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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10 - Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM_________TO _________
COMMISSION FILE NUMBER: 0-22689
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SCM MICROSYSTEMS, INC
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0444317
STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER)
131 ALBRIGHT WAY, LOS GATOS, CA 95032
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)
(408) 370-4888
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
N/A
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE
LAST REPORT)
------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [ ] Yes [X] No
At November 6, 1997, 10,624,584 shares of common stock were outstanding.
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PART I. FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
SCM MICROSYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30 September 30
--------------------- ---------------------
1997 1996 1997 1996
-------- -------- -------- --------
Net sales:
Security and access products $ 7,952 $ 4,927 $ 17,772 $ 10,716
PCMCIA peripheral products -- 1,073 163 3,797
-------- -------- -------- --------
Total net sales 7,952 6,000 17,935 14,513
Cost of sales 5,108 3,903 11,234 10,074
-------- -------- -------- --------
Gross profit 2,844 2,097 6,701 4,439
-------- -------- -------- --------
Operating expenses:
Research and development 713 598 2,131 1,778
Sales and marketing 928 889 2,941 2,297
General and administrative 597 605 1,730 1,513
Settlement of patent claim 515 -- 515 --
-------- -------- -------- --------
Total operating expenses 2,753 2,092 7,317 5,588
-------- -------- -------- --------
Income (loss) from operations 91 5 (616) (1,149)
Interest and other income (expense), net 111 (70) 169 (218)
Foreign currency transaction gains 162 92 401 148
-------- -------- -------- --------
Income (loss) before income taxes 364 27 (46) (1,219)
Provision for income taxes 30 -- 30 --
-------- -------- -------- --------
Net income (loss) 334 27 (76) (1,219)
Accretion on redeemable convertible preferred stock (324) (72) (802) (215)
-------- -------- -------- --------
Net income (loss) attributable to common stockholders $ 10 $ (45) $ (878) $ (1,434)
======== ======== ======== ========
Earnings (loss) per share:
Net income (loss) $ 0.05 $ 0.01 $ (0.01) $ (0.23)
======== ======== ======== ========
Net income (loss) attributable to common stockholders $ 0.00 $ (0.01) $ (0.13) $ (0.27)
======== ======== ======== ========
Shares used in computing earnings (loss) per share 7,340 5,361 6,926 5,218
======== ======== ======== ========
See accompanying notes to financial statements.
1
3
SCM MICROSYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands)
ASSETS
September 30, December 31,
1997 1996
------------- ------------
(unaudited)
Current assets:
Cash and cash equivalents $10,171 $ 2,593
Accounts receivable 7,837 5,237
Inventories 3,487 2,279
Prepaids and other current assets 786 519
------- -------
Total current assets 22,281 10,628
Property, equipment, and other assets, net 996 831
======= =======
$23,277 $11,459
======= =======
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
STOCK, AND STOCKHOLDERS' DEFICIT
Current liabilities:
Notes payable 2,286 8,246
Accounts payable 4,599 3,351
Accrued expenses 1,246 818
-------- --------
Total current liabilities 8,131 12,415
Redeemable convertible preferred stock 22,147 5,068
Stockholders' deficit:
Capital Stock 3 2
Additional paid-in capital 2,899 2,387
Accumulated deficit (8,893) (8,015)
Deferred compensation (172) (224)
Cumulative translation adjustment (838) (174)
-------- --------
Total stockholders' deficit (7,001) (6,024)
-------- --------
$ 23,277 $ 11,459
======== ========
See accompanying notes to financial statements.
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4
SCM MICROSYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)
NINE-MONTH PERIODS
ENDED SEPT. 30,
--------------------
1997 1996
-------- --------
Cash flows from operating activities:
Net loss $ (76) $ (1,219)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 266 186
Amortization of deferred employee compensation 52 --
Non-cash charges from issuance of warrants 493 --
Changes in operating assets and liabilities:
Accounts receivable (2,993) (1,422)
Inventories (1,264) (234)
Prepaid expenses (463) (313)
Accounts payable 1,637 1,118
Accrued expenses 423 280
-------- --------
Net cash used in operating activities (1,925) (1,604)
-------- --------
Cash flows used in investing activities - capital expenditures (497) (442)
-------- --------
Cash flows from financing activities:
Proceeds from notes payable -- 3,457
Payments on notes payable (1,309) (1,712)
Principal payments on long-term debt (63) (1)
Proceeds from issuance of redeemable
convertible Preferred Stock 12,148 --
Proceeds from issuance of common stock, net -- 28
Proceeds from line of credit -- 1,000
-------- --------
Net cash provided by financing activities 10,776 2,772
-------- --------
Effect of exchange rates on cash (776) (180)
-------- --------
Net increase in cash 7,578 546
Cash at beginnning of period 2,593 739
-------- --------
Cash at end of period $ 10,171 $ 1,285
======== ========
Supplemental disclosures of cash flow information:
Cash paid during the period - interest $ 96 $ 217
======== ========
Noncash financing activities:
Interest accretion on redeemable convertible
Preferred Stock $ 802 $ 215
======== ========
Conversion of related party and non-related party debt
into redeemable convertible Preferred Stock $ 4,240 $ --
======== ========
See accompanying notes to financial statements.
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SCM MICROSYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulations S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring adjustments)
considered for a fair presentation have been included. Operating results
for the three month and nine month periods ended September 30, 1997 are
not necessarily indicative of the results that may be expected for the
year ending December 31, 1997. For further information, refer to the
financial statements and footnotes thereto for the year ended December 31,
1996 included in the Company's Form S-1 filed with the Securities and
Exchange Commission on October 3, 1997.
2. PROVISION FOR INCOME TAXES
The Company's effective tax rate was 8.2% for the quarter ended September
30, 1997. This tax rate includes the effect of net operating losses (NOLs)
carried forward from prior periods.
3. NET INCOME (LOSS) PER SHARE
Net income (loss) per share is computed using net income (loss), and is
based on the weighted average number of shares of common stock outstanding
and common equivalent shares from stock options (under the treasury stock
method, if dilutive) and convertible preferred stock on as "as converted"
basis. In accordance with SEC Staff Accounting Bulletins, such
computations include all common and common equivalent shares issued within
12 months of the Company's October 1997 initial public offering of Common
Stock ("IPO") for all periods presented.
The Financial Accounting Standards Board (FASB) recently issued Statement
of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. SFAS
No. 128 requires the presentation of basic earnings per share (EPS) and,
for companies with complex capital structures, diluted EPS. SFAS No. 128
is effective for annual and interim periods ending after December 15,
1997. The Company expects that for profitable periods basic EPS will be
higher than EPS as presented in the accompanying financial statements and
diluted EPS will not differ materially from EPS as presented in the
accompanying financial statements. Computations for loss periods should
not change significantly.
4. SUBSEQUENT EVENTS
In October 1997, the Company completed its IPO with the sale of 3.8
million shares of Common Stock at a price to the public of $13.00 per
share. Additionally in October, the Company sold 200,000 shares of Common
Stock to a third party at $9.00 per share pursuant to a patent
infringement settlement agreement between the two companies which was
executed on September 4, 1997. The net proceeds to the Company from these
two transactions approximated $45.8 million.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those set forth in this section as well as those discussed under the
caption "Factors That May Affect Future Operating Results."
OVERVIEW
SCM Microsystems designs, develops and sells standards-compliant hardware,
firmware and software products and technologies used in smart card and other
token-based network security and conditional access systems. The Company's
security and access products are targeted at OEM computer, telecommunication and
digital video broadcasting ("DVB") component and system manufacturers. The
Company markets, sells and