Actividentity 10-Q 2007 Q1 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 December 31, 2006

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

ActivIdentity Corporation

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

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

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

As of January 31, 2007, the Registrant had outstanding 45,621,058 shares of Common Stock.

ACTIVIDENTITY CORPORATION

INDEX TO QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED DECEMBER 31, 2006

		Page
PART I FINANCIAL INFORMATION
ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS	3
	CONDENSED CONSOLIDATED BALANCE SHEETS	3
	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS	4
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	5
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	6
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	14
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK	21
ITEM 4.	CONTROLS AND PROCEDURES	21
PART II OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	21
ITEM 1A.	RISK FACTORS	21
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	25
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	25
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	25
ITEM 5.	OTHER INFORMATION	25
ITEM 6.	EXHIBITS	25
	SIGNATURE	26

2

PART I FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

ACTIVIDENTITY CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

	December 31, 2006			September 30, 2006(1)
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	16,881		$	11,477
Short-term investments		119,093			116,570
Accounts receivable, net of allowance for doubtful accounts		9,447			18,048
Inventories		2,307			1,633
Prepaid and other current assets		2,869			2,976
Total current assets		150,597			150,704
Property and equipment, net		4,097			3,612
Other intangible assets, net		8,990			9,830
Other long-term assets		971			968
Goodwill		35,874			35,874
Total assets	$	200,529		$	200,988
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	3,726		$	2,001
Accrued compensation and related benefits		5,933			6,425
Current portion of accrual for restructuring liability		754			750
Accrued and other current liabilities		5,013			4,585
Current portion of deferred revenue		12,230			12,788
Total current liabilities		27,656			26,549
Deferred revenue, net of current portion		2,079			1,945
Long-term portion of accrual for restructuring liability, net of current portion		2,076			2,249
Long-term deferred rent		875			919
Total liabilities		32,686			31,662
Minority interest		373			373
Commitments and contingencies (Note 12)
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, 45,699,489 and 45,673,252 issued and outstanding at December 31, 2006 and September 30, 2006, respectively		46			46
Additional paid-in capital		421,238			420,527
Accumulated deficit		(238,597	)		(237,203	)
Accumulated other comprehensive loss		(15,217	)		(14,417	)
Total stockholders’ equity		167,470			168,953
Total liabilities and stockholders’ equity	$	200,529		$	200,988

⁽¹⁾ Derived from audited consolidated financial statements.

See accompanying notes to consolidated financial statements.

3

ACTIVIDENTITY CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except per share data, unaudited)

	Three Months Ended December 31,
	2006			2005
Revenue:
Software	$	6,780		$	5,181
Hardware		3,729			2,935
Maintenance and support		4,106			3,356
Total revenue		14,615			11,472
Cost of revenue:
Software		756			1,009
Hardware		1,906			1,768
Maintenance and support		1,047			896
Amortization of acquired developed technology and patents		792			663
Total cost of revenue		4,501			4,336
Gross profit		10,114			7,136
Operating expenses:
Sales and marketing		5,820			6,574
Research and development		4,993			4,756
General and administration		2,885			3,934
Restructuring expense		—			532
Amortization of acquired intangible assets		48			274
Total operating expenses		13,746			16,070
Loss from operations		(3,632	)		(8,934	)
Other income (expense):
Interest income, net		1,388			1,035
Other income (expense), net		867			(700	)
Total other income, net		2,255			335
Loss before income tax and minority interest		(1,377	)		(8,599	)
Income tax provision		(15	)		(20	)
Minority interest		(2	)		33
Net loss	$	(1,394	)	$	(8,586	)
Other comprehensive income (loss):
Net loss		(1,394	)		(8,586	)
Unrealized gain on short-term investments, net		35			142
Foreign currency translation gain (loss)		(835	)		646
Comprehensive loss	$	(3,588	)	$	(16,384	)
Net loss per share basic and diluted	$	(0.03	)	$	(0.19	)
Shares used to compute basic and diluted net loss per share		45,625			45,140

See accompanying notes to consolidated financial statements.

4

ACTIVIDENTITY CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

	Three Months Ended December 31,
	2006			2005
Cash flows from operating activities:
Net loss	$	(1,394	)	$	(8,586	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization of fixed assets		399			418
Amortization of acquired developed technology and patents		792			663
Amortization of acquired intangible assets		48			274
Stock-based compensation expense		711			768
Loss on disposal of property and equipment		—			45
Minority interest in ActivIdentity Europe S.A		2			(33	)
Changes in:
Accounts receivable		8,845			(1,909	)
Inventories		(613	)		255
Prepaid and other current assets		148			687
Accounts payable		1,633			738
Accrued compensation and related benefits		(701	)		(800	)
Accrual for restructuring liability		(165	)		(328	)
Accrued and other current liabilities		243			(1,088	)
Deferred revenue		(564	)		945
Deferred rent		(24	)		(5	)
Net cash provided by (used in) operating activities		9,360			(7,956	)
Cash flows from investing activities:
Purchases of property and equipment		(846	)		(238	)
Purchases of short-term investments		(34,515	)		(25,228	)
Proceeds from sales and maturities of short-term investments		32,041			32,265
Cash used in acquisitions, net of cash received		—			(784	)
Other long-term assets		—			(286	)
Net cash provided by (used in) investing activities		(3,320	)		5,729
Cash flows from financing activities:
Proceeds from exercise of options, rights and warrants		—			68
Net cash provided by financing activities		—			68
Effect of exchange rate changes		(636	)		557
Net increase (decrease) in cash and cash equivalents		5,404			(1,602	)
Cash and cash equivalents, beginning of period		11,477			13,167
Cash and cash equivalents, end of period	$	16,881		$	11,565
Supplemental disclosures:
Cash paid for interest	$	—		$	—
Cash paid for income taxes	$	240		$	177

See accompanying notes to consolidated financial statements.

5

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Nature of Business

ActivIdentity Corporation (formerly known as ActivCard Corp.) is a trusted provider of digital identity assurance solutions for the enterprise, government, healthcare, and financial services markets worldwide. The Company’s headquarters are located at 6623 Dumbarton Circle, Fremont, California, 94555

The Company provides a fully-integrated platform enabling organizations to issue, manage and use identity devices and credentials for secure access, secure communications, legally binding digital transactions, as well as intelligent citizen services. ActivIdentity^® solutions include Smart Employee ID, Enterprise Single Sign On, Strong Authentication, Secure Information and Transactions, and Smart Citizen ID. ActivIdentity products include SecureLogin^® SSO, ActivClient™ smart card middleware, ActivID™ Card Management System, 4TRESS™ AAA Server, one-time password (OTP) tokens, and ActivKey™ USB tokens. ActivIdentity customers experience multiple benefits including increased network security, protection against identity theft and online fraud, enhanced workforce productivity, business process efficiencies, and regulatory compliance.

2. Basis of Presentation

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

The accompanying condensed balance sheet as of September 30, 2006, which has been derived from audited financial statements, and the unaudited interim condensed consolidated financial statements as of and for the three months ended December 31, 2006 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 primarily 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, 2007.

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 Annual Report on Form 10-K for the year ended September 30, 2006.

3. Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FIN 48,Accounting for Income Tax Uncertainties. FIN 48 defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. The recently issued literature also provides guidance on the derecognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of disclosures associated with any recorded income tax uncertainties. FIN 48 is effective for fiscal years beginning after December 15, 2006. Any differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The Company is currently in the process of determining the impact of adopting the provisions of FIN 48 on its financial position, results of operations and cash flows.

