of significant risks and uncertainties, including: the risks that the Company will not be able to retain the employees or business relationships of the acquired company or otherwise effectively integrate the operations of the acquired company with those of the Company; the risk that the Company will fail to realize any synergies or other cost reduction objectives expected from the acquisition; the risks that pursuing acquisition opportunities and integrating acquired products, technologies or companies may distract management from performing their regular responsibilities; difficulties in the assimilation of the operations, products and personnel of the acquired company; risks of entering markets in which the Company has no direct prior experience; and, with respect to the acquisition of operations located at any significant distance from the Company's primary facilities, the risks and additional costs associated with managing geographically disparate operations. There can be no assurance that the Company will ever successfully complete an acquisition or that any such acquisition will result in benefits to the Company. See "--Integration of Global Locations." INTEGRATION OF GLOBAL LOCATIONS The Company's U.S. headquarters are located in Los Gatos, California, its European headquarters are located in Pfaffenhofen, Germany, and its research and development facilities are located in Erfurt, Germany and La Ciotat, France. In addition, a significant portion of the Company's contract manufacturing occurs in Singapore. Operating in diverse geographic locations imposes a number of risks and burdens on the Company, 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 the Company seeks to mitigate the difficulties associated with operating in diverse geographic locations through the extensive use of electronic mail and teleconferencing, there can be no assurance that it will not encounter unforeseen difficulties or logistical barriers in operating in diverse locations. Furthermore, operations in widespread geographic locations require the Company to implement and operate complex information systems that are capable of providing timely information which can readily be consolidated. Although the Company believes that its information systems are adequate, the Company may in the future have to implement new information systems. Implementation of such new information systems may be costly and may require training of personnel. Any failure or delay in implementing these systems, procedures and controls on a timely basis, if necessary, or in expanding these areas in an efficient manner at a pace consistent with the Company's business could have a material adverse effect on the Company's business and operating results. PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY The Company's success depends significantly upon its proprietary technology. The Company currently relies on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect its proprietary rights. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. The Company generally enters into confidentiality and non-disclosure agreements with its employees and with key vendors and suppliers. The Company's SwapBox trademark is registered in the United States, and the SwapSmart trademark is the subject of an allowed, pending application. The Company will continue to evaluate the registration of additional trademarks as appropriate. The Company currently has one U.S. patent issued, six U.S., one French and one Japanese patent applications pending, and exclusive licenses under four other U.S. patents associated with its products. Furthermore, the Company intends to obtain an exclusive license from one of its employees to five other patents relating to its products. There can be no assurance that any new patents will be issued, that the Company will develop proprietary products or technologies that are patentable, that any issued patent will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have a material adverse effect on the Company's business. 15
17 There has also been substantial litigation in the technology industry regarding intellectual property rights, and litigation may be necessary to protect the Company's proprietary technology. The Company has from time to time received claims that it is infringing upon third parties' intellectual property rights, and there can be no assurance that third parties will not in the future claim infringement by the Company with respect to current or future products, patents, trademarks or other proprietary rights. In April 1997, Gemplus served the Company with a complaint alleging that the Company's SwapSmart product infringes certain claims of a French patent held by Gemplus. Although such dispute was settled on terms acceptable to the Company, there can be no assurance that future disputes with third parties will not arise nor that any such disputes can be resolved on terms acceptable to the Company. The Company expects that companies in the computer and digital information security market will increasingly be subject to infringement claims as the number of products and competitors in the Company's target markets grows. Any such claims or litigation may be time-consuming and costly, cause product shipment delays, require the Company to redesign its products or require the Company to enter into royalty or licensing agreements, any of which could have a material adverse effect on the Company's business and operating results. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information and software that the Company regards as proprietary. 