Actividentity 10-Q 2005 Q2 Quarterly report

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, 2005

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 000-50223

ActivCard Corp.

(Exact name of Registrant as specified in its charter)

Delaware	45-0485038
(State or other jurisdiction of incorporation or organization)	(I.R.S. employer identification no.)
6623 Dumbarton Circle, Fremont, CA	94555
(Address of principal executive offices)	(Zip Code)

(510) 574-0100

(Registrant’s telephone number, including area code)

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

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

As of April 30, 2005, the Registrant had outstanding 43,928,982 shares of Common Stock.

ACTIVCARD CORP.

INDEX TO QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED MARCH 31, 2005

		Page
	PART I    FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS
	CONSOLIDATED BALANCE SHEETS	3
	CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS	4
	CONSOLIDATED STATEMENTS OF CASH FLOWS	5
	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS	6
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	17
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	35
ITEM 4.	CONTROLS AND PROCEDURES	36
	PART II    OTHER INFORMATION
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	37
ITEM 5.	OTHER INFORMATION	37
ITEM 6.	EXHIBITS	38
	SIGNATURE	39

2

PART I    FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ACTIVCARD CORP.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

	March 31, 2005			September 30, 2004(1)
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	13,123		$	17,113
Short-term investments		171,086			196,950
Accounts receivable, net of allowance for doubtful accounts		6,392			5,325
Inventories		1,711			1,996
Prepaid expenses and other current assets		3,535			2,450
Total current assets		195,847			223,834
Property and equipment, net		3,487			3,989
Restricted investments		—			715
Other intangible assets, net		3,018			2,286
Other long-term assets		835			800
Goodwill		15,356			19,462
Total assets	$	218,543		$	251,086
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,480		$	2,324
Short-term borrowings		—			1,605
Accrued compensation and related benefits		5,294			7,339
Current portion of accrual for restructuring, business realignment, and severance benefits		927			1,262
Accrued and other current liabilities		2,650			3,278
Current portion of deferred revenue		4,606			6,962
Total current liabilities		15,957			22,770
Long-term deferred revenue, net of current portion		2,858			3,677
Long-term portion of accrual for restructuring, business realignment, and severance benefits, net of current portion		3,438			3,605
Long-term deferred rent		1,130			1,109
Total liabilities		23,383			31,161
Minority interest		1,326			1,394
Commitments and Contingencies (Note 11)
Stockholders’ equity:
Preferred stock, $0.001 par value:
10,000,000 shares authorized, none issued and outstanding		—			—
Common stock, $0.001 par value:
75,000,000 shares authorized, 43,803,506 issued and outstanding at March 31, 2005 and 42,483,883 issued and outstanding at September 30, 2004		44			42
Additional paid-in capital		409,481			400,014
Deferred employee stock-based compensation		(834	)		(639	)
Accumulated deficit		(199,000	)		(166,805	)
Accumulated other comprehensive loss		(15,857	)		(14,081	)
Total stockholders’ equity		193,834			218,531
Total liabilities and stockholders’ equity	$	218,543		$	251,086

⁽¹⁾ Derived from audited consolidated financial statements.

See accompanying notes to consolidated financial statements.

3

ACTIVCARD CORP.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
Revenue:
Hardware	$	2,632		$	3,797		$	6,477		$	7,013
Software		4,317			1,997			9,998			4,075
Maintenance and support		2,207			1,509			4,236			2,938
		9,156			7,303			20,711			14,026
Cost of revenue:
Hardware		1,584			1,816			3,672			3,742
Software		1,443			731			2,400			1,957
Maintenance and support		620			478			1,263			940
Amortization and impairment of acquired developed technology		4,357			102			4,613			204
		8,004			3,127			11,948			6,843
Gross profit		1,152			4,176			8,763			7,183
Operating expenses:
Sales and marketing		7,442			5,409			15,090			10,027
Research and development		4,254			4,934			9,004			10,263
General and administration		2,742			1,544			5,643			3,157
Impairment of goodwill		9,426			—			9,426			—
Write-down of acquired intangible assets		2,352			—			2,352			—
Amortization of acquired intangible assets		611			12			626			34
Restructuring, business realignment, and severance benefits		409			1,187			409			1,391
In-process research and development		—			—			537			—
Total operating expenses		27,236			13,086			43,087			24,872
Loss from operations		(26,084	)		(8,910	)		(34,324	)		(17,689	)
Other income (expenses):
Interest income, net		1,063			1,016			2,139			2,038
Other income (expense), net		(283	)		410			70			437
Equity in net loss of Aspace Solutions Limited		—			(1,572	)		—			(3,111	)
Total other income (expenses), net		780			(146	)		2,209			(636	)
Loss before income taxes and minority interest		(25,304	)		(9,056	)		(32,115	)		(18,325	)
Income taxes		(108	)		(55	)		(110	)		(209	)
Minority interest		5			35			30			80
Net loss	$	(25,407	)	$	(9,076	)	$	(32,195	)	$	(18,454	)
Other comprehensive income (loss):
Unrealized (loss) gain on marketable securities, net	$	(630	)	$	252		$	(1,232	)	$	(108	)
Foreign currency translation (loss) gain		(61	)		(407	)		(543	)		173
Comprehensive loss	$	(26,098	)	$	(9,231	)	$	(33,970	)	$	(18,389	)
Basic and diluted net loss per common share	$	(0.58	)	$	(0.22	)	$	(0.75	)	$	(0.44	)
Shares used to compute basic and diluted net loss per share		43,485			42,144			43,080			42,123

See accompanying notes to consolidated financial statements.

4

ACTIVCARD CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended March 31,
	2005			2004
Cash flows from operating activities:
Net loss from operations	$	(32,195	)	$	(18,454	)
Adjustments to reconcile net loss from operations to net cash used in operations:
Depreciation and amortization		1,019			1,219
Amortization and impairment of acquired developed technology		4,613			204
Impairment of goodwill		9,426			—
Write-down of acquired intangible assets		2,352			—
Amortization of acquired intangible assets		626			34
In-process research and development		537			—
Amortization of employee stock-based compensation		112			119
Loss on disposal of property and equipment		22			—
Minority interest in ActivCard S.A.		(30	)		(80	)
Equity in net loss of Aspace Solutions Limited		—			3,111
Changes in:
Accounts receivable		(927	)		2,684
Inventories		359			387
Prepaid expenses and other current assets		(590	)		605
Accounts payable		77			(152	)
Accrued compensation and related benefits		(2,238	)		(818	)
Accrual for restructuring, business realignment, and severance benefits		(537	)		162
Accrued and other current liabilities		(78	)		(358	)
Deferred revenue		(3,244	)		752
Deferred rent		20			146
Cash used in operating activities		(20,676	)		(10,439	)
Cash flows from investing activities:
Purchases of property and equipment		(555	)		(1,133	)
Purchases of short-term investments		(14,159	)		(127,238	)
Proceeds from sale or maturities of short-term investments		38,375			100,854
Cash used in acquisition of Aspace Solutions Limited		(7,162	)		—
Investment in and loans to Aspace Solutions Limited		—			(2,177	)
Acquisition of ActivCard S.A. minority interest		(33	)		—
Other long-term assets		(22	)		184
Cash provided by (used in) investing activities		16,444			(29,510	)
Cash flows from financing activities:
Proceeds from exercise of stock options, rights, and warrants		2,145			806
Repayment of short-term borrowings		(1,670	)		—
Repayment of long-term debt		—			(3	)
Cash provided by financing activities		475			803
Effect of exchange rate changes		(233	)		83
Net decrease in cash and cash equivalents		(3,990	)		(39,063	)
Cash and cash equivalents, beginning of period		17,113			80,101
Cash and cash equivalents, end of period	$	13,123		$	41,038
Supplemental disclosures:
Cash paid for interest	$	54		$	1
Cash paid for income taxes		65			92
Non-cash financing activities:
Issuance of common stock in connection with acquisition of Aspace Solutions Limited	$	7,023		$	—

See accompanying notes to consolidated financial statements.

5

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended March 31, 2005 and 2004

(Unaudited)

1. Basis of Presentation

The accompanying condensed consolidated financial statements include the accounts of ActivCard Corp. and its wholly owned subsidiaries (Company). The Company has subsidiaries in Asia, Australia, Canada, Europe, and South Africa.

These interim 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 the rules and regulations of the Securities and Exchange Commission for interim financial statements. In the opinion of management, the unaudited condensed consolidated financial statements include all adjustments (consisting only of normal recurring accruals) that management considers necessary for a fair presentation of the Company’s financial position, operating results and cash flows for the interim periods presented. All inter-company accounts and transactions have been eliminated in consolidation. Operating results and cash flows for interim periods are not necessarily indicative of results to be expected for the entire fiscal year ending September 30, 2005.

These interim condensed consolidated financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Transition Report on Form 10-K for the nine month transition period ended September 30, 2004.

Change in fiscal year end –In September 2004, the Company changed its fiscal year end from December 31 to September 30. Accordingly, the consolidated financial information for three months ended March 31, 2005 reflects the Company’s second quarter of fiscal 2005 and the consolidated financial information for the six months ended March 31, 2005 reflects the first six months of fiscal 2005. The comparative historical consolidated financial information for the three months ended March 31, 2004 reflects the Company’s first quarter of fiscal 2004. The comparative historical financial information for the six months ended March 31, 2004 reflects the six month period comprised of the Company’s fourth fiscal quarter of fiscal 2003, ended December 31, 2003 and the first fiscal quarter of fiscal 2004, ended March 31, 2004.

Reclassifications –The Company has made the following reclassifications of prior period expenses to conform to the current period’s presentation.

• The Company has reclassified auction rate securities of $4.6 million in the consolidated balance sheet as of September 30, 2004 from cash and cash equivalents to short-term investments;

• The Company has reclassified $102,000 for the three months ended March 31, 2004, and $204,000 for the six months ended March 31, 2004, from amortization of acquired intangibles to amortization of acquired developed technology;

• The Company has reclassified $716,000 for the three months ended March 31, 2004, and $1,479,000 for the six months ended March 31, 2004, from sales and marketing expense to research and development expense; and

• The Company has reclassified $166,000 for the three months ended March 31, 2004, and $400,000 for the six months ended March 31, 2004, from research and development expense to general and administration expense.

6

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

These reclassifications had no effect on reported revenues, net loss, net loss per share, or stockholders’ equity.