In September 2006, the Securities and Exchange Commission (SEC) issued SAB No. 108,Materiality. The interpretations in SAB 108 are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB 108 is effective for the first interim period of the first fiscal year ending after November 15, 2006. Adoption of SAB 108 during the first fiscal quarter of 2007, had no significant impact on the Company’s financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,Fair Value Measurements. SFAS 157 replaces the different definitions of fair value in the accounting literature with a single definition. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157 is effective for fair-value measurements already required or permitted by other standards for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently in the process of determining the impact of adopting the provisions of SFAS 157 on its financial position, results of operations and cash flows.

In September 2006, FASB issued statement No. SFAS 158,Employers Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statement No. 87, 88, 106 and 132(R). SFAS 158 requires an employer to recognize the funded status of a defined benefit postretirement plan (other than multiemployer plan) as an asset or liability measured by the difference between the fair value of the plan assets and the benefit obligation. SFAS 158 also requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income in stockholders’ equity. Under SFAS 158 the Company will be required to initially recognize the funded status of its defined benefit postretirement plans and to provide additional required disclosures in the fourth quarter of 2007. The Company anticipates that adoption the provisions of SFAS 158 will not have a material effect on its financial statements.

6

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

4. Stock-Based Compensation

Equity Compensation Plans

Warrants

Director share warrant plans:From 1995 to 2002, the Company’s predecessor maintained share warrant plans for the purpose of granting warrants to certain executive officers and to members of the Board of Directors. Shares granted under the director share warrant plans vest over four years and have a term of five years. No warrants were granted in any of the periods presented. Plan activity is as follows:

	Number of Warrants		Weighted Average Exercise Price
Outstanding at 9/30/2006	216,500		$	7.46
Expired	(76,500	)		9.04
Outstanding at 12/31/2006	140,000		$	6.60
Exercisable at 12/31/2006	140,000		$	6.60

Warrant issued to service provider:In August 2004, the Company issued a warrant to purchase 50,000 shares of the Company’s common stock at an exercise price of $6.60 to a service provider. The warrant was fully vested and exercisable upon issuance and expires in August 2010. The fair value of the warrant was determined using the Black-Scholes model with an expected volatility of 85%, a risk-free interest rate of 3.8%, expected life of 6 years, and expected dividend yield of zero. The Company recorded a charge to operations of $242,000 in the nine months ended September 30, 2004 in connection with this warrant.

Stock Option Plans

The Company has several stockholder approved stock option plans under which it grants or has granted options to purchase shares of its common stock to employees. As of December 31, 2006, the Company had an aggregate of 8.6 million shares of its common stock reserved for issuance under its various equity plans approved by the stockholders, of which 7.8 million shares were subject to outstanding awards and 0.8 million shares were available for future grants.

Stock option plans prior to 2002 were established by ActivIdentity Europe S.A. (formerly known as ActivCard Europe S.A. and ActivCard S.A.) under the laws of France. Options granted under these plans vest over four years and have a maximum term of seven years. For these option plans, the Board of Directors established the exercise price as the weighted average closing price quoted on Nasdaq Europe during the twenty trading days prior to the date of grant. The difference between the grant price and the fair market value is being amortized over the options’ vesting period. The Company has made no grants under the stock options plans established prior to 2002 during any of the periods presented.

In August 2002, the Company’s stockholders approved the 2002 Stock Option Plan (2002 Plan) and reserved 8.6 million shares for issuance under the plan. Options granted under the 2002 Plan vest over four years and have a maximum term of 10 years. The Board of Directors establishes the exercise price as the closing price quoted on the NASDAQ Global Market on the date of grant.

In August 2004, the Company’s stockholders approved the 2004 Equity Incentive Plan (2004 Plan). The 2004 Plan replaces the 2002 Plan with substantially the same terms as the 2002 Plan. The remaining share reserve from the 2002 Plan was transferred to the 2004 Plan. In addition to stock options, the 2004 Plan allows for the grant of restricted stock, stock appreciation rights, and cash awards in addition to options.

The option plans prohibit residents of France employed by the Company from selling their shares prior to the fifth anniversary from the date of grant for options granted prior to 2000. For options granted in 2000 and later, the option plans prohibit residents of France employed by the Company from selling their shares prior to the fourth anniversary from the date of grant.

Activity under the Company’s stock equity plans is as follows:

	Number of Options		Weighted Average Exercise Price		Aggregate Intrinsic Value (in thousands)
Outstanding at 9/30/2006	6,354,083		$	7.37
Granted	122,500			4.53
Forfeited	(453,857	)		8.70
Outstanding at 12/31/2006	6,022,726		$	7.21	$	2,895
Excercisable at 12/31/2006	2,787,911		$	9.95	$	249

Stock options and directors’ share warrants outstanding and exercisable as of December 31, 2006 are as follows:

	Options and Director Share Warrants Outstanding				Options and Director Share Warrants Exercisable
Range of Exercise Prices	Number	Weighted Average Remaining Contractual Term (in Years)	Weighted Average Exercise Price		Number	Weighted Average Exercise Price
$3.30-4.23	1,013,250	8.90	$	3.44	128,732	$	3.39
$4.24-5.00	1,644,500	6.64		4.31	104,530		4.76
$5.22-6.82	1,223,077	6.17		6.48	799,690		6.54
$7.10-8.95	1,425,711	5.29		7.88	1,058,994		7.63
$9.04-17.77	367,200	3.17		10.65	346,977		10.73
$19.21-32.80	488,988	0.55		21.85	488,988		21.85
$3.30-4.23	6,162,726	5.92	$	7.19	2,927,911	$	9.79

7

-ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Restricted Stock and Restricted Stock Units

The Company’s Board of Directors has issued a total of 215,000 shares of restricted stock and restricted stock units as of December 31, 2006 to the Company’s officers and directors pursuant to the 2004 Plan. 110,000 restricted stock units were granted at no cost to the board members and vest monthly over one to three years. 55,000 restricted stock units were granted at no cost to officers in 2004, one-third of which vest on the first anniversary of the grant date and the remaining vest in equal monthly installments over the following twenty-four months. 50,000 shares of restricted stock were granted to the Company’s new chief financial officer in 2006 at $0.001 per share, one-fourth of which vest on the first anniversary of the grant date and the remaining vest in equal monthly installments over the following thirty-six months. The total compensation expense related to the restricted stock granted to the Company’s chief financial officer of $175,000 is being amortized over the vesting period.

A summary of the status of the Company’s restricted stock and restricted stock units as of September 30, 2006 and changes during the three months ended December 31, 2006 is as follows:

Nonvested Restricted Stock and Restricted Stock Units	Number of Shares (in Thousands)		Weighted Average Grant-Date Fair Value
Nonvested at September 30, 2006	75,279		$	4.66
Vested	(9,999	)		5.30
Nonvested at December 31, 2006	65,280		$	4.56

Adoption of SFAS 123(R)

On October 1, 2005, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which 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. 123(R) 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 such cost as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of October 1, 2005, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of and for the three months ended December 31, 2006 and 2005 reflect the impact of SFAS 123(R).