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. There can be no assurance that the Company's means of protecting its proprietary and intellectual property rights will be adequate or that the Company's competitors will not independently develop similar technology, duplicate the Company's products or design around patents issued to the Company or other intellectual property rights of the Company. DEPENDENCE ON CONTRACT AND OFFSHORE MANUFACTURING; LIMITED NUMBER OF SUPPLIERS OF KEY COMPONENTS The Company has implemented a global sourcing strategy that it believes will enable it to achieve greater economies of scale, improve gross margins and maintain uniform quality standards for its products. The Company currently sources its products through three contract manufacturers in Europe and Asia. In the event any of the Company's contract manufacturers are unable or unwilling to continue to manufacture the Company's products, the Company may have to rely on other current manufacturing sources or identify and qualify new contract manufacturers. In this regard, one of the Company's contract manufacturers has recently been involved in bankruptcy proceedings and may be unable to continue manufacturing the Company's products. In the event that such manufacturer (or any other key supplier) were unable to meet the Company's requirements, there can be no assurance that the Company would be able to identify or qualify new contract manufacturers in a timely manner or that such manufacturers would allocate sufficient capacity to the Company in order to meet its requirements. Any significant delay in the Company's ability to obtain adequate supplies of its products from its current or alternative sources would materially and adversely affect the Company's business and operating results. In an effort to reduce manufacturing costs, the Company has shifted volume production of many components of its products to Singapore. The Company is currently considering shifting the production of other components of its products to other suppliers in Europe or Asia. Difficulties encountered in transferring production may have a disruptive effect on the Company's 16
18 manufacturing process and increase overall production costs. Due to the substantial concentration of the Company's manufacturing operations in Singapore, a disruption of operations at its contractor's facilities there could have a material adverse effect on the Company's business and operating results. Foreign manufacturing is subject to 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. The Company relies upon a limited number of suppliers of several key components utilized in the assembly of the Company's products. For example, the Company purchases many of the components for use in its SwapSmart and SwapBox products from Intellicard Systems, a Singapore-based supplier, and mechanical components for use in its smart card reader product exclusively from Stocko, a German-based supplier. The Company's reliance on sole source suppliers involves several risks, including a potential inability to obtain an adequate supply of required components, price increases, late deliveries and poor component quality. Although to date the Company has been able to purchase its requirements of such components, there can be no assurance that the Company will be able to obtain its full requirements of such components in the future or that prices of such components will not increase. In addition, there can be no assurance that problems with respect to yield and quality of such components and timeliness of deliveries will not occur. Disruption or termination of the supply of these components could delay shipments of the Company's products and could have a material adverse effect on the Company's business and operating results. Such delays could also damage relationships with current and prospective customers. 17
19 DEPENDENCE ON NEW PRODUCTS; RAPID TECHNOLOGICAL CHANGE The markets for the Company's products are characterized by rapid technological change, changing customer needs, frequent new product introduction and evolving industry standards and short product lifecycles. The introduction by the Company or its competitors of products embodying new technologies and the emergence of new industry standards could render the Company's existing products obsolete and unmarketable. Therefore, the Company's future success will depend upon its ability to successfully develop and to introduce on a timely and continuous basis new and enhanced products that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. The timing and success of product development is unpredictable due to the inherent uncertainty in anticipating technological developments, the need for coordinated efforts of numerous technical personnel and the difficulties in identifying and eliminating design flaws prior to product release. Any significant delay in releasing new products could have a material adverse effect on the ultimate success of a product and other related products and could impede continued sales of predecessor products, any of which could have a material adverse effect on the Company's business and operating results. There can be no assurance that the Company will be able to introduce new products on a timely basis, that new products introduced by the Company will achieve any significant degree of market acceptance or that any such acceptance will be sustained for any significant period. Failure of new products to achieve or sustain market acceptance could have a material adverse effect on the Company's business and operating results. RISKS OF INTERNATIONAL SALES; CURRENCY FLUCTUATIONS The Company was originally a German corporation and continues to conduct a substantial portion of its business in Europe. Approximately 49%, 53%, 69% and 79% of the Company's revenues in 1995, 1996, 1997, and the first three months of 1998, respectively, were derived from customers located outside the United States. Because a significant number of the Company's principal customers are located in other countries, the Company anticipates that international sales will continue to account for a significant portion of its revenues. As a result, a significant portion of the Company's 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 and exchange controls and potential adverse tax consequences. These factors may have a material adverse effect on the Company's business and operating results. As a result of the Company's multinational operations and sales, the Company's operating results are subject to significant fluctuations based upon changes in the exchange rates of certain currencies, particularly the German mark, in relation to the U.S. dollar. The Company does not currently engage in hedging activities with respect to its foreign currency exposure. Although management will continue to monitor the Company's exposure to currency fluctuations, and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, there can be no assurance that exchange rate fluctuations will not have a material adverse effect on the Company's business and operating results. In the future, the Company could be required to denominate its product sales in other currencies, which would make the management of currency fluctuations more difficult and expose the Company to greater risks in this regard. 18