Recent Accounting Pronouncements –In December 2004, the Financial Accounting Standards Board (FASB) revised and retitled Statement of Financial Accounting Standards (SFAS) No. 123R,Share-BasedPayment. SFAS No. 123R establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions where an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS No. 123R is effective as of the first fiscal year that begins on or after June 15, 2005. The Company will adopt the provisions of SFAS No. 123R for its first quarter of fiscal 2006 beginning October 1, 2005. Management is currently assessing the impact of adopting SFAS No. 123R.

2. Stock-Based Compensation

The Company is required to report pro forma earnings as if the Company had accounted for its stock-based awards to employees under the fair value method of SFAS No. 123,Accounting for Stock Based Compensation. For purposes of pro forma reporting, the fair value of stock-based awards to employees is calculated using the Black-Scholes options pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.

The weighted-average fair value of stock-based compensation to employees is based on the single option valuation approach. Forfeitures are recognized as they occur and it is assumed no dividends will be declared. The estimated fair value of stock-based compensation awards to employees is amortized using the straight-line method over the vesting period of the options. The weighted-average fair value calculations are based on the following weighted-average assumptions:

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
Risk-free interest rate	3.7	%	3.0	%	3.4	%	3.2	%
Expected volatility	45	%	46	%	45	%	47	%
Expected life (years)	4.0		4.0		4.0		4.3

7

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

Pro forma results are as follows (in thousands, except per share amounts):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
Net loss, as reported	$	(25,407	)	$	(9,076	)	$	(32,195	)	$	(18,454	)
Less: Employee stock-based compensation expense included in reported net loss		(166	)		61			112			119
Add: Total employee stock-based compensation expense determined under fair value based method for all awards		(762	)		(204	)		4,135			(5	)
Pro forma net loss	$	(26,335	)	$	(9,219	)	$	(27,948	)	$	(18,340	)
Basic and diluted net loss per share, as reported	$	(0.58	)	$	(0.22	)	$	(0.75	)	$	(0.44	)
Basic and diluted net loss per share, pro forma	$	(0.61	)	$	(0.22	)	$	(0.65	)	$	(0.44	)
Shares used to compute basic and diluted loss per share		43,485			42,144			43,080			42,123

For the six months ended March 31, 2005, the total employee stock-based compensation expense determined under the fair value based method reduces the pro forma net loss as a result of the cancellation of stock options for which the amortization of the fair value compensation expense had been previously included in our pro forma results. Cancellations consist primarily of unexercised options of former employees.

3. Business Combinations

Aspace Solutions Limited

In July 2003, the Company acquired a 38% interest in Aspace Solutions Limited (Aspace) by purchasing 38,140 common shares of Aspace from existing shareholders for £954,000 (£25.00 per share) or $1.6 million. In connection with the acquisition of common shares, the Company also provided Aspace with a two-year, senior convertible loan in the amount of £2.5 million or $4.1 million, bearing interest at 6% per annum, with a right to convert the loan into common shares.

In December 2003, the Company provided Aspace with an additional two-year loan facility in the amount of £1.0 million or $1.7 million, bearing interest at 6% per annum and repayable on November 30, 2005. In connection with the additional loan, the Company received warrants convertible into 21,245 newly issued shares of Aspace at a price of £0.01 per share. The Company exercised the warrant conversion rights in December 2003 increasing its ownership to 59,385 common shares or 49% of the outstanding common shares of Aspace.

In May 2004, the Company provided Aspace with an additional loan of £250,000 or $458,000, payable upon demand. Prior to the May 2004 loan, generally accepted accounting principles required the Company to record 100% of the net losses incurred by Aspace despite holding less than a controlling interest because the investments of other shareholders had been fully applied to previous losses. The May 2004 loan constituted a reconsideration event in accordance with FASB Interpretation No. 46R,Consolidation of Variable Interest Entities. Accordingly, management determined that the total equity investment at risk in Aspace was not sufficient to permit Aspace to finance its activities without additional subordinated financial support provided by

8

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

any party, including equity holders. As a result, effective May 27, 2004, the Company was required to consolidate the financial results of Aspace. The fair value of Aspace’s equity and intangible assets were based on independent valuations prepared using estimates and assumptions provided by management. The fair value of tangible assets and liabilities were determined by management using estimates of current replacement cost. The value of the tangible and intangible assets were established effective May 27, 2004 and recorded in the condensed consolidated financial statements as follows (in thousands):

Current assets	$	214
Property and equipment		212
Other intangible assets subject to amortization:
Developed technology		1,246
Customer relationships		100
In-process research and development costs		383
Goodwill		4,140
Total assets recorded upon consolidation		6,295
Current liabilities		(1,979	)
Other investors’ interest		(292	)
Net assets consolidated	$	4,024

Approximately $383,000 of the enterprise value was allocated to the estimated fair value of an in-process research and development project. At the date of consolidation, the project had not reached technological feasibility and had no future alternative use. Accordingly, the value allocated to the project was charged to operations on the date of consolidation. The estimated fair value of the project was determined by applying the income approach, which considers the present value of the projected free cash flows that will be generated by the products, incorporating the acquired technologies under development, assuming they will be successfully completed. The discount rate used was 30% to take into account the novelty of the technology, the extent of Aspace’s familiarity with the technology, the stage of completion and the risks surrounding successful development and commercialization of the project.

In September and October 2004, the Company provided additional loans to Aspace in the total amount of £1.0 million or $1.8 million, originally due and payable on February 7, 2005. In November 2004, the Company loaned Aspace an additional £330,000 or $597,000, originally due and payable on February 7, 2005.

In December 2004, the Company acquired the remaining 51% equity interest of Aspace for total consideration of $14.2 million, including $393,000 of direct acquisition costs. In December 2004, the Company paid cash of £2.5 million, or $4.9 million, and issued 579,433 shares of common stock, valued at approximately $5.1 million, for the initial purchase consideration. In January 2005, the Company paid additional cash consideration of £1.0 million, or $1.9 million and issued 231,773 shares of common stock, valued at approximately $1.9 million, to the Aspace selling shareholders for fulfilling an earn-out contingency.

The Company acquired Aspace to expand its financial segment product portfolio and increase its penetration in the financial services market. Management expects to leverage the potential customer relationships of Aspace as well as to be able to cross sell the Aspace products to its existing customers.

The fair value of the Company’s common stock issued to Aspace shareholders as part of the initial consideration was determined based on the average closing price per share of the Company’s common stock over

9

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

a 5-day period beginning two trading days before and ending two trading days after the terms of acquisition were agreed and announced in December 2004. The fair value of the Company’s common stock issued to Aspace shareholders as part of fulfilling an earn-out contingency was determined based on the average closing price per share of the Company’s common stock over a 5-day period beginning two trading days before and ending two trading days after the fulfillment of the earn-out contingency in January 2005. Fair values of intangible assets acquired are based on an independent valuation prepared using estimates from management. The purchase price, paid as of March 31, 2005, for the remaining 51% of Aspace has been allocated as follows (in thousands):

Purchased technology	$	4,474
Customer relationships		3,856
In-process research and development		537
Goodwill		5,320
Total	$	14,187

The Company is amortizing the purchased technology and customer relationships over their estimated useful lives of one to three years.

A total of $537,000 of the additional Aspace enterprise value was allocated to the estimated fair value of an in-process research and development project. At the date of acquisition, the project had not reached technological feasibility and had no alternative future use. Accordingly, the value allocated to the project was expensed to operations on the date of acquisition. The estimated fair value of the project was determined by applying the income approach, which considers the present value of the projected free cash flows that will be generated by the products, incorporating the acquired technologies under development, assuming they will be successfully completed. The discount rate used was 25% to take into account the novelty of the technology, the extent of Aspace’s familiarity with the technology, the stage of completion and the risks surrounding successful development and commercialization of the project. The Company began consolidating the operations of Aspace from May 2004, the date it became a variable interest entity under FASB Interpretation No. 46R,Consolidation of Variable Interest Entities. As the acquisition of the remaining 51% equity interest resulted only in additional intangible assets of $8.3 million, goodwill of $5.3 million and additional amortization of intangible assets of $1.1 million in the six months ended March 31, 2005, correspondingly pro forma results of operations are not presented. Subsequent to the purchase date, Aspace failed to satisfy an earn-out contingency, resulting in a write-down of the acquired intangible assets and goodwill. See further discussion in Note 6 and Note 7.

4. Accounts Receivable and Customer Concentration

Activity in the allowance for doubtful accounts is as follows (in thousands):

Balance, December 31, 2003	$	42
Provision for doubtful accounts		100
Amounts written off		(7	)
Balance, September 30, 2004		135
Provision for doubtful accounts		225
Amounts written off		(11	)
Balance, March 31, 2005	$	349

No one customer accounted for over 10% of accounts receivable as of March 31, 2005. One customer accounted for 12% of accounts receivable as of September 30, 2004.

10

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

The following customers accounted for 10% or more of total revenue:

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
Customer A	10	%	—		—		—
Customer B	—		—		14	%	—
Customer C	—		22	%	—		23	%

5. Inventories

Inventories consist of the following (in thousands):

	March 31, 2005		September 30, 2004
Components	$	634	$	1,088
Finished Goods		1,077		908
	$	1,711	$	1,996

6. Other Intangible Assets

Other intangible assets consist of the following (in thousands):

	March 31, 2005
	Gross Amount		Accumulated Amortization		Net
Acquired developed technology	$	8,416	$	6,447	$	1,969
Customer relationships		1,367		325		1,042
Patents		661		654		7
	$	10,444	$	7,426	$	3,018

In March 2005, Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement, resulting in the Company revising its near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit, the Company determined that the carrying value of the intangible assets associated with the reporting unit exceeded their fair value, resulting in write-downs of $3.6 million and $2.4 million related to acquired developed technology and customer relationships, respectively, in the three months ended March 31, 2005.