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under S FAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s Consolidated Statements of Operations, other than as related to restricted stock units and option grants to employees and directors below the fair market value of the underlying stock at the date of grant.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. As stock-based compensation expense recognized in the Consolidated Statement of Operations for the three months ended December 31, 2006 and 2005 is based on awards ultimately expected to vest, this expense has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company’s estimated forfeiture rates differ for executive and non-executive employees and for employees located in France. The weighted average estimated forfeiture rate for grants made during the three months ended December 31, 2006 and 2005 of approximately 19.9% and 25%, respectively, were based on historical forfeiture experience.

SFAS 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. Due to the Company’s loss position, there were no such tax benefits during the three months ended December 31, 2006. Prior to the adoption of Statement SFAS 123(R) those benefits would have been reported as operating cash flows had the Company received any tax benefits related to stock option exercises.

The fair value of stock-based awards to employees is calculated using the Black-Scholes Merton option 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 Merton model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate is based on the U.S Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of the Company’s stock price. These factors could change in the future, which would affect the stock-based compensation expense in future periods.

Valuation and Expense Information under SFAS 123(R)

The weighted-average fair value of stock-based compensation to employees is based on the single option valuation approach. Forfeitures are estimated 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. Below are the ranges of assumptions used:

	Three Months Ended December 31,
	2006	2005
Risk-free interest rate	4.55% - 4.56%	4.56%
Expected life (years)	4.80 - 5.40	4.00 - 5.20
Expected volatility	50.1% - 55.0%	44.0% - 52.00%
Weighted average expected volatility	51.60%	50.38%

8

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table summarizes stock-based compensation expense related to employee stock options, warrants and restricted stock units under SFAS 123(R) for the three months ended December 31, 2006 and 2005, which was allocated as follows (in thousands):

	Three months ended December 31,
	2006		2005
Cost of sales—software	$	32	$	25
Cost of sales—hardware		10		5
Cost of sales—support and maintenance		21		16
Stock-based compensation expense included in cost of sales		63		46
Research and development		218		197
Sales and marketing		136		121
General and administrative		294		404
Stock-based compensation expense included in operating expenses		648		722
Stock-based compensation expense related to employee stock options	$	711	$	768

As of December 31, 2006, total unrecognized compensation costs related to nonvested stock options and restricted stock was $6.2 million, which is recognized as an expense over a weighted average vesting period of approximately 2.8 years. The weighted average grant date fair value of options granted during the three months ended December 31, 2006 was $2.26.

5. Accounts Receivable and Customer Concentration

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

Balance, September 30, 2006	$	350
Amounts charged to expense		33
Recoveries		(130	)
Impact of exchange rate changes		10
Balance, December 31, 2006	$	263

The following customers accounted for 10% or more of accounts receivable:

	December 31, 2006		September 30, 2006
Customer A	14	%	29	%
Customer B		*	17	%

* Customer accounted for less than 10% of A/R at the end of period.

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

	Three Months Ended December 31,
	2006		2005
Customer A	17	%	10	%
Customer C	14	%	10	%

6. Inventories

Inventories consist of the following (in thousands):

	December 31, 2006		September 30, 2006
Components	$	212	$	412
Finished goods		2,095		1,221
	$	2,307	$	1,633

9

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

7. Other Intangible Assets

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

	September 30, 2006			Additions			December 31, 2006
Gross Carrying Amount
Acquired developed technology and patents	$	15,294		$	—		$	15,294
Customer relationships		2,028			—			2,028
Patents		4,659			—			4,659
Other intangible assets at cost		21,981			—			21,981
Accumulated Amortization
Acquired developed technology		(9,796	)		(625	)		(10,421	)
Customer relationships		(1,536	)		(48	)		(1,584	)
Patents		(819	)		(167	)		(986	)
Total accumulated amortization		(12,151	)		(840	)		(12,991	)
Other intangible assets, net	$	9,830					$	8,990

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

	Acquired developed technology and patents		Customer relationships
Fiscal years ending September 30,
2007 (remaining 9 months)	$	2,157	$	138
2008		2,380		165
2009		2,168		140
2010		666		—
2011		666		—
Thereafter		510		—
	$	8,547	$	443

8. Goodwill

There were no changes to goodwill during the three months ended December 31, 2006. Based on the results of its annual impairment test in accordance with SFAS No. 142, the Company determined that no impairment on the carrying value of its goodwill of $35.9 million existed as of December 1, 2006, the Company’s annual impairment date. The Company will continue to evaluate goodwill on an annual basis as of December 1 and whenever events and changes in circumstances indicate that there may be a potential impairment.

9. Sales Warranty Reserve

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

Balance, September 30, 2006	$	203
Warranty costs incurred		—
Additions related to current period sales		28
Impact of exchange rate changes		8
Balance, December 31, 2006	$	239

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

10. Restructuring and Business Realignment Expenses

The Company has accounted for its 2002 restructuring under Emerging Issue Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. Costs associated with restructuring activities initiated on or after January 1, 2003 are accounted for in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, and SFAS 112, Employer’s Accounting for Postemployment Benefits, when applicable. All restructurings subsequent to December 15, 2002 have been accounted for under SFAS No. 146 which requires that a liability for a cost associated with an exit or disposal activity be recognized when a liability is incurred rather than when an exit or disposal plan is approved.

10

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following summarizes the restructuring activity (in thousands):

	2002 Restructuring			2004 Restructuring			2005 Restructuring						2006 Restructuring
	Facility Exit Costs			Facility Exit Costs			Workforce Reduction			Facility Exit Costs			Workforce Reduction			Facility Exit Costs			Total
Balances, September 30, 2005		3,290			373			331			201			—			—			4,195
Provision for restructuring expenses		—			—			—			—			680			127			807
Adjustments to accruals for changes in estimates		68			(13	)		(10	)		(39	)		31			(39	)		(2	)
Cash payments		(614	)		(177	)		(262	)		(164	)		(705	)		(92	)		(2,014	)
Impact of exchange rate changes		—			7			6			2			(6	)		4			13
Balances, September 30, 2006		2,744			190			65			—			—			—			2,999
Cash payments		(138	)		(26	)		—			—			—			—			(164	)
Impact of exchange rate changes		—			(8	)		3			—			—			—			(5	)
Balances, December 31, 2006		2,606			156			68			—			—			—			2,830
Less current portion		(581	)		(105	)		(68	)		—			—			—			(754	)
Long-term portion	$	2,025		$	51		$	—		$	—		$	—		$	—		$	2,076

2002 Restructuring

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. Charges for the reduction in workforce consisted of severance, outplacement, and other termination costs. 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 total estimated sublease income. Sublease income was estimated assuming then current market lease rates and vacancy periods. In June 2005, the Company subleased the excess facilities. The estimated remaining restructuring liability was increased by $87,000 in fiscal 2005 and $68,000 in fiscal 2006 due to changes in sublease assumptions. Cash payments for the remaining liability of $2.6 million as of December 31, 2006, for facility exit activities, will be made over the remaining life of the lease ending February 2011.

2004 Restructuring

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. Relating to the 2004 restructurings, the Company has recorded a total charge of $3.8 million, consisting of $3.1 million for workforce reduction, $0.7 million for excess facilities, and $40,000 for the termination of the non-strategic project. The 109 terminated employees include 19 employees 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. During the three months ended March 31, 2006, the Company reduced the remaining liability by $13,000 related to higher than anticipated sublease income for the property in Canada. Cash payments for the remaining liability of $156,000 as of December 31, 2006, for facility exit activities, will be made over the remaining life of the lease ending June 2008. Cash payments related to the workforce reduction were completed in fiscal year 2005.