20 PRODUCT LIABILITY RISKS Customers rely on the Company's token-based security products to prevent unauthorized access to their digital content. A malfunction of or design defect in the Company's products could result in tort or warranty claims. Although the Company attempts to reduce the risk of exposure from such claims through warranty disclaimers and liability limitation clauses in its sales agreements and by maintaining product liability insurance, there can be no assurance that such measures will be effective in limiting the Company's liability for any such damages. Any liability for damages resulting from security breaches could be substantial and could have a material adverse effect on the Company's business and operating results. In addition, a well-publicized actual or perceived security breach involving token-based security systems could adversely affect the market's perception of token-based security products in general, or the Company's products in particular, regardless of whether such breach is attributable to the Company's products. This could result in a decline in demand for the Company's products, which would have a material adverse effect on the Company's business and operating results. YEAR 2000 COMPLIANCE Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, many companies' software and computer systems may need to be upgraded or replaced in order to comply with such "Year 2000" requirements. Although the Company believes that its products and systems are Year 2000 compliant, the Company utilizes third-party equipment or software that may not be Year 2000 compliant. Failure of such third-party equipment or software to operate properly with regard to the Year 2000 and thereafter could require the Company to incur unanticipated expenses to remedy any problems, which could have a material adverse effect on the Company's business and operating results. Furthermore, the purchasing patterns of customers or potential customers may be affected by Year 2000 issues as companies expend significant resources to correct their current systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase products and services such as those offered by the Company, which could have a material adverse effect on the Company's business and operating results. DEPENDENCE ON KEY PERSONNEL; ABILITY TO RECRUIT PERSONNEL The Company's future performance depends in significant part upon the continued service of Robert Schneider, the Company's Chairman of the Board, Steven Humphreys, the Company's President and Chief Executive Officer, and Bernd Meier, the Company's Chief Operating Officer, as well as its other key technical and senior management personnel. The Company 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, the Company's German subsidiary has entered into substantially similar employment agreements with each of Messrs. Schneider and Meier pursuant to which each serves as a Managing Director of the subsidiary. Each of the respective agreements has no set termination date, may be terminated by the subsidiary or the officer with six months notice, and provides that the officer is bound by a 19
21 non-compete provision during the one-year period following his termination. Non-compete agreements are, however, generally difficult to enforce and therefore these provisions may not provide significant protection to the Company. The Company also has an employment agreement with Jean-Yves Le Roux, its Vice President, Engineering, that is terminable by either party at will. The Company does not have employment agreements with any of its other key employees and does not maintain key man life insurance on any of its employees. The loss of the services of one or more of the Company's officers or other key employees could have a material adverse effect on the Company's business and operating results. The Company believes that its future success will depend in large part on its continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its key technical and management employees or that it can attract, assimilate or retain other highly qualified technical and management personnel in the future. POTENTIAL VOLATILITY OF STOCK PRICE 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 the Company's Common Stock has been highly volatile and is likely to continue to be so. Factors such as variations in the Company's financial results, comments by security analysts, the Company's ability to increase its manufacturing capability as required by customer demand, any loss of key management, announcements of technological innovations or new products by the Company or its competition, patents or other proprietary rights or product or patent litigation, may have a significant effect on the market price of the Company's Common Stock. 20
22 PART II: OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. 27 Financial Data Schedule (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the quarter ended March 31, 1998. 21
23 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: May 14, 1998 /s/ JOHN G. NIEDERMAIER ------------------------------- John G. Niedermaier Vice President- Finance, Chief Financial Officer (Principal Financial and Accounting Officer) 22
24 INDEX TO EXHIBITS <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION - ------ ----------- <S> <C> 27 Financial Data Schedule </TABLE>