	September 30, 2004
	Gross Amount		Accumulated Amortization		Net
Acquired developed technology	$	8,493	$	6,385	$	2,108
Customer relationships		487		324		163
Patents		661		646		15
	$	9,641	$	7,355	$	2,286

11

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

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

	Acquired Developed Technology		Customer Relationships		Patents
Fiscal years ending September 30,
2005 (remaining 6 months)	$	474	$	466	$	7
2006		909		555		—
2007		577		21		—
2008		9		—		—
	$	1,969	$	1,042	$	7

7. Goodwill

Changes in goodwill are as follows (in thousands):

Balance, December 31, 2003	$	15,322
Goodwill recorded upon initial consolidation of Aspace Solutions Limited (see Note 3)		4,140
Balance, September 30, 2004		19,462
Goodwill recorded upon acquisition of remaining 51% of Aspace Solutions Limited (see Note 3)		5,320
Impairment of Goodwill		(9,426	)
Balance, March 31, 2005	$	15,356

In March 2005, Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement, resulting in the Company revising its near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit, the Company recorded a goodwill impairment charge of $9.4 million in the three months ended March 31, 2005.

8. Sales Warranty Reserve

Changes in sales warranty reserve are as follows (in thousands):

Balance, December 31, 2003	$	248
Warranty costs incurred		(158	)
Additions related to current period sales		38
Adjustments to reserve related to prior period sales		32
Balance, September 30, 2004		160
Warranty costs incurred		(66	)
Additions related to current period sales		24
Adjustments to reserve related to prior period sales		6
Balance, March 31, 2005	$	124

The sales warranty reserve is included in accrued and other current liabilities in the consolidated balance sheets.

12

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

9. Restructuring and Business Realignment Expenses

The Company has accounted for its 2002 restructuring under Emerging Issue Task Force Issue No. 94-3,Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, is effective for restructurings activities initiated after December 15, 2002, therefore the 2003 and 2004 restructurings have been accounted for under SFAS No. 146.

2002 Restructuring Plan

In February 2002, the Company commenced a restructuring of its business to enhance operational efficiency and reduce expenses. The plan included reduction in workforce and excess facilities and other direct costs. The Company recorded a total charge of $8.7 million, consisting of $6.1 million for excess facilities and $2.6 million for costs associated with the reduction in workforce. The charge for excess facilities was comprised primarily of future minimum lease payments payable over the remaining life of the lease ending February 2011, net of estimated sublease income of $626,000. Sublease income was estimated assuming current market lease rates and vacancy periods. The charge for the reduction in workforce consisted of severance, outplacement, and other termination costs. In March 2005, the Company recorded a charge of $191,000 related to the timing of when the sublease would commence. All expenses related to the workforce reduction have been paid and the remaining cash expenditures to complete the facility exit activities will be made over the remaining life of the lease ending February 2011.

2003 Restructuring Plan

In March 2003, the Company took measures to restructure its business and reduce its operating costs by implementing a reduction in workforce that resulted in the termination of 17 employees. Of the terminated employees, nine were in sales and marketing, seven were in research and development, and one was in manufacturing and logistics. The Company recorded a total charge of $1.3 million associated with the reduction in workforce consisting of severance, outplacement, and other termination costs. All expenses related to this restructuring plan have been paid.

2004 Restructuring Plan

In March 2004, the Company initiated a restructuring plan to reduce operating costs, streamline and consolidate operations, and reallocate resources. The plan included a reduction in workforce that resulted in the termination of 109 employees, closure of five facilities, and termination of a non-strategic project under an existing agreement. As of March 31, 2005, the Company has recorded a total charge of $3.7 million, consisting of $3.1 million for workforce reduction, $618,000 for excess facilities, and $40,000 for the termination of the non-strategic project. The non-strategic project was terminated during the three months ended March 31, 2004. All 109 employees have been terminated as of December 31, 2004, of whom 19 were in sales and marketing, 63 in research and development, three in manufacturing and logistics, and 24 in general and administrative functions. Charges for the reduction in workforce consisted of severance, outplacement, and other termination costs. As part of the restructuring, in September 2004, the Company vacated its Canada office and recorded a charge related to the remaining liability under the associated lease net of estimated sublease income of $855,000. Sublease income was estimated assuming current market lease rates and vacancy periods. In March 2005, the Company recorded a charge of $218,000 related to the timing of when the sublease would commence and reduced the expected sublease income. Remaining cash expenditures to complete the facility exit activities will be made over the remaining life of the lease ending June 2008. The remaining cash payments to complete the workforce reduction are expected to be made by June 30, 2005.

13

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

The following summarizes the restructuring activity (in thousands):

	2002 Restructuring Facility Exit Costs			2003 Restructuring Workforce Reduction			2004 Restructuring
							Workforce Reduction			Project Termination			Facility Exit Costs			Total
Balances, December 31, 2003	$	4,507		$	244		$	—		$	—		$	—		$	4,751
Provision for restructuring and business realignment costs		—			—			3,110			40			400			3,550
Adjustments to accruals for changes in estimates		10			—			(31	)		—			—			(21	)
Cash payments		(519	)		(244	)		(2,620	)		(40	)		—			(3,423	)
Impact of exchange rates		—			—			23			—			—			23
Non-cash charges		—			—			—			—			(13	)		(13	)
Balances, September 30, 2004	$	3,998		$	—		$	482		$	—		$	387		$	4,867
Cash payments		(165	)		—			(264	)		—			(82	)		(511	)
Impact of exchange rates		—			—			23			—			24			47
Balances, December 31, 2004	$	3,833		$	—		$	241		$	—		$	329		$	4,403
Adjustments to accruals for changes in estimates		191			—			—			—			218			409
Cash payments		(167	)		—			(196	)		—			(75	)		(438	)
Impact of exchange rates		—			—			(10	)		—			1			(9	)
Balances, March 31, 2005		3,857			—			35			—			473			4,365
Less current portion		(691	)		—			(35	)		—			(201	)		(927	)
Long-term portion	$	3,166		$	—		$	—		$	—		$	272		$	3,438

10. Net Loss Per Share

The following is a reconciliation of the numerator and denominator used to determine basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
Numerator:
Net loss	$	(25,407	)	$	(9,076	)	$	(32,195	)	$	(18,454	)
Denominator:
Weighted average number of shares outstanding		43,485			42,144			43,080			42,123
Basic and diluted net loss per share	$	(0.58	)	$	(0.22	)	$	(0.75	)	$	(0.44	)

For the above mentioned periods the Company had securities outstanding which could potentially dilute basic earnings per share in the future, which were excluded from the computation of diluted net loss per share in the periods presented as their impact would have been antidilutive. Weighted average common share equivalents, consisting of stock options and restricted stock units outstanding, excluded from the calculation of diluted net

14

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

loss per share were 836,328 and 450,081, respectively, in the three months ended March 31, 2005 and 2004. Weighted average common share equivalents, consisting of stock options and restricted stock units outstanding, excluded from the calculation of diluted net loss per share were 1,015,476 and 728,857, respectively, in the six months ended March 31, 2005 and 2004.

11. Contingencies

In the ordinary course of business, from time to time, the Company has been named as a defendant in legal actions arising from its normal business activities, which management believes will not have a material adverse effect on the Company’s financial condition or results of operations.

In the ordinary course of business, the Company enters into standard indemnification agreements with certain of its customers and business partners. These agreements include provisions for indemnifying the customer against any claim brought by a third-party to the extent any such claim alleges that an ActivCard product infringes a patent, copyright or trademark, or violates any other proprietary rights of that third-party. It is not possible to estimate the maximum potential amount of future payments the Company could be required to make under these indemnification agreements. To date, the Company has not incurred any costs to defend lawsuits or settle claims related to these indemnification agreements. No liability for these indemnification agreements has been recorded at March 31, 2005 or September 30, 2004.

As permitted under Delaware law, the Company has agreements indemnifying its executive officers and directors for certain events and occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is not estimable. The Company maintains directors and officers liability insurance designed to enable it to recover a portion of any such future payments. No liability for these indemnification agreements has been recorded at March 31, 2005 or September 30, 2004.

15

ACTIVCARD CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Six Months Ended March 31, 2005 and 2004

(Unaudited)

12. Segment Information

The Company operates in one segment, Digital Identity Solutions. Accordingly, the Company is disclosing segmented information by geographic area only. Transfers between geographic areas are eliminated in the consolidated financial statements. The following is a summary of operations by geographic region (in thousands):

	North America			Europe			Asia Pacific			Total
Three months ended March 31, 2005
Total revenue	$	4,465		$	4,212		$	479		$	9,156
Loss from operations		(4,956	)		(21,110	)		(18	)		(26,084	)
Capital expenditures		106			181			9			296
Depreciation and amortization		193			277			14			484
Three months ended March 31, 2004
Total revenue	$	2,839		$	4,235		$	229		$	7,303
Loss from operations		(6,229	)		(2,252	)		(429	)		(8,910	)
Capital expenditures		465			148			12			625
Depreciation and amortization		269			289			19			577
Six months ended March 31, 2005
Total revenue	$	10,679		$	8,872		$	1,160		$	20,711
Income (loss) from operations		(9,520	)		(24,870	)		66			(34,324	)
Capital expenditures		218			328			9			555
Depreciation and amortization		410			554			55			1,019
Six months ended March 31, 2004
Total revenue	$	5,279		$	8,262		$	485		$	14,026
Loss from operations		(12,054	)		(4,737	)		(898	)		(17,689	)
Capital expenditures		637			462			34			1,133
Depreciation and amortization		561			591			67			1,219
March 31, 2005
Goodwill		8,699			6,550			107			15,356
Long-lived assets		2,780			4,486			74			7,340
Total assets		194,749			20,980			2,814			218,543
September 30, 2004
Goodwill		8,698			10,657			107			19,462
Long-lived assets		3,561			4,035			194			7,790
Total assets		224,309			23,685			3,092			251,086

The Europe segment includes the goodwill impairment charge of $9.4 million and the write-down of acquired intangible assets of $6.0 million recorded in the three months ended March 31, 2005.

13. Subsequent Events

On April 1, 2005, the Company decided to implement an organizational restructuring that includes the elimination of approximately 10% of its workforce. As a result of the restructuring, the Company expects to record a one-time restructuring charge related to severance of approximately $900,000 in the three months ending June 30, 2005.