2005 Restructuring

In April 2005, the Company implemented an organizational restructuring to eliminate 18 employees, of whom 11 were in sales and marketing, five in research and development, and two in general and administration functions and recorded a restructuring charge of $837,000 for severance, benefits and other costs related to the reduction. All employees have been terminated and the cash payments related to workforce reduction have been made.

In July 2005, following the announcement of the Protocom acquisition, the Company implemented an organizational restructuring to take advantage of the complementary operating models and infrastructures. The restructuring included the elimination of excess facilities in four locations and termination of 31 employees, of whom 15 were in sales and marketing, 15 in research and development, and one in general and administrative functions. The Company recorded a restructuring charge of $206,000 for excess facilities, related to vacating part of one facility in London and $1.1 million for workforce reduction, for a total of $1.3 million. Charges for the reduction in workforce consisted of severance, outplacement, and other termination costs. Sublease income for the vacated premises was estimated assuming then current market lease rates and vacancy periods. During 2006, the Company reduced the remaining liability for reduction in workforce by $10,000. When the final cash payments related to the facility exit costs were completed in fiscal year 2006 the facility exit costs were reduced by $39,000. The remaining liability of $68,000 related to workforce reduction is expected to be paid during the third quarter of fiscal 2007.

2006 Restructuring

In December 2005, the Company implemented an organizational restructuring to terminate 12 employees, of whom three were in sales and marketing, seven in research and development, and two in general and administrative functions and recorded a restructuring charge of $532,000 for workforce reduction. In January 2006, the Company recorded an additional restructuring charge of $148,000, which was increased during the quarter ended June 30, 2006 by approximately $31,000 when final cash severance payments were made. All terminated employees have left the Company. In January 2006, the Company vacated the remaining space of the facility in London and recorded a charge related to the remaining liability under the associated lease of $127,000 net of estimated sublease income. The Company reduced the remaining liability for facility exit costs by $39,000 when the cash payments related to the facility exit costs were completed in fiscal 2006.

11

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

11. 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 December 31,
	2006			2005
Numerator:
Net loss	$	(1,394	)	$	(8,586	)
Denominator:
Weighted average number of shares outstanding		45,625			45,140
Basic and diluted net loss per share	$	(0.03	)	$	(0.19	)

For the above periods, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, that were excluded from the computation of diluted net loss per share in the periods presented as their impact would have been anti-dilutive. At December 31, 2006 and 2005, approximately 6.2 million and 6.8 million potential common shares (prior to application of treasury method), respectively, consisting of options and warrants, are excluded from the determination of diluted net loss per share as the effect of such shares is anti-dilutive.

12. Commitments and Contingencies

On August 5, 2005, the Company acquired Protocom Development Systems Pty. Ltd (Protocom). for cash of $21.0 million, 1,650,000 shares of its common stock, and incurred direct acquisition related costs of $625,000, for a total initial consideration of $29.2 million. Concurrently with the closing of the Protocom acquisition, the Company entered into an employment agreement with Jason Hart, then Protocom’s chief executive officer, who now serves as the Company’s chief executive officer and a member of the board of directors. Pursuant to the acquisition agreement, the Company agreed to issue up to an additional 2,100,000 shares of its common stock to the former Protocom shareholders, including Mr. Hart, under an earn-out provision if Protocom achieved a revenue target between $13.6 million and $18.7 million during the one-year period ended June 30, 2006. If any portion of the earn-out is ultimately paid, Mr. Hart would receive approximately 68.7% of these additional payments. Based on the Company’s calculations of qualifying revenues that are credited to this earn-out right, it has concluded that the revenue targets have not been met and no additional consideration is owed. The Company notified the Protocom shareholder representative in the fourth quarter of fiscal 2006 that none of the additional consideration would be paid. The Protocom shareholder representative has objected to certain items in our calculation and in accordance with the agreement, the matter is being referred to an independent auditor for resolution. No liability for this earn-out provision has been recorded at December 31, 2006 or September 30, 2006.

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 ActivIdentity 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 December 31, 2006 or September 30, 2006.

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 December 31, 2006 or September 30, 2006.

12

ACTIVIDENTITY CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

13. Segment Information

The Company operates in one segment, Digital Identity Solutions. Accordingly, the Company is disclosing geographic information 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 December 31, 2006
Total revenue	$	5,802		$	7,996		$	817		$	14,615
(Loss) income from operations		(1,865	)		148			(1,915	)		(3,632	)
Capital expenditures		589			217			40			846
Depreciation and amortization of fixed assets		211			109			79			399
Three months ended December 31, 2005
Total revenue		5,277			5,392			803			11,472
Loss from operations		(4,697	)		(2,596	)		(1,641	)		(8,934	)
Capital expenditures		61			74			103			238
Depreciation and amortization of fixed assets		188			157			73			418
December 31, 2006
Goodwill		7,748			6,345			21,781			35,874
Long-lived assets		7,356			1,310			5,392			14,058
Total assets		147,475			23,943			29,111			200,529
September 30, 2006
Goodwill		7,748			6,345			21,781			35,874
Long-lived assets		4,037			2,632			7,741			14,410
Total assets		149,406			19,258			32,324			200,988

During the three months ended December 31, 2006, customers located in the United States, France and United Kingdom accounted for 40%, 18% and 16% of the Company’s net revenue, respectively. No other individual country accounted for 10% or more of the Company’s net revenue for the period.

13

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 Part II Item 1A “Risk Factors” below and elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended September 30, 2006 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

ActivIdentity Corporation (formerly known as ActivCard Corp.) is a trusted provider of digital identity assurance solutions for the enterprise, government, healthcare, and financial services markets worldwide. We provide software and hardware products that enable organizations to issue, manage and use trusted digital identities for secure physical and logical access, secure communications, and legally binding digital transactions.

Our solutions include strong authentication, smart employee ID, single sign on, secure information and transactions, and smart citizen ID. Our products support strong authentication utilizing a range of security devices, such as smart cards, USB tokens, OTP tokens, soft OTP tokens for mobile phones and personal digital assistants, and proximity badges and biometric devices. This enables organizations to address their security, compliance and auditing requirements by confirming identities before granting access to computer systems, networks, applications, and physical locations. More than 15 million users and 4,000 customers at businesses, government agencies, and financial institutions worldwide rely on solutions from ActivIdentity to safely and efficiently interact electronically.

Results of operations

Revenue

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

	Three Months Ended December 31,				Increase (Decrease)		Percentage Change
	2006		2005
Software	$	6,780	$	5,181	$	1,599	31	%
Hardware		3,729		2,935		794	27	%
Maintenance and support		4,106		3,356		750	22	%
Total revenue	$	14,615	$	11,472	$	3,143	27	%

Software revenue is comprised of sales of standard software and professional services associated with customization, installation and integration. The increase in software revenue in the three months ended December 31, 2006 compared to the same period in the prior year was primarily due to increased demand for card management software.

Hardware revenue is comprised of tokens, readers, smart cards and related equipment as well as hardware storage modules (HSM), which include integrated software components. The increase in hardware revenue in the three months ended December 31, 2006 compared to the same period in the prior year was due increase in shipments of tokens of approximately $0.7 million and HSM of $0.3 million offset by lower sales of smartcards.

The increase in maintenance and support revenue in the three months ended December 31, 2006 compared to the same period in the prior year is primarily due to maintenance contract renewals from a growing installed base of customers.