16

On May 9, 2005, the Compensation Committee of the Board of Directors determined that the vesting criteria for the restricted stock grant made to Ben C. Barnes, the Company’s Chief Executive Officer, under Mr. Barnes’s employment agreement, dated May 29, 2004 had not been satisfied as of March 31, 2005. As a result, 100,000 shares of restricted common stock that had been previously purchased by Mr. Barnes for $0.001 per share were being purchased by the Company for the purchase price. Accordingly, the amortization charge of $276,000 previously recorded by the Company was reversed in the quarter ended March 31, 2005 and a corresponding adjustment for the amortized and unamortized portions of the award, which amounted to $890,000 in the aggregate, was made to paid-in capital at that time.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included in this Quarterly Report on Form 10-Q, other than statements that are purely historical, are forward-looking statements. Words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “seeks”, “estimates”, and similar expressions also identify forward-looking statements. Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. Forward-looking statements in this Quarterly Report on Form 10-Q include, without limitation, statements regarding operating results, product development, marketing initiatives, business plans, and anticipated trends. The forward-looking statements in this Quarterly Report on Form 10-Q are subject to additional risks and uncertainties further discussed under “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risks Factors” and in our Transition Report on Form 10-K for the fiscal year ended September 30, 2004 filed with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q.

The following discussion of our financial condition and results of operations should be read in conjunction with our Condensed Consolidated Financial Statements and related notes included in “Item 1. Financial Statements” in this Quarterly Report on Form 10-Q.

Overview

We develop, market, and support strong authentication and trusted digital identity systems and products that enable our customers to issue, use, and maintain digital identities in a secure, manageable, and reliable manner. Our solutions and products include software and hardware products that facilitate the authentication of a user to a network, a system, or applications through different security devices, such as smart cards, tokens, biometric devices, mobile phones, and personal digital assistants. Our solutions enable organizations to confirm identities before granting access to computer networks, applications, and physical locations. We market our solutions to governments, financial institutions, network service providers, and enterprise customers directly through our own sales organization and indirectly through system integrators, value added resellers, and original equipment manufacturers.

Significant events

Our financial results for the three and six months ended March 31, 2005 and 2004, respectively were affected by certain significant events that should be considered in comparing the periods presented.

17

Change in fiscal year

In September 2004, we changed our fiscal year end from December 31 to September 30. Accordingly, the consolidated financial information for three months ended March 31, 2005 reflects our second quarter of fiscal 2005 and the consolidated financial information for the six months ended March 31, 2005 reflects the first six months of fiscal 2005. The comparative historical consolidated financial information for the three months ended March 31, 2004 reflects our first quarter of fiscal 2004. The comparative historical financial information for the six months ended March 31, 2004 reflects the six month period comprised of our fourth fiscal quarter of fiscal 2003, ended December 31, 2003 and the first fiscal quarter of fiscal 2004, ended March 31, 2004.

Restructurings

We have previously restructured and re-aligned portions of our business in March 2004, March 2003, and February 2002. These restructuring and re-alignment initiatives have resulted in significant charges associated with workforce reduction, facility exit costs, and other related expenses. Additionally we announced a restructuring on April 1, 2005 that will result in a reduction of approximately 10% in our workforce.

Business combinations

In December 2004, we acquired the remaining 51% equity interest of Aspace for a total consideration of $14.2 million, including $393,000 of direct acquisition costs. In December 2004, we paid cash of £2.5 million, or $4.9 million, and issued 579,433 shares of common stock, valued at approximately $5.1 million, for the initial purchase consideration. In January 2005, we paid additional cash consideration of £1.0 million, or $1.9 million and issued 231,773 shares of common stock, valued at approximately $1.9 million, to the Aspace selling shareholders for fulfilling an earn-out contingency.

Aspace develops online solutions that address multi-channel needs of organizations requiring secure access to systems that are easy to use. We acquired Aspace to expand our financial segment product portfolio and increase our penetration in the financial services market. We expect to leverage the potential customer relationships of Aspace as well as to be able to cross sell the Aspace products to our existing customers.

In March 2005, Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement resulting in us revising our near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit we determined that the carrying value of the intangible assets associated with the reporting unit exceeded their fair value, resulting in write-downs of $3.6 million and $2.4 million related to acquired developed technology and customer relationships, respectively, in the three months ended March 31, 2005. Additionally, we recorded a goodwill impairment charge of $9.4 million in the three months ended March 31, 2005.

Results of operations

Revenue

Total revenue, mix by type, and period-over-period changes are as follows (dollars in thousands):

	Three Months Ended March 31,				Percentage Change		Six Months Ended March 31,				Percentage Change
	2005		2004				2005		2004
Hardware	$	2,632	$	3,797	(31	)%	$	6,477	$	7,013	(8	)%
Software		4,317		1,997	116	%		9,998		4,075	145	%
Maintenance and support		2,207		1,509	46	%		4,236		2,938	44	%
	$	9,156	$	7,303	25	%	$	20,711	$	14,026	48	%

18

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
Hardware	29	%	52	%	31	%	50	%
Software	47		27		48		29
Maintenance and support	24		21		21		21
	100	%	100	%	100	%	100	%

Hardware revenue is comprised of tokens, readers, and smart cards. The decrease in hardware revenue of 31% to $2.6 million in the three months ended March 31, 2005 compared to $3.8 million in the three months ended March 31, 2004 was primarily due to a decrease in token sales to a major European financial institution. The decrease in hardware revenue of 8% to $6.5 million in the six months ended March 31, 2005 compared to $7.0 million in the six months ended March 31, 2004 was primarily due to a decrease in token revenue of $3.1 million.

The increase in software revenue of 116% and 145% in the three and six months ended March 31, 2005, respectively, compared to the three and six months ended March 31, 2004, respectively is primarily due to a significant increase in purchases of our client software by various departments of the U.S. Government and increased sales to our enterprise customers.

Maintenance and support revenue consists of maintenance, training, and consulting. The increase in maintenance and support revenue of 46% and 44% in the three and six months ended March 31, 2005, respectively compared to the three and six months ended March 31, 2004, respectively, was primarily due to maintenance contract renewals from a growing installed base of customers.

Revenue by geography as a percentage of total revenue, is as follows:

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
North America	49	%	39	%	51	%	38	%
Europe	46		58		43		59
Asia Pacific	5		3		6		3
	100	%	100	%	100	%	100	%

The increase in revenue in North America in the three and six months ended March 31, 2005 compared to the three and six months ended March 31, 2004, respectively, is primarily a result of growth in revenue from the U.S. Government with the decrease in Europe for the comparable periods resulting from a corresponding decline in our authentication token sales primarily to a major European financial institution.

Hardware and software revenue by segment as a percentage of total hardware revenue and software revenue, is as follows:

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
Enterprise	55	%	37	%	46	%	35	%
Government	32		20		40		19
Financial	13		43		14		46
	100	%	100	%	100	%	100	%

19

For the three and six month periods ended March 31, 2005 compared to the same periods a year ago we experienced growth in revenue from the enterprise sector and in the U.S. Government as our products gained more visibility and wider acceptance. The decline in the financial sector is due to the decline in our authentication token sales primarily to a major European financial institution.

Cost of revenue

Total cost of revenue, costs as a percentage of corresponding revenue, and period-over-period changes are as follows (dollars in thousands):

	Three Months Ended March 31,						Percentage Change		Six Months Ended March 31,						Percentage Change
	2005			2004					2005			2004
Cost of hardware revenue	$	1,584		$	1,816		(13	)%	$	3,672		$	3,742		(2	)%
As a percentage of hardware revenue		60	%		48	%				57	%		53	%
Cost of software revenue		1,443			731		97	%		2,400			1,957		23	%
As a percentage of software revenue		33	%		37	%				24	%		48	%
Cost of maintenance and support revenue		620			478		30	%		1,263			940		34	%
As a percentage of maintenance and support revenue		28	%		32	%				30	%		32	%
Amortization and impairment of developed technology		4,357			102		4,172	%		4,613			204		2,161	%
Total cost of revenue	$	8,004		$	3,127		156	%	$	11,948		$	6,843		75	%

Cost of hardware revenue

Cost of hardware revenue includes costs associated with the manufacturing and shipping of product, logistics, operations, and adjustments to warranty reserves and inventory. Our smart card and reader revenue reflects products manufactured for us by original equipment manufacturers, and accordingly have lower margins, compared to tokens that are manufactured by us and yield higher gross margins. Cost of hardware revenue as a percentage of related hardware revenue increased from 48% in the three months ended March 31, 2004 to 60% in the three months ended March 31, 2005 and from 53% in the six months ended March 31, 2004 to 57% in the six months ended March 31, 2005. The increase in all periods presented is primarily due to a decline in our hardware revenue without a corresponding decline in the fixed portion of our hardware cost of sales primarily associated with headcount.

Cost of software revenue

Cost of software revenue includes costs associated with software duplication, packaging, documentation such as user manuals and CDs, royalties, logistics, operations, and customization services. Cost of software revenue as a percentage of related software revenue decreased from 37% in the three months ended March 31, 2004 to 33% in the three months ended March 31, 2005 and decreased from 48% in the six months ended March 31, 2004 to 24% in the six months ended March 31, 2005. The decrease in the cost of software revenue as a percentage of software revenue for all periods resulted primarily from increased sales of non-customized software products.

Cost of maintenance and support revenue

Cost of maintenance and support revenue consists primarily of personnel costs and expenses incurred in providing telephonic support, on-site consulting services, and training services. Cost of maintenance and support revenue as a percentage of related maintenance and support revenue decreased from 32% in the three and six months ended March 31, 2004 to 28% and 30% in the three and six months ended March 31, 2005, respectively,

20

primarily as a result of an increase in maintenance and support revenue from a growing installed base of customers.

Amortization and impairment of acquired developed technology

Amortization of acquired developed technology includes amortization of technology capitalized in acquisitions. Amortization, including the impairment charge, increased to $4.4 million and $4.6 million in the three and six months ended March 31, 2005, respectively, from $102,000 and $204,000 in the three and six months ended March 31, 2004, primarily due to the impairment charge of $3.6 million recorded in the three months ended March 31, 2005 and the additional amortization of technology capitalized as part of the consolidation and subsequent acquisition of Aspace.

Operating expenses

A substantial proportion of our operating expenses are comprised of personnel costs, facilities, and associated information technology costs to support our personnel, and are fixed. Accordingly, a small variation in the timing of recognition of revenue can cause significant variations in operating results from quarter to quarter.

Sales and marketing

Sales and marketing expenses consist primarily of salaries and other payroll expenses such as commissions and travel, depreciation, costs associated with marketing programs, promotions, trade shows, and allocations of facilities and information technology costs.

Sales and marketing expenses and period-over-period changes are as follows (dollars in thousands):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
Sales and marketing	$	7,442		$	5,409		$	15,090		$	10,027
Percentage change from comparable period		38	%					50	%
As a percentage of total revenue		81	%		74	%		73	%		71	%
Headcount at March 31		122			95

Sales and marketing expenses increased $2.0 million or 38% in the three months ended March 31, 2005 compared to the three months ended March 31, 2004. The increase in absolute dollars resulted principally from the inclusion of Aspace sales and marketing expenses of $1.1 million, an increase in personnel and related costs of $950,000 due to increased headcount and higher sales, and an increase in allocated facility and information technology costs of $243,000. Sales and marketing expenses increased $5.1 million or 50% in the six months ended March 31, 2005 compared to the six months ended March 31, 2004. The increase in absolute dollars resulted principally from an increase in personnel and related costs of $2.7 million due to increased headcount and higher sales, the inclusion of Aspace sales and marketing expenses of $1.4 million, increased spending related to certain sales and marketing activities of $575,000, and an increase in allocated facility and information technology costs of $489,000.

Research and development

Research and development expenses consist primarily of salaries, costs of components used in research and development activities, travel, depreciation, and an allocation of facilities and information technology costs. The focus of our research and development efforts is to bring new products, as well as new versions of existing products, to market in order to address customer demand.

21

Research and development expenses and period-over-period changes are as follows (dollars in thousands):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
Research and development	$	4,254		$	4,934		$	9,004		$	10,263
Percentage change from comparable period		(14	)%					(12	)%
As a percentage of total revenue		46	%		68	%		43	%		73	%
Headcount at March 31		118			140

Research and development expenses decreased $680,000 or 14% in the three months ended March 31, 2005 compared to the three months ended March 31, 2004. The decrease in research and development expenses is due to lower headcount as a result of our 2004 restructuring, partially offset by the inclusion of Aspace research and development expenses of $862,000, and an increase in allocated facility and information technology costs of $267,000. Research and development expenses decreased $1.3 million or 12% in the six months ended March 31, 2005 compared to the six months ended March 31, 2004. The decrease in research and development expenses is due to lower headcount as a result of our 2004 restructuring, partially offset by the inclusion of Aspace research and development expenses of $1.7 million, and an increase in allocated facility and information technology costs of $491,000.

General and administrative

General and administrative expenses consist primarily of personnel costs for administration, finance, human resources, and legal, as well as professional fees related to legal, audit and accounting, costs associated with Sarbanes-Oxley Act compliance, director and officers insurance, and an allocation of facilities and information technology costs.

General and administrative expense and period-over-period changes are as follows (dollars in thousands):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
General and administrative	$	2,742		$	1,544		$	5,643		$	3,157
Percentage change from comparable period		78	%					79	%
As a percentage of total revenue		30	%		21	%		27	%		23	%
Headcount at March 31		41			46

General and administrative expenses increased $1.2 million or 78% in the three months ended March 31, 2005 compared to the three months ended March 31, 2004. The increase in absolute dollars resulted primarily from the increased staffing costs resulting from the transfer of finance activities from Canada to the United States of approximately $584,000 and costs associated with Sarbanes-Oxley Act compliance of approximately $358,000. General and administrative expenses increased $2.5 million or 79% in the six months ended March 31, 2005 compared to the six months ending March 31, 2004. The increase in absolute dollars resulted from the inclusion of Aspace general and administrative expense of $862,000, increased staffing costs resulting from the transfer of finance activities from Canada to the United States of approximately $600,000, costs associated with Sarbanes-Oxley Act compliance of approximately $750,000, provision for doubtful accounts of approximately $200,000, and to a lesser extent increased premiums for our directors and officers insurance.

Impairment of goodwill

In March 2005, Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement resulting in us revising our near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit we recorded a goodwill impairment charge of $9.4 million in the three months ended March 31, 2005. There were no such write-downs in the three and six months ending March 31, 2004.

22

Write-down of acquired intangible assets

As noted above, Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement resulting in us revising our near term revenue forecast lower. Based on the updated revenue forecast we recorded a write-down of $2.4 million related to customer relationships in the three months ended March 31, 2005. There were no such write-downs in the three and six month ending March 31, 2004.

Amortization of acquired intangible assets

Amortization of acquired intangible assets includes amortization of customer relationships, trademark, and trade name intangibles capitalized in acquisitions. Amortization increased to $611,000 and $626,000 in the three and six months ended March 31, 2005, respectively from $12,000 and $34,000 in the three and six months ended March 31, 2004 primarily due to the additional amortization of intangible assets capitalized as part of the consolidation and subsequent acquisition of Aspace.

Restructuring, business realignment, and severance benefits

Restructuring and business realignment expenses consist of severance and other costs associated with the reduction of headcount and facility exit costs, consisting primarily of future minimum lease payments net of estimated sub-lease income.

In the three months ended March 31, 2005, we incurred $409,000 of restructuring, business realignment and severance benefits due to changes in estimates of our February 2002 restructuring of $191,000 and our March 2004 restructuring of $218,000 related to facility exit costs, primarily as a result of an increase in the time required to sublease our exited facilities. We did not incur any restructuring related charges in the three months ended December 31, 2004.

In March 2004, we initiated a restructuring plan to reduce operating costs, streamline and consolidate operations, and reallocate resources. The plan included a reduction in workforce that resulted in the termination of 109 employees, closure of five facilities, and termination of a non-strategic project under an existing agreement. As of March 31, 2004, the Company had recorded a charge of $1.2 million, consisting of approximately $1.1 million for the termination of 44 employees and $40,000 for the termination of a non-strategic project. In the three months ended December 31, 2003, we recorded $204,000 of employee termination costs related to our 2003 restructuring.

Though we do not expect to incur any significant charges related to our previous restructurings, a change in the estimated sublease income from or time required to sublease our exited facilities could result in future charges to our statement of operations.

In-process research and development

In the six months ended March 31, 2005, a total of $537,000 of the additional Aspace enterprise value was allocated to the estimated fair value of an in-process research and development project. At the date of acquisition, the project had not reached technological feasibility and had no alternative future use. Accordingly, the value allocated to the project was expensed to operations on the date of acquisition. The estimated fair value of the project was determined by applying the income approach, which considers the present value of the projected free cash flows that will be generated by the products, incorporating the acquired technologies under development, assuming they will be successfully completed. The discount rate used was 25% to take into account the novelty of the technology, the extent of Aspace’s familiarity with the technology, the stage of completion and the risks surrounding successful development and commercialization of the project. No such charges were recorded in the six months ended March 31, 2004.

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Total other income (expenses), net

Total other income (expenses), net consists of interest income on our cash, cash equivalents, and short-term investments, equity in net loss of Aspace, gains or losses on foreign exchange transactions, and mark-to-market adjustments on our deferred compensation plan assets. Interest income, net, increased slightly to $1.1 million and $2.1 million in the three and six months ended March 31, 2005 compared to $1.0 million and $2.0 million in the three and six months ended March 31, 2004, respectively primarily due to an increase in the yield on our portfolio. No equity in net loss of Aspace was recorded in fiscal 2005, as the financial statements of Aspace have been consolidated in our statement of operations since May 2004. Other expense, net, of $283,000 for the three months ended March 31, 2005 is comprised of foreign exchange losses of $165,000 and $118,000 of expense related to the mark-to-market of our deferred compensation plan assets, which was terminated in March 2005. This compares to other income, net, of $410,000 for the three months ended March 31, 2004, which consists almost entirely of foreign exchange gains. Other income, net of $70,000 for the six months ended March 31, 2005 is comprised of foreign exchange gains of $127,000 offset by other expense of $57,000, primarily related to the mark-to-market of our deferred compensation plan assets. This compares to other income, net of $437,000 for the six months ended March 31, 2004, which consists almost entirely of foreign exchange gains.

Income taxes

Income taxes in all periods represents minimum taxes payable in various jurisdictions. Income taxes were $108,000 and $110,000 in the three and six months ended March 31, 2005, respectively compared to $55,000 and $209,000 in the three and six months ended March 31, 2004, respectively. Our effective tax rate differs from the statutory rate as we have recorded a 100% valuation allowance related to our deferred tax assets as we do not consider the generation of taxable income to realize their benefits to be more likely than not.

Minority interest

Minority interest was $5,000 and $30,000 in the three and six months ended March 31, 2005, respectively and $35,000 and $80,000 in the three and six months ended March 31, 2004, representing the minority interest share in the consolidated net loss of ActivCard S.A. The decline in minority interest for all periods presented is primarily due to the decrease in the consolidated net loss of ActivCard S.A. During the three months ended March 31, 2005, 4,002 shares of ActivCard S.A. common stock were repurchased for total consideration of approximately $20,000. During the six months ended March 31, 2005, 5,502 shares of ActivCard S.A. common stock were repurchased for total consideration of approximately $33,000.

Liquidity and capital resources

As of March 31, 2005, we had cash, cash equivalents, and short-term investments of $184.2 million, a decrease of $29.9 million from September 30, 2004, primarily due to the use of $20.7 million in operating activities, $7.2 million to acquire the remaining 51% of Aspace, and $1.7 million to repay short-term borrowings of Aspace.

Cash used in operations was $20.7 million in the six months ended March 31, 2005 compared to $10.4 million in the six months ended March 31, 2004. In the six months ended March 31, 2005, our net loss was $32.2 million, including non-cash charges totaling $18.7 million, primarily related to impairment of goodwill, write-down of acquired intangible assets, depreciation and amortization, an in-process research and development charge related to the acquisition of the remaining 51% of Aspace, and amortization of employee stock-based compensation. Also contributing to the use of cash was a reduction in deferred revenue of $3.2 million and a decrease in liabilities of $2.8 million, primarily accrued compensation related to payment of calendar 2004 bonus. In the six months ended March 31, 2004, our net loss was $18.5 million, including non-cash charges totaling $4.6 million, primarily related to depreciation and amortization, and equity in the net loss of Aspace. Increases in assets and decreases in liabilities were offset by a reduction in accounts receivable of $2.7 million.

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Investing activities in the six months ended March 31, 2005 generated net cash of $16.4 million from the proceeds of sales or maturities of short-term investments of $38.4 million offset by use of cash of $14.2 million for the purchases of short-term investments and $7.2 million in the acquisition of the remaining 51% of Aspace. Investing activities used net cash of $29.5 million in the six months ended March 31, 2004 primarily for the purchases of short-term investments of $127.2 million, net of proceeds from sales and maturities of $100.9 million, and investment in Aspace of $2.2 million. Purchases of property and equipment used $555,000 and $1.1 million of cash in the six months ended March 31, 2005 and 2004, respectively.