Period-over-period changes in revenue by geography and as a percentage of total revenue, are as follows:

	Three Months Ended December 31,
	2006		2005
North America	40	%	46	%
Europe	55	%	47	%
Asia Pacific	5	%	7	%
	100	%	100	%

In absolute dollars, revenue in North America increased by $0.6 million in the three months ended December 31, 2006 compared to the same period in the prior year, primarily as a result of $0.7 million higher hardware sales offset by $0.2 million in lower software revenue.

European revenues were higher during the first fiscal quarter of 2007 when compared to the same period in fiscal 2006 mainly due to an agreement entered into during the fourth quarter of 2006 to supply a European government department with our employee identification solutions, which contributed revenue of $1.7 million for the period. Additionally, maintenance revenue was higher during the first quarter of 2007 due to continued growth in installed base of customers.

14

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

	Three Months Ended December 31,
	2006		2005
Enterprise	45	%	57	%
Government	33	%	16	%
Financial	22	%	27	%
	100	%	100	%

The increase in the government sector during the three months ended December 31, 2006 when compared to the same period in prior year was mainly attributable to the agreement entered into during the fourth quarter of 2006 to supply a European government department with our employee identification solutions. In absolute dollars, revenue from the financial sector and the enterprise sector remained relatively constant during the three months ended December 31, 2006 when compared to the same period in the prior year.

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 Ending December 31,						Increase (Decrease)			Percentage Change
	2006			2005
Software	$	756		$	1,009		$	(253	)	-25	%
As a percentage of software revenue		11	%		19	%
Hardware		1,906			1,768			138		8	%
As a percentage of hardware revenue		51	%		60	%
Maintenance and support		1,047			896			151		17	%
As a percentage of license revenue		25	%		27	%
Amortization of acquired developed technology and patents		792			663			129		19	%
Total cost of revenue	$	4,501		$	4,336		$	165		4	%

Cost of software revenue includes costs associated with software duplication, packaging, documentation such as user manuals and CDs, royalties, logistics, operations, and professional services associated with customization, integration and installation services. The software margin improvement during the three months ended December 31, 2006 resulted primarily from a decrease in sales of professional services related to customized software products and a relative increase in sales of standard software with lower cost.

Cost of hardware revenue includes costs associated with the manufacturing and shipping of hardware products, logistics, operations, and adjustments to reserves for warranty and inventory. Our smart card and reader revenues reflect products manufactured for us by original equipment manufacturers, and accordingly, have lower margins compared to tokens that are manufactured for us by contract manufacturers which yield higher gross margins. Cost of hardware revenue in absolute dollars increased during the three months ended December 31, 2006 when compared to the same period in prior year due to higher hardware sales. The margin improvements are attributable to cost reductions achieved in part through higher volumes and relatively constant overhead costs.

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 increased in absolute dollars during the three months ended December 31, 2006 when compared to the same period in the prior year primarily due to higher headcount required for the support of our single-sign-on products, as well as the support required for a growing installed base.

Amortization of acquired developed technology includes amortization of technology capitalized in our acquisitions and purchase of certain patents and related intellectual property from a third party. Increased amortization during fiscal 2006 is primarily due to the amortization of patents acquired during the fourth quarter of fiscal 2006.

Operating expenses

A substantial proportion of our operating expenses are comprised of personnel costs, facilities, and associated information technology costs to support our personnel, which are generally 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.

15

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

	Three Months Ended December 31,
	2006			2005
Sales and marketing	$	5,820		$	6,574
Percentage change from comparable prior period		-11.5	%
As a percentage of net revenue		39.8	%		57.3	%
Headcount, end of period		107			113

The decrease in sales and marketing expenses during the three months ended December 31, 2006, when compared to the same period in the prior year resulted principally from a $342,000 decrease in sales and marketing personnel and related benefits expense, $270,000 lower professional services expenses, $89,000 lower travel expenses, $44,000 lower marketing costs and $222,000 lower corporate allocations which were partially offset by $220,000 higher sales commissions.

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.

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

	Three Months Ended December 31,
	2006			2005
Research and development	$	4,993		$	4,756
Percentage change from comparable prior period		5.0	%
As a percentage of net revenue		34.2	%		41.5	%
Headcount, end of period		135			134

The increase in research and development expenses in the three months ended December 31, 2006, when compared to the same period in the prior year, was primarily due to increased headcount and temporary contract workforce. The increase in headcount was required to support and develop the existing software portfolio as well as develop new and enhanced versions of our existing portfolio.

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, 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 December 31,
	2006			2005
General and administration	$	2,885		$	3,934
Percentage change from comparable prior period		-26.7	%
As a percentage of net revenue		19.7	%		34.3	%
Headcount, end of period		43			36

General and administrative expenses decreased in the three months ended December 31, 2006 compared to the same period in the prior year mainly due to $513,000 decrease in accounting, audit and other professional services fees, a $277,000 decrease in bad debt expense, a $110,000 decrease in stock-based compensation and $67,000 lower travel expenses.

Restructuring expenses

Restructuring 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 December 31, 2006 we recorded no restructuring expenses compared to $532,000 recorded in the same period in the prior year associated with the December 2005 restructuring. As part of the fiscal 2006 restructuring, we terminated the employment of 12 employees, of whom three were in sales and marketing, seven in research and development and two in general and administrative functions.

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

Amortization of acquired intangible assets

Amortization of acquired intangible assets includes amortization of customer relationships, trademark, and trade name intangibles capitalized in acquisitions. Amortization decreased to $48,000 in the three months ended December 31, 2006, from $274,000 in the three months ended December 31, 2005 primarily due to intangible assets related to the acquisition of Aspace Solutions Limited becoming fully amortized during the 2006 fiscal year.

16

Other income (expenses)

Other income (expense) consists of interest income on our cash, cash equivalents, and short-term investments and gains or losses on foreign exchange transactions and investments. Interest income, net, increased by $353,000 in the three months ended December 31, 2006 when compared to the same period in prior year. While our short-term investments balance has decreased from December 31, 2005, we have earned a higher average yield on our short-term investment portfolio. Other income (expense), net is comprised primarily of foreign exchange gains or losses. During the three months ended December 31, 2006 the foreign exchange gain amounted to $835,000 compared to a loss of $646,000 during the same period in the prior year. The fluctuation is mainly due to lower U.S dollar against European currencies, especially the British Pound during the first quarter of 2007.

Income taxes

Income taxes in all periods represent minimum taxes payable in various U.S. jurisdictions and income taxes payable in foreign jurisdictions. Income tax expenses were $15,000 and $20,000 in the three months December 31, 2006 and 2005, 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 currently consider the generation of taxable income to realize their benefits to be more likely than not.

Minority interest

Minority interest represents the minority interest share in the consolidated net income of ActivIdentity Europe S.A.

Liquidity and capital resources

The following sections discuss the effect of changes in our balance sheet and cash flows and contractual obligations on our liquidity and capital resources.

Balance Sheet and Cash Flows

Cash and Cash Equivalents and Short-term investments. The following table summarizes our cash and cash equivalents and short-term investments (in thousands):

	December 31, 2006		September 30, 2006		Increase
Cash and cash equivalents	$	16,881	$	11,477	$	5,404
Short-term investments		119,093		116,570		2,523
	$	135,974	$	128,047	$	7,927

Cash provided by operations was $9.4 million in the three months ended December 31, 2006 compared to an $8.0 million of cash used in operations in the three months ended December 31, 2005. In the three months ended December 31, 2006, our net loss was $1.4 million, including non-cash charges totaling $2.0 million, primarily related to depreciation and amortization and employee stock-based compensation. Decreases in accounts receivable of $8.8 million, and prepaid assets of $148,000 and increases in accounts payable of $1.6 million and accrued and other current liabilities of $243,000 provided cash during the period. Decreases in accrued benefits and restructuring of $867,000 and deferred revenue of $564,000 and an increase in inventory of $613,000 used cash during the period. The reduction in accounts receivable balance at December 31, 2006 is attributable to more effective collections, which resulted in improvement in days of sales outstanding (DSO) to 58 days during the first quarter of fiscal year 2007 from 70 days during the first quarter of fiscal 2006. In the three months ended December 31, 2005, our net loss was $8.6 million, including non-cash charges totaling $2.1 million, primarily related to depreciation and amortization and employee stock-based compensation. Contributing to the use of cash was an increase in accounts receivable of $1.9 million, and a decrease in liabilities of $1.5 million, primarily related to accrued compensation.

In the three months ended December 31, 2006, investing activities used $2.5 million of cash to purchase short-term investments and $846,000 to acquire property and equipment. Investing activities in the three months ended December 31, 2005 generated net cash of $5.7 million from the proceeds of sales or maturities of short-term investments of $32.3 million offset by use of cash of $25.2 million for the purchases of short-term investments and $784,000 for acquisition related expenses.

Financing activities provided net cash of $68,000 in the three months ended December 31, 2005 from the issuance of common stock from 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 acquire or obtain the right to use complementary technologies.

Accounts Receivable, net. The following table summarizes our accounts receivable, net (in thousands):

	December 31, 2006		September 30, 2006		Decrease
Accounts receivable, net	$	9,447	$	18,048	$	(8,601	)

The decrease in accounts receivable at December 31, 2006 compared to September 30, 2006 was primarily due to the effective collections of our receivables during the first quarter of fiscal 2007. As a result, our DSO improved to 58 days at December 31, 2006 compared to 91 days at September 30, 2006.

17

Deferred Revenue. The following table summarizes our deferred revenue (in thousands):

	December 31, 2006		September 30, 2006		Increase/ (Decrease)
Maintenance and support	$	11,558	$	11,351	$	207
Product		2,751		3,382		(631	)
Total	$	14,309	$	14,733	$	(424	)
Reported as:
Current	$	12,230	$	12,788	$	(558	)
Noncurrent		2,079		1,945		134
Total	$	14,309	$	14,733	$	(424	)

The increase in deferred maintenance and support revenue reflects the impact of the increase in post-contract customer support contract initiations and renewals, partially offset by the ongoing amortization of deferred maintenance and support revenue. The decrease in deferred product revenue was primarily related to unrecognized software license payments at September 30, 2006 which were recognized to earnings during the first quarter of fiscal 2007 after all the revenue recognition criteria for the undelivered elements of the arrangements had been met.

Contractual Obligations

The following summarizes our contractual obligations at December 31, 2006, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):

	Total		Less than 1 Year(1)		1 to 3 Years		4 to 5 Years		After 5 Years
Operating leases(2)	$	12,108	$	2,272	$	5,943	$	3,893	$	—

⁽¹⁾ Represents remaining nine months of fiscal year.

⁽²⁾ Operating leases include amounts related to non-cancelable operating leases that are included in the charge for restructuring expenses exclusive of expected sublease income of $1.0 million.

On August 5, 2005, we acquired Protocom Development Systems Pty. Ltd. (Protocom) for cash of $21.0 million, 1,650,000 shares of our common stock, and incurred direct acquisition related costs of $625,000, for a total initial consideration of $29.2 million. Concurrently with the closing of the Protocom acquisition, we entered into an employment agreement with Jason Hart, then Protocom’s chief executive officer, who now serves as our chief executive officer and a member of the board of directors. Pursuant to the acquisition agreement, we agreed to issue up to an additional 2,100,000 shares of our common stock to the former Protocom shareholders, including Mr. Hart, under an earn-out provision if Protocom achieved a revenue target between $13.6 million and $18.7 million during the one-year period ended June 30, 2006. If any portion of the earn-out is ultimately paid, Mr. Hart would receive approximately 68.7% of these additional payments. Based on our calculations of qualifying revenues that are credited to this earn-out right, we have concluded that the revenue targets have not been met and no additional consideration is owed. We notified the Protocom shareholder representative in the fourth quarter of fiscal 2006 that none of the additional consideration would be paid. The Protocom shareholder representative has objected to certain items in our calculation and in accordance with the agreement, the matter is being referred to an independent auditor for resolution. No liability for this earn-out provision has been recorded at December 31, 2006 or September 30, 2006.

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FIN 48,Accounting for Income Tax Uncertainties. FIN 48 defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. The recently issued literature also provides guidance on the derecognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of disclosures associated with any recorded income tax uncertainties. FIN 48 is effective for fiscal years beginning after December 15, 2006. Any differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The Company is currently in the process of determining the impact of adopting the provisions of FIN 48 on its financial position, results of operations and cash flows.

In September 2006, the Securities and Exchange Commission (SEC) issued SAB No. 108Materiality. The interpretations in SAB 108 are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB 108 is effective for the first interim period of the first fiscal year ending after November 15, 2006. The adoption of SAB 108 during the first quarter of 2007 had no material effect on our financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,Fair Value Measurements. SFAS 157 replaces the different definitions of fair value in the accounting literature with a single definition. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157 is effective for fair-value measurements already required or permitted by other standards for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently in the process of determining the impact of adopting the provisions of SFAS 157 on our financial position, results of operations and cash flows.

In September 2006, FASB issued statement No. SFAS 158,Employers Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statement No. 87, 88, 106 and 132(R). SFAS 158 requires an employer to recognize the funded status of a defined benefit postretirement plan (other than multiemployer plan) as an asset or liability measured by the difference between the fair value of the plan assets and the benefit obligation. SFAS 158 also requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income in stockholders’ equity. Under SFAS 158 we will be required to initially recognize the funded status of the defined benefit postretirement plans and to provide additional required disclosures in the fourth quarter of 2007. We do not anticipate the adoption of SFAS 158 to have a material impact on our financial statements.

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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. We have reviewed our critical accounting policies and their application in the preparation of our financial statements and related disclosures with our Audit Committee of the Board of Directors. Our critical accounting policies and estimates are described below.

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) 97-2,Software Revenue Recognition, SEC Staff Accounting Bulletin (SAB) No. 104,Revenue Recognition, Emerging Issues Task Force (EITF) 00-21,Revenue Arrangements with Multiple Deliverables and EITF 03-05Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software. The application of the appropriate accounting principle to our revenue is dependent upon the specific transaction and whether the sale includes hardware products, software products, post contract customer support (PCS), other services, or a combination of these items.

Subject to the conditions described below, revenue is not recognized until

• Evidence of an arrangement exists;

• The fee is fixed or determinable;

• No significant obligations remain; and

• Collection of the corresponding receivable is reasonably assured.

For multiple element arrangements that contain one or more deliverables for which the functionality is not dependent on the software, the arrangement fee is allocated between the “non-software” and software deliverables in accordance with EITF 00-21 if the following criteria are met:

• The delivered item has stand alone value;

• There is objective and reliable evidence of the fair value of the undelivered elements as demonstrated by vendor specific objective evidence (VSOE) or third party evidence; and

• If the arrangement includes a general return right relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor.