Financing activities provided net cash of $475,000 in the six months ended March 31, 2005 from the issuance of common stock upon the exercise of stock options, rights, and warrants of $2.1 million offset by the repayment of Aspace short-term borrowings of $1.7 million. Financing activities provided cash of $803,000 in the six months ended March 31, 2004, primarily from the issuance of common stock upon the exercise of stock options, rights, and warrants.

We believe that our cash and cash equivalent and short-term investments will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next twelve months. From time to time, in the ordinary course of business, we evaluate potential acquisitions of business, products, or technologies. A portion of our cash may be used to acquire or invest in businesses or products or to obtain the right to use complementary technologies.

Contractual Obligations

The following summarizes our contractual obligations at March 31, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):

Contractual cash obligations	Total		Less than 1 Year (1)		1 to 3 Years		4 to 5 Years		After 5 Years
Operating leases(2)	$	16,807	$	1,702	$	5,794	$	5,418	$	3,893

⁽¹⁾ Represents remaining six months of fiscal year.

⁽²⁾ Operating lease payments are exclusive of expected sublease income.

Recent Accounting Pronouncements

In December 2004, the FASB revised and retitled SFAS No. 123RShare-Based Payment. SFAS No. 123R establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions where an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS No. 123R is effective as of the first fiscal year that begins on or after June 15, 2005. We will adopt the provisions of SFAS No. 123R for our first quarter of fiscal 2006 beginning October 1, 2005. We are currently assessing the impact of adopting SFAS No. 123R.

Critical Accounting Policies and Estimates

The above discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. We believe there are several accounting policies that are critical to understanding our consolidated financial statements, as these policies affect the reported amounts of revenue and expenses and involve management’s judgment regarding significant estimates. Our critical accounting policies and estimates are described below.

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Revenue Recognition

We recognize revenue in accordance with accounting principles generally accepted in the United States, as set forth in American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2Software Revenue Recognition, as amended, Securities and Exchange Commission Staff Accounting Bulletin No. 104,Revenue Recognition, and other related pronouncements.

Revenue is derived primarily from the sale of software licenses, hardware, and service agreements. Revenue from software license agreements is generally recognized upon shipment, provided that:

• Evidence of an arrangement exists;

• The fee is fixed or determinable;

• No significant obligations remain; and

• Collection of the corresponding receivable is probable.

In software arrangements that include hardware products, rights to multiple software products, maintenance, and/or other services, the total arrangement fee is allocated among each deliverable, based on vendor-specific objective evidence of fair value (VSOE) of each element if vendor-specific objective evidence of each element exists. We determine VSOE of an element based on the price charged when the same element is sold separately. For an element not yet sold separately, VSOE is established by management having the relevant authority as long as it is probable that the price, once established, will not change before separate introduction of the element in the marketplace. When arrangements contain multiple elements and VSOE exists for all undelivered elements, we recognize revenue for the delivered elements based on the residual value method. For arrangements containing multiple elements wherein VSOE does not exist for all undelivered elements, revenue for the delivered and undelivered elements is deferred until VSOE exists or all elements have been delivered.

We do not include acceptance clauses for shrink-wrapped software products. Acceptance clauses usually give the customer the right to accept or reject the software after the product has been delivered. However, we provide certain customers with acceptance clauses for customized or significantly modified software products developed under product development agreements, and on occasion, for hardware products and client/server software products as well. In instances where an acceptance clause exists, no revenue is recognized until the product is formally accepted by the customer in writing or the defined acceptance period has expired.

Revenue from the sale of hardware is recognized upon shipment of the product, provided that no significant obligation remains and collection of the receivable is considered probable.

Post-contract customer support is recognized on a straight-line basis over the term of the contract.

Service revenue includes revenue from training, installation, or consulting. From time-to-time, we develop and license software to customers that requires significant customization, modification or production. Where the services are essential to the functionality of the software element of the arrangement, separate accounting for the services is not permitted and contract accounting is applied to both the software and service elements. For these projects, we recognize revenue in accordance with SOP 81-1,Accounting for Performance of Construction-Type and Certain Production-Type Contracts, typically on a percentage-of-completion basis as evidenced by labor hours incurred to estimated total labor hours. Amounts billed in excess of revenue recognized are recorded as deferred revenue in the accompanying consolidated balance sheets. Unbilled work-in-process is recorded as a receivable in the accompanying consolidated balance sheets.

Service revenue is recognized separately from the software element when the services are performed if VSOE exists to allocate the revenue to the various elements in a multi-element arrangement, the services are not essential to the functionality of any other element of the arrangement and the total price of the contract would vary with the inclusion or exclusion of the services.

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In certain specific and limited circumstances, we provide product return and price protection rights to certain distributors and resellers. We generally recognize revenue from product sales upon shipment to resellers, distributors, and other indirect channels, net of estimated returns or estimated future price changes. Our policy is to not ship product to a reseller or distributor unless the reseller or distributor has a history of selling our products or the end user is known and has been qualified by us. We have established a reasonable basis through historical experience for estimating future returns and price changes. Actual returns have not been material to date. Price protection rights typically expire after 30 days and have not been material to date.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. We base our estimates and judgments on historical experience and on various assumptions that we believe are reasonable under current circumstances. However, future events are subject to change and estimates and judgments routinely require adjustments therefore actual results could differ from our current estimates. Significant estimates made in the accompanying financial statements are:

• Allowance for Doubtful Accounts – We provide an allowance for doubtful accounts receivable based on account aging, historical bad debt experience, and customer creditworthiness. Changes in the allowance are included as a component of general and administrative expense in the consolidated statement of operations. If actual collections differ significantly from our estimates, it may result in a decrease or increase in our general and administrative expenses.

• Inventory Valuation – We provide for slow moving and obsolete inventories based on historical experience and forecast of product demands. A change in the value of the inventory is included as a component of cost of hardware revenue. If sales of inventory on-hand are less than our current projections or if there is a significant change in technology making our current inventory obsolete, we may be required to record additional charges adversely affecting our margins and results of operations.

• Long-lived Assets – We perform an annual review of the valuation of long-lived assets, including property and equipment. We also assess the recoverability of long-lived assets on an interim basis whenever events and circumstances indicate that the carrying value may not be recoverable based on an analysis of estimated expected future undiscounted net cash flows to be generated by the assets over their estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over their estimated useful lives, we record an impairment charge in the amount by which the carrying value of the assets exceeds their fair value. Should conditions prove to be different than management’s current assessment, material write-downs of long-lived assets may be required, adversely affecting our results of operations.

• Other Intangible Assets – We generally record intangible assets when we acquire companies. The cost of the acquisition is allocated to the assets and liabilities acquired, including identifiable intangible assets. Certain identifiable intangible assets such as developed technology, customer relationships, trademarks, and trade names are amortized over time, while in-process research and development is recorded as a charge on the date of acquisition. Accordingly, the allocation of the acquisition cost to identifiable intangible assets has a significant impact on our future operating results. The allocation process requires extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. If impairment indicators are identified with respect to other intangible assets, the fair value of other intangible assets is re-assessed using valuation techniques that require significant management judgment. Should conditions prove to be different than management’s original assessment, material write-downs of the fair value of intangible assets may be required. Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement resulting in us revising our near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit, we determined that the carrying value of the intangible assets associated with

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the reporting unit exceeded their fair value, resulting in write-downs of $3.6 million and $2.4 million related to acquired developed technology and customer relationships, respectively, in the three months ended March 31, 2005. We also recorded such impairments in the three month periods ended September 2004, June 2003, and December 2002. We periodically review the estimated remaining useful lives and recoverability of our other intangible assets. A reduction in the estimate of remaining useful life or recoverability could result in accelerated amortization or a write-down in future periods and may adversely affect our results of operations.

• Goodwill – Under current accounting guidelines, we periodically assess goodwill for impairment, and at least annually as of December 1. Accordingly, goodwill recorded in business combinations may significantly affect our future operating results to the extent impaired, but the magnitude and timing of any such impairment is uncertain. If impairment indicators are identified with respect to goodwill, the fair value of goodwill is re-assessed using valuation techniques that require significant management judgment. In the three months ended March 31, 2005 Aspace failed to satisfy an earn-out contingency set forth in the acquisition agreement resulting in us revising our near term revenue forecast lower. Based on the updated revenue forecast for the Aspace reporting unit we recorded a goodwill impairment charge of $9.4 million. Should conditions be different than management’s last assessment, significant write-downs of goodwill may be required which will adversely affect our results of operations.

• Restructuring, Business Realignment, and Severance Benefits – In connection with our 2004, 2003, and 2002 restructurings, we accrued restructuring liabilities associated with costs of employee terminations, vacating facilities, write-off of assets that will no longer be used in operations, and costs for a project termination based on management estimates. Recording of costs associated with vacating facilities require management to estimate future sub-lease income. In the three months ended March 31, 2005 we revised the expected sublease income and the time required to sublease our exited facilities and recorded an additional charge of $409,000. If the actual future payments, net of any sub-lease income, differ from our estimates, it may result in an increase or decrease in our restructuring charge, and could adversely affect our results of operations.

• Sales Warranty Reserve – We accrue expenses associated with potential warranty claims at the time of sale, based on warranty terms and historical experience. The warranty we provide is in excess of warranty coverage provided by our product assembly contractors. Our standard warranty period is one year for hardware products. Changes in the warranty reserve are included as a component of cost of hardware revenue. If actual returns under warranty differ significantly from our estimates, it may result in a decrease or increase in our cost of hardware revenue.

• Provision for Income Taxes – The provision for income taxes includes taxes currently payable and changes in deferred tax assets and liabilities. We record deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. If we do not generate sufficient taxable income, the realization of deferred tax assets could be impaired resulting in additional income tax expense. As a result, we record a valuation allowance to reduce net deferred tax assets to amounts that are more likely than not to be recognized. Deferred tax assets are principally the result of the tax benefit of disqualifying dispositions of stock options and net operating loss carry-forwards. We have established a valuation allowance to fully reserve these deferred tax assets due to uncertainty regarding their realization.

Risk Factors

Set forth below are certain risks and uncertainties that could affect our business, financial condition, operating results, and/or stock price. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem less significant also may impair our business operations.

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We have a history of losses and we expect to experience losses in the foreseeable future.

We have not achieved profitability on an operating basis and we expect to incur operating losses for at least the remainder of fiscal 2005. In the six months ended March 31, 2005 and 2004, we incurred losses of approximately $32.2 million and $18.5 million, respectively. As of March 31, 2005, our accumulated deficit was $199.0 million, which represents our net losses since inception. Even our sizable cash balance may not last long enough for our operations to become profitable.

We will need to achieve significant incremental revenue growth and contain costs to achieve profitability. Even if we do achieve profitability, we may be unable to sustain profitability on a quarterly or annual basis in the future. It is possible that our revenue will grow more slowly than we anticipate or that operating expenses will exceed our expectations.

Our cost-reduction initiatives may not result in the anticipated savings or more efficient operations and may harm our long-term viability.

In March 2004, we completed a plan to enhance and improve sales and marketing activities, rationalize research and development projects and general and administrative functions, and consolidate geographic locations. We instituted additional cost-cutting measures in April 2005 with a planned reduction of approximately 10% of our workforce. As a result of these actions, we incurred restructuring charges of $409,000 in the six months ended March 31, 2005, $3.5 million in the nine months ended September 30, 2004 and expect to incur an additional $900,000 in restructuring charges in the three months ending June 30, 2005. We incurred restructuring charges of $1.5 million in the year ended December 31, 2003 and $8.6 million in the year ended December 31, 2002 in connection with restructuring plans to streamline operations, improve efficiency, and reduce costs. These restructuring efforts are disruptive to operations and our current efforts may not generate anticipated cost savings.

Additionally, our restructuring plan may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce or increased difficulties in managing our day-to-day operations. Although we believe that it was necessary to reduce the size and cost of our operations to improve our financial results, the reduction in our operations may make it more difficult to develop and market new products and to compete successfully with other companies in our industry. In addition, many of the employees who were terminated possessed specific knowledge or expertise that may prove to have been important to our operations and their absence may create significant difficulties. This personnel reduction may also subject us to the risk of litigation, which may adversely impact our ability to conduct our operations and may cause us to incur significant expense. Additionally, these efforts may not result in anticipated cost savings making it harder for us to achieve profitability.

The Sarbanes-Oxley Act of 2002 requires us to document and test our internal accounting controls in the fiscal year ending September 30, 2005 and requires our independent public accountants to attest to our report on these controls. Any delays or difficulty in satisfying these requirements could harm our future results of operations and our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires management to report on our internal controls over financial reporting beginning with our annual report for the year ending September 30, 2005 and also requires our independent registered public accountants to attest to this report. Our previous independent registered public accountants informed us that they believed that our financial closing and reporting process in the quarter ended June 30, 2004 represented a significant deficiency in internal control, which means that these were matters that in the auditors’ judgment could adversely affect our ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. Since that time, we completed the restructuring of our finance department and have devoted resources to remediate and improve our internal controls.

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Additionally, in the quarter ended December 31, 2004, our independent registered public accountants identified an adjustment relating to the accounting treatment of our inventory and informed us that this adjustment demonstrates the existence of a significant deficiency in our internal controls. We believe we have remedied this deficiency by augmenting our staff in our finance and accounting departments, performing additional analytical procedures, and training our staff in generally accepted accounting principles. Although we believe that these efforts have strengthened our internal controls and addressed the concerns that gave rise to the significant deficiency we are continuing to work to improve our internal controls. We cannot be certain that these measures will ensure that we are able to implement and maintain adequate controls over our financial processes and reporting in the future.

Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations, including our obligation to report on our internal controls as of September 30, 2005. These developments could make it more difficult to retain or recruit directors and executive officers. Inadequate internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on our results of operations and the trading price of our stock.

Increased costs associated with corporate governance compliance may significantly impact the results of our operations.

Changing laws, regulations, and standards relating to corporate governance, public disclosure, and compliance practices, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission regulations, and Nasdaq National Market rules, are creating uncertainty for companies such as ours in understanding and complying with these laws, regulations, and standards. As a result of this uncertainty and other factors, devoting the necessary resources to comply with evolving corporate governance and public disclosure standards have resulted in increased general and administrative expenses and a diversion of management time and attention to compliance activities and are expected to continue to do so. Our compliance costs continue to be approximately $400,000 per quarter and are expected to increase over the remaining two quarters of our 2005 fiscal year. We expect these developments to continue to increase our legal compliance and financial reporting costs. In addition, these developments may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher premiums to obtain such coverage.

It is difficult to integrate acquired companies, products and technologies into our operations and our inability to do so could greatly lessen the value of any such acquisitions.

We have made various strategic acquisitions of companies, products or technologies, including our acquisition of the remaining equity interest in Aspace Solutions Limited completed in December 2004, and we may make additional acquisitions in the future in order to implement our business strategy. These acquisitions involve numerous risks, including:

• Difficulties in integrating the operations, technologies, products, and personnel of the acquired companies;

• Diversion of management’s attention from normal daily operations of the business;

• Disputes over earn-outs or contingent payment obligations;

• Insufficient revenue to offset increased expenses associated with acquisitions; and

• The potential loss of key employees of the acquired companies.

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Acquisitions may result in:

• Recording goodwill and other intangible assets that are subject to impairment testing on a regular basis and can result in potential periodic impairment charges which could be substantial;

• Increasing our amortization expense;

• Incurring large and immediate write-offs, and restructurings; and

• Disputes regarding representations and warranties, indemnities, earn-outs, and other provisions in acquisition agreements.

During 2004, 2003, and 2002, we recorded charges to earnings associated with the impairment of other intangible assets, write-downs of property and equipment, and losses from discontinued operations from our previous acquisitions. In addition, due to a change in our revenue assumptions related to our acquisition of Aspace, we recorded a charge of $9.4 million related to the impairment of goodwill and a write-down of intangible assets of $6.0 million in the three months ended March 31, 2005. Additionally, acquisitions can also lead to expensive and time-consuming litigation and may subject us to unanticipated liabilities or risks, disrupt our operations, divert management’s attention from day-to-day operations, and increase our operating expenses.

To date, we have primarily used cash and stock to finance our business acquisitions. We may incur debt to finance future acquisitions. The issuance of equity securities for any future acquisitions could be substantially dilutive to our stockholders. If we are unable to successfully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of such acquisitions and we may be required to take future charges to earnings.

We derive revenue from only a limited number of products and we do not have a diversified product base.

Substantially all of our revenue is derived from the sale of our digital identity systems and products. We anticipate that substantially all of the growth in revenue, if any, will also be derived from these products. If for any reason our sale of these products is impeded, and we have not diversified our product offerings, our business and results of operations could be harmed. We have reduced our product offerings as part of our restructuring initiatives to focus on just our core products and we do not expect to diversify our product offerings in the foreseeable future. By limiting our product offerings in the future, we will likely increase the risks associated with not having a diversified product base.

Our customer base is highly concentrated and the loss of any one of these customers could adversely affect our business.

Our customers consist primarily of medium to large enterprises, system integrators, resellers, distributors, and original equipment manufacturers. Historically, we have experienced a concentration of revenue through certain of our channel partners to customers and there has been a high concentration of revenue through a number of system integrators to the U.S. government. We ship product to the U.S. government exclusively through system integrators. Many of our contracts with our significant channel partners are short-term. The following customers accounted for more than 10% of total revenue:

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
Customer A	10	%	—		—		—
Customer B	—		—		14	%	—
Customer C	—		22	%	—		23	%

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If we lose any of the above or other significant customers or if any of our significant channel partners do not renew their contract upon expiration, it could adversely affect our business and operating results. We expect to continue to depend upon a small number of large customers for a substantial portion of our revenue.

We have a long and often complicated sales cycle, which can result in significant revenue fluctuations from quarter to quarter.

The sales cycle for our products is typically long and subject to a number of significant risks over which we have little control. The typical sales cycle is six to nine months for an enterprise customer and over twelve months for a network service provider or government. As our operating expenses are based on anticipated revenue levels, a small fluctuation in the timing of sales can cause our operating results to vary significantly from period to period. If revenue falls significantly below anticipated levels, our business would be negatively impacted.

Purchasing decisions for our products and systems may be subject to delay due to many factors that are outside of our control, such as:

• Political and economic uncertainties;

• Time required for a prospective customer to recognize the need for our products;

• Time and complexity for us to assess and determine a prospective customer’s IT environment;

• Significant expense of digital identity products and network systems;

• Customer’s requirement for customized features and functionalities;

• Customer’s internal budgeting process; and

• Customer’s internal procedures for the approval of large purchases.

Furthermore, the implementation process is subject to delays resulting from concerns associated with incorporating new technologies into existing networks, deployment of a new network system or preservation of existing network infrastructure and data migration to the new system. Full deployment of our technology and products for such networks, servers, or other host systems can be scheduled to occur over an extended period and the licensing of systems and products, including client and server software, smart cards, readers, and tokens, and the recognition of maintenance revenues would also occur over this period, thereby negatively impacting the results of our operations in the near term, resulting in unanticipated fluctuations from quarter to quarter.

The market for our products is still developing and if the industry adopts standards or a platform different from our platform, then our competitive position would be negatively affected.

The market for digital identity products is still emerging and is also experiencing consolidation. The evolution of the market is in a constant state of flux that may result in the development of different network computing platforms and industry standards that are not compatible with our current products or technologies.

We believe that smart cards are an emerging platform for providing digital identity for network applications and services. Our business model is premised on the smart card becoming a common access platform for network computing in the future. Further, we have focused on developing our products for certain operating systems related to smart card deployment and use. Should platforms or form factors other than the smart card emerge as a preferred platform or should operating systems other than the specific systems we have focused on emerge as preferred operating systems, our current product offerings could be at a disadvantage. If this were to occur, our future growth and operating results could be negatively affected.

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In addition, the digital identity market lacks industry-wide standards. While we are actively engaged in discussions with industry peers to define what these standards should be, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines.

We may be adversely affected by operating in international markets.

Our international operations subject us to risks associated with operating in foreign markets, including fluctuations in currency exchange rates that could adversely affect our results of operations and financial condition. International sales and expenses make up a substantial portion of our business. A severe economic decline in one of our major foreign markets could make it difficult for our customers to pay us on a timely basis. Any such failure to pay, or deferral of payment, could adversely affect our results of operations and financial condition. During the six months ended March 31, 2005 and 2004 markets outside of North America accounted for 49% and 62%, respectively, of total revenue.

We face a number of additional risks inherent in doing business in international markets, including among others:

• Unexpected changes in regulatory requirements;

• Potentially adverse tax consequences;

• Export controls relating to encryption technology;

• Tariffs and other trade barriers;

• Difficulties in staffing and managing international operations;

• Laws that restrict our ability, and make it costly to reduce headcount;

• Changing economic or political conditions;

• Exposures to different legal standards;

• Burden of complying with a variety of laws and legal systems;

• Fluctuations in currency exchange rates; and

• Seasonal reductions in business activity during the summer months in Europe as well as other parts of the world.

While we prepare our financial statements in U.S. dollars, we have historically incurred a significant portion of our expenses in euros and in the British pound. We expect that a significant portion of our expenses will continue to be incurred in euros and in the British pound, as well as in other currencies, although to a lesser extent. Fluctuations in the value of these currencies relative to the U.S. dollar have caused and will continue to cause dollar-translated amounts to vary from period-to-period. Due to the constantly changing currency exposures and the substantial volatility of currency exchange rates, we cannot predict the effect of exchange rate fluctuations upon future operating results.

We have recorded significant write-downs in recent periods for impairment of acquired intangible assets and may have similar write-downs in future periods.

We recorded an impairment write-down of goodwill of $9.4 million in the six months ended March 31, 2005. Additionally, we have recorded impairment write-downs of acquired intangible assets of $6.0 million in the three months ended March 31, 2005, $45,000 in the nine months ended September 30, 2004, $758,000 in the year ended December 31, 2003, and $5.1 million in the year ended December 31, 2002. The impaired assets consisted of developed and core technology, customer relationships, agreements, contracts, and trade names and trademarks capitalized in our acquisitions. Additionally, we terminated certain non-core activities during 2003,

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including our biometric hardware product line, hosting of PKI digital certificate issuance, and overlapping product offerings. As a result of these decisions, we recorded charges to earnings of $4.2 million during 2003.

We may terminate additional non-core activities in the future or determine that our long-lived assets, acquired intangible assets, or goodwill have been impaired. Any future termination or impairment related charges could be significant and would have a material adverse effect on our financial position and results of operations. As of March 31, 2005, we had $3.0 million of other intangible assets and $15.4 million of goodwill accounting for 8% of our total assets.

We rely on strategic relationships with other companies to develop and market our products. If we are unable to enter into additional relationships, or if we lose an existing relationship, our business could be harmed.

Our success depends on establishing and maintaining strategic relationships with other companies to develop, market, and distribute our technology and products and, in some cases, to incorporate our technology into their products. Part of our business strategy has been to enter into strategic alliances and other cooperative arrangements with other companies in the industry. We are currently involved in cooperative efforts to incorporate our products into products of others, to jointly engage in research and development efforts, and to jointly engage in marketing efforts and reseller arrangements. None of these relationships is exclusive, and some of our strategic partners have cooperative relationships with certain of our competitors.

If we are unable to enter into cooperative arrangements in the future or if we lose any of our current strategic or cooperative relationships, our business could be adversely affected. We do not control the time and resources devoted to such activities by parties with whom we have relationships. In addition, we may not have the resources available to satisfy our commitments, which may adversely affect these relationships. These relationships may not continue, may not be commercially successful, or may require the expenditure of significant financial, personnel, and administrative resources from time to time. Further, certain of our products and services compete with the products and services of our strategic partners which may adversely affect our relationships with our these partners, which could adversely affect our business.

If the members of our management team are unable to work together effectively, our ability to manage and expand our business will suffer.

The members of our management team have not previously worked together, and we cannot be sure that they will be able to work together effectively. Our management team has changed significantly in the past twelve months. Our Senior Vice President, Sales and Marketing, Frank Bishop, will be leaving the Company. In May 2004, we appointed Ben C. Barnes as our Chief Executive Officer, in November 2004, we appointed Ragu Bhargava as our Chief Financial Officer, and in September 2004 we appointed Stacey Soper as our Senior Vice President, Products. If these and other members of our senior management team cannot work together effectively, or if other members of our senior management team resign, our ability to manage our business will suffer.

Our operating results could suffer if we are subject to an intellectual property infringement claim.

We may face claims of infringement on proprietary rights of others that could subject us to costly litigation and possible restriction on the use of such proprietary rights. There is a risk that our products infringe on the proprietary rights of third parties. While we currently do not believe that our products infringe on proprietary rights of third parties, infringement or invalidity claims may nevertheless be asserted or prosecuted against us and our products may be found to have infringed the rights of third parties. Such claims are costly to defend and could subject us to substantial litigation costs. If any claims or actions are asserted against us, we may be required to modify our products or may be forced to obtain a license for such intellectual property rights. However, we may not be able to modify our products or obtain a license on commercially reasonable terms, or at all.

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In addition, despite precautions that we take, it may be possible for competitors to copy or reverse-engineer aspects of our current or future products, to independently develop similar or superior technology, or to design around the patents we own. Monitoring unauthorized use and transfer of our technology is difficult and technology piracy currently is and can be expected to continue to be a persistent problem. In addition, the laws of some foreign countries do not protect our intellectual property rights to the same extent as in the United States. It may be necessary to enforce our intellectual property rights through litigation, arbitration or other adversarial proceedings, which could be costly and distracting to management, and there is no assurance that we would prevail in any such proceedings.

The threat of new terrorist attacks and the continued weakness in the global economy may affect our ability to meet expectations, which could negatively impact the price of our stock.

Our operating results can vary significantly based upon the impact of changes in global and domestic economic and political conditions. Capital investment by businesses, particularly investments in new technology, has been experiencing substantial weakness. The threat of new terrorist attacks and the United States’ continued involvement in Iraq have contributed to continuing economic and political uncertainty that could result in a further decline in new technology investments. These uncertainties could cause customers to defer or reconsider purchasing our products or services if they experience a downturn in their business or if there is a renewed downturn in the general economy. Such events could have a material adverse effect on our business.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Exchange rate sensitivity

We are exposed to currency exchange fluctuations as we sell our products and incur expenses internationally, principally in euros and the British pound. We manage the sensitivity of our international sales by denominating transactions in U.S. dollars. A natural hedge exists in some local currencies, as local currency denominated revenue offsets some of the local currency denominated operating expenses.

During the three and six months ended March 31, 2005, approximately 55% and 62%, respectively of total sales were invoiced in U.S. dollars. During the three and six months ended March 31, 2004, approximately 76% and 70%, respectively of total sales were invoiced in U.S. dollars. Although we purchase many of our components in U.S. dollars, approximately half of our expenses are denominated in other currencies, primarily Australian dollar, British pound, Canadian dollar, euro, Japanese yen, Singapore dollar, and South African rand.

Interest rate sensitivity

We are exposed to interest rate risk as a result of our significant cash and cash equivalent and short-term investments. The rate of return that we may be able to obtain on investment securities will depend on market conditions at the time we make these investments and may differ from the rates we have secured in the past.

At March 31, 2005, we held $13.1 million of cash and cash equivalents and $171.1 million in short-term investments for a total of $184.2 million. Our cash and cash equivalents consist primarily of cash and money-market funds and our short-term investments are primarily comprised of government and government agency securities. Due to the low current market yields and the relatively short-term nature of our investments, a hypothetical 10% change in interest rates is not expected to have a material effect on the fair value of our portfolio or our results of operations.

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ITEM 4: CONTROLS AND PROCEDURES

We have twice been informed of weaknesses in our internal controls by our independent registered public accountants in the past twelve months. Most recently, in the quarter ended December 31, 2004, our independent registered public accountants identified an adjustment relating to the accounting treatment under generally accepted accounting principles (GAAP) of our inventory. Our independent registered public accountants informed us that this adjustment demonstrates the existence of a significant deficiency in our internal controls. We believe we have remedied this deficiency by augmenting the current staffing in our finance and accounting departments, performing additional analytical procedures, and training our staff in GAAP rules. Though we believe we have remedied this deficiency, other deficiencies may be identified that we may be unable to remediate prior to September 30, 2005, when our internal controls will be required to be certified by our independent registered public accountants, and thus we may be unable to conclude that our internal controls over financial reporting are effective as of that date.

Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15(d)-15(e)), as of the end of the period covered by this report. Based on their evaluation, these officers have concluded that our disclosure controls and procedures were effective to ensure that material information required to be disclosed in our reports that are filed or submitted under the Exchange Act are recorded, processed, summarized and reported within the periods specified in the Securities and Exchange Commission rules and forms.

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PART II    OTHER INFORMATION

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Our 2005 Annual Meeting of Stockholders was held on February 7, 2005. The following proposals were submitted to a vote of the stockholders:

Proposal No. 1: Election of Directors

The following votes were cast for each director nominee:

Name	For	Withheld
Yves Audebert	32,841,369	322,300
Ben C. Barnes	32,976,269	187,400
William Crowell	32,416,292	747,377
John A. Gordon	32,901,269	262,400
Clifford Gundle	33,036,169	127,500
Richard A. Kashnow	32,416,192	747,477
Montague Koppel	33,026,304	137,365
James E. Ousley	32,901,469	262,200
Richard White	32,232,483	931,186

Proposal No. 2: Ratification of independent registered public accountants

The stockholders voted to ratify the appointment of BDO Seidman, LLP as the Company’s independent registered public accountants for the fiscal year ending September 30, 2005 by the following vote:

FOR:	33,075,286
AGAINST:	82,999
ABSTAIN:	5,384

ITEM 5: OTHER INFORMATION

In February 2005, the Compensation Committee of the Board of Directors approved the payment of cash bonuses for the Company’s six executive officers in the aggregate amount of $438,000. The bonuses were paid pursuant to the Company’s annual bonus plan for the calendar year ended December 31, 2004 and included $89,000 paid to Ben C. Barnes, the Company’s Chief Executive Officer, pursuant to his employment agreement. The bonus amount paid to each officer was based on individual performance in the calendar year ended December 31, 2004, as well as based on the terms of each individual officer’s employment agreement with the Company.

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ITEM 6. EXHIBITS

Exhibit Number	Description
31.1	Certification of Chief Executive Officer Pursuant to Section 302(a) of The Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant to Section 302(a) of The Sarbanes-Oxley Act of 2002
32.1	Certification of the Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, ActivCard Corp. has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Fremont, State of California, on the 10^th day of May 2005.

ActivCard Corp.
By:	/s/    RAGU BHARGAVA
	Ragu Bhargava Senior Vice President and Chief Financial Officer

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