If the above criteria are met, we allocate the arrangement fee to the delivered items using the residual value method. Revenue for the elements whose functionality is not dependent upon the delivered software is recognized in accordance with SAB 104, and revenue for software elements is recognized in accordance with SOP 97-2. If the above criteria are not met, all deliverables are considered a single unit of accounting and revenue is normally recognized in accordance with SOP 97-2.

For the deliverables subject to SOP 97-2, as amended by SOP 98-9, the arrangement fee is allocated among each element, based on vendor-specific objective evidence of fair value 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. Additionally, where VSOE for undelivered elements does not exist and where the only undelivered element is PCS, revenue for the delivered and undelivered elements is recognized on a straight-line basis over the life of the PCS contract.

From time-to-time, we have provided certain of our customers acceptance rights, which give the customer the right to accept or reject the software after it has been delivered, for customized or significantly modified software products developed under product development agreements, and on occasion, for hardware products and client/server software products. In instances where an acceptance clause exists, no revenue is recognized until the product is formally accepted by the customer or the acceptance period has expired.

Service revenue includes revenue from training, installation and consulting. From time-to-time, we develop and license software to customers that requires some customization, modification or production. Where the services are essential to the functionality of the software element of the arrangement and separate accounting for the services is not permitted, contract accounting is applied to both the software and service elements. For these projects, revenue is recognized 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.

PCS contracts are typically priced as a percentage of the product license fee and generally have a one-year term. Services provided to customers under PCS contracts include technical product support and unspecified product upgrades. Revenues from advance payments for PCS contracts are recognized on a straight-line basis over the term of the contract.

Even though delivery of PCS and services has started, if all of the criteria in SOP 97-2 for revenue recognition are not met, PCS and service revenue recognition may not commence. At the time all the criteria in SOP 97-2 are met, the portion of the deferred amount based on the proportion of the service period that has already expired to the total service period is immediately recognized and the residual amount is recognized ratably over the remaining PCS service period.

Revenue from stand alone product sales is recognized upon shipment (unless shipping terms determine otherwise) to resellers, distributors and other indirect channels, net of estimated returns or estimated future price changes. Our policy is not to ship product to a reseller or distributor unless the reseller or distributor has a history of selling the products or the end user is known and has been qualified by us. In certain specific and limited circumstances, we provide product return and price protection rights to certain distributors and resellers. We have established a reasonable basis through historical experience for estimating future returns and price changes. Actual returns and price protection claims have not been material to date.

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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 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 purchased technology, customer lists, 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. When we conduct our annual evaluation of other intangible assets as of December 1, or if in the interim 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 our original assessment, material write-downs of the fair value of intangible assets may be required. We recorded such impairments in fiscal 2005 and 2004. We periodically review the estimated remaining useful lives of our other intangible assets. A reduction in the estimate of remaining useful life could result in accelerated amortization or an impairment charge in future periods and may adversely affect our results of operations.

• Goodwill – Under current accounting guidelines, we periodically assess goodwill for impairment. 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. When we conduct our annual evaluation of goodwill as of December 1, or if impairment indicators are identified in the interim with respect to goodwill, the fair value of goodwill is re-assessed using valuation techniques that require significant management judgment. The key judgments used include analysis of future cash flow which management believes to be an important factor in determination of the fair value of the Company’s sole reporting unit. This analysis takes into consideration certain revenue growth and operating expense forecasts. Should conditions be different than our last assessment, significant write-downs of goodwill may be required which will adversely affect our results of operations. We recorded a goodwill impairment charge in fiscal 2005. If the enterprise value at a future date is lower than the enterprise value as of our last impairment evaluation date of December 1, 2006, the test could result in an impairment of goodwill charge.

• Restructuring Expense – In connection with our 2006, 2005, 2004, 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 terminated project based on estimates. Accrual of costs associated with terminations requires us to estimate severance payments. Recording of costs associated with vacating facilities require us to estimate future sub-lease income. If the actual future severance or lease 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. We have recorded additional charges associated with the change in our estimates for future sublease income in fiscal 2006 and 2005.

• Hardware 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. The Company’s standard warranty period is ninety days for software products and 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.

• Upon adoption of SFAS 123(R) on October 1, 2005, we began estimating the value of employee stock options on the date of grant using the Black-Scholes Merton model. Prior to the adoption of SFAS 123(R), the value of each employee stock option was estimated on the date of grant using the Black-Scholes Merton model for the purpose of the pro forma financial disclosure in accordance with SFAS 123. The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of

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the awards, and actual and projected employee stock option exercise behaviors. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The expected volatility is based on the historical volatility of our stock price.

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 Australian dollar. 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 months ended December 31, 2006 and 2005, approximately 48% and 63%, 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, including the 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 December 31, 2006, we held $16.9 million of cash and cash equivalents and $119.1 million in short-term investments for a total of $136.0 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. Based on our cash, cash equivalents and short-term investments at December 31, 2006, a hypothetical 10% change in interest rates would increase/decrease our annual interest income by approximately $700,000.

ITEM 4: CONTROLS AND PROCEDURES

(a) The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Securities Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the Securities Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management including its Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required financial disclosure.

(b) There was no change in our internal control over financial reporting during our quarter ended December 31, 2006 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 1: Legal Proceedings

From time to time, we are involved in disputes or regulatory inquiries that arise in the ordinary course of business. Any claims or regulatory actions against us, whether valid or not, could be time consuming, result in costly litigation, require significant amounts of management time, and result in the diversion of significant operational resources.

Item 1A: Risk Factors

Risk Factors That May Affect Results of Operations and Financial Condition

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.

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

We have not achieved profitability and we may incur losses for the foreseeable future. During the three months ended December 31, 2006, our net loss was $1.4 million and in fiscal 2006 we incurred losses of approximately $22.5 million. As of December 31, 2006, our accumulated deficit was $238.6 million representing our net losses since inception. Although our cash balance is sizable, it may not last long enough for our operations to become profitable.

We will need to achieve significant incremental revenue growth and manage our 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 grow.

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

Over the past several years, we have implemented extensive cost cutting measures and have incurred significant restructuring charges as we have attempted to streamline operations, improve efficiency, and reduce costs. Although we believe that it has been necessary to reduce the size and cost of our operations to

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improve our performance, 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 have been terminated as part of our restructuring activities possessed specific knowledge or expertise that may prove to have been important to our operations and their absence may create significant difficulties. These efforts may not result in anticipated cost savings, making it difficult for us to achieve profitability. These cost reduction initiatives may also preclude us from making complementary acquisitions and/or other potentially significant expenditures that could improve our product offerings, competitiveness or long-term prospects.

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 our future 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 prior 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 more diversified product base.

Our customer base is highly concentrated and the loss of any one of these customers or delay in anticipated orders 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 in fiscal 2006 there was a high concentration of revenue through a number of system integrators to the U.S. and international government agencies. Many of our contracts with our significant channel partners are short-term. Two customers each accounted for more than 10% of our total revenue during the three months ended December 31, 2006 and 2005. Additionally, due to uncertainties surrounding Homeland Security Presidential Directive #12, the revenue generated by our U.S government business declined during fiscal 2005 and 2006, and it has been difficult to forecast. The government business recovered somewhat during the fourth quarter of fiscal 2006 and accounted for 29% of revenue in fiscal year 2006 and 33% during the first quarter of fiscal 2007. We expect that this variability will continue for the foreseeable future.

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, or if there are further delays in orders from the U.S. government, 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.

Our quarterly gross margins are difficult to predict, and if we miss quarterly financial expectations, our stock price could decline.

Our quarterly revenue, expense levels and operating results are difficult to predict and fluctuate from quarter to quarter. It is likely that our operating results in some periods will be below investor expectations. If this happens, the market price of our common stock is likely to decline. Fluctuations in our future quarterly operating results may be caused by many factors, including:

• The size and timing of customer orders, which are received unevenly and unpredictably throughout a fiscal year and may be subject to seasonality relating to the U.S. federal government’s fiscal year and related spending patterns;

• The mix of products licensed and types of license agreements;

• The effect of generally accepted accounting principles on the timing of revenue recognition;

• The timing of customer payments;

• The size and timing of revenue recognized in advance of actual customer billings and customers with installment payment schedules that may result in higher accounts receivable balances;

• The relative mix of our license and services revenue;

• Our ability to win new customers and retain existing customers;

• Changes in our pricing and discounting practices and licensing terms and those of our competitors;

• Changes, if any, in the interpretation of the authoritative literature under which we recognize revenue;

• The timing of product releases or upgrades by us or our competitors;

• The integration, by us or our competitors, of newly-developed or acquired products;

• Our ability to establish credit for certain customers; and

• Consolidation within our industry which may provide our competitors an advantage of put us at a disadvantage.

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;

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• Significant expense of digital identity products and network systems;

• Customer’s requirement for customized features and functionalities;

• Turnover of key personnel at existing and prospective customers;

• 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 such as the Microsoft’s recent introduction of Windows Vista, our current product offerings could be at a disadvantage. If this were to occur, our future growth and operating results could be negatively affected. The acquisitions of RSA Security, Inc. by EMC Corporation and Alacris by Microsoft are expected to create a more difficult competitive environment for us and may result in the broader adoption of their platforms and systems, which compete with ours.

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. Uncertainty surrounding the Homeland Security Presidential Directive #12 may affect sales of our products to government agencies. If our products do not comply with the requirements of Homeland Security Presidential Directive #12, we may not be able to sell to agencies that must comply with this Directive.

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 the products of others, to jointly engage in research and development efforts, and to jointly engage in marketing efforts and reseller arrangements. To date, 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 these partners, which could adversely affect our business.

If the members of our management team are unable to work together effectively or if there is additional turnover in senior management, our ability to manage and expand our business will suffer.

Our management team has changed significantly in the past 12 months. In February 2006, we appointed Mark Lustig as our Chief Financial Officer to replace Ragu Bhargava, our former Senior Vice President and Chief Financial Officer who resigned in December 2005. Also, in February 2006 we appointed Jason Hart, our former Senior Vice President, Sales and Marketing, as our Chief Executive Officer to replace Ben C. Barnes, our former Chief Executive Officer, who resigned in February 2006. At the same time, Thomas Jahn, our former Chief Restructuring and Integration Officer, was appointed as our Chief Operating Officer. 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.

Employee turnover could adversely impact our revenues, costs and productivity.

As employees leave ActivIdentity, we suffer loss of productivity while new employees are hired or promoted into vacant positions. The departure of highly skilled employees sometimes results in a loss of talent or knowledge that is difficult to replace. There are also costs of recruiting and relocating new employees. For example, the recruiting market for experienced operations personnel is very competitive and we may be limited in our ability to attract and retain key operations talent. New employees must learn the ActivIdentity organization, products and procedures. All of this takes time, reduces productivity and increases cost. The potential adverse impact of employee turnover is greater for situations involving senior positions in the company. For example, the resignation of our Controller in January 2007 adversely impacted our ability to prepare the financial statements for the prior quarter and file the related quarterly report. If we cannot replace this employee and augment our finance and accounting staff, we may be similarly impacted in future periods. Turnover rates tend to increase as economic conditions improve. If turnover increases, the adverse impact of turnover could materially affect our costs, productivity or ability respond quickly to the competitive environment.

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

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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 three months ended December 31, 2006 and 2005, markets outside of North America accounted for 60% and 54%, 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 our workforce;

• 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 British Pounds. We expect that a significant portion of our expenses will be incurred in Euros and in the Australian Dollar, 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.

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 Protocom in August 2005 and the remaining equity interest in Aspace in December 2004, and we may make additional acquisitions in the future as a component of 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 entities.

Acquisitions may also 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;

• Increases in our amortization expense;

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

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

In the past we have recorded charges to earnings associated with the impairment of other intangible assets, write-downs of goodwill and property and equipment, and losses from discontinued operations from our previous acquisitions. In addition, due to a change in our revenue forecast related to our acquisition of Aspace, we recorded a charge of $9.4 million related to the impairment of goodwill and a charge of $6.1 million related to the impairment of intangible assets in fiscal 2005. Additionally, acquisitions can also lead to expensive and time-consuming litigation, including disputes relating to the achievement of earn-out targets, 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 may be subject to additional consideration for acquisition related earn-out rights.

On August 5, 2005, we acquired Protocom Development Systems Pty. Ltd (Protocom) for cash of $21.0 million, 1,650,000 shares of our common stock,

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and incurred direct acquisition related costs of $625,000, for a total initial consideration of $29.2 million. Concurrently with the closing of the Protocom acquisition, we entered into an employment agreement with Jason Hart, then Protocom’s chief executive officer, who now serves as our chief executive officer and a member of the board of directors. Pursuant to the acquisition agreement, we agreed to issue up to an additional 2,100,000 shares of our common stock to the former Protocom shareholders, including Mr. Hart, under an earn-out provision if Protocom achieved a revenue target between $13.6 million and $18.7 million during the one-year period ended June 30, 2006. Based on our calculations of qualifying revenues that are credited to this earn-out right, we have concluded that the revenue targets have not been met and no additional consideration is owed. We notified the Protocom shareholder representative in the fourth quarter of fiscal 2006 that none of the additional consideration would be paid. The Protocom shareholder representative has objected to certain items in our calculation and in accordance with the agreement, the matter is being referred to an independent auditor for resolution. If any portion of the earn-out is ultimately paid, the issuance of equity securities would be dilutive to our stockholders and would lead to recording of goodwill that is subject to impairment testing on a regular basis and can result in potential periodic impairment charges which could be substantial.

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 charge of $9.4 million related to goodwill in fiscal 2005. Additionally, we have recorded impairment of acquired developed technology of $3.7 million in fiscal 2005, and impairment of acquired intangible assets of $2.4 million in fiscal 2005 and $45,000 in the nine months ended September 30, 2004. The impaired assets consisted of developed and core technology, customer relationships, agreements, contracts, and trade names and trademarks capitalized in our acquisitions.

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 December 31, 2006, we had $9.0 million of other intangible assets and $35.9 million of goodwill, accounting for approximately 22% of our total assets. We performed the annual impairment evaluation of goodwill as of December 1, 2006 and determined that no goodwill impairment existed as of that date. If the enterprise value at December 1, 2007 is lower than the enterprise value as of our last impairment evaluation date of December 1, 2006, the annual evaluation could result in an impairment of goodwill and/or other intangible assets charge in the quarter ending December 31, 2007 or at any time the circumstances indicate that an impairment may exist.

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.

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.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDER

None

ITEM 5. OTHER INFORMATION

None

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, ActivIdentity Corporation 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 13th day of February 2006.

ActivIdentity Corporation
By:	/s/ Mark Lustig
	Mark Lustig
	Chief Financial Officer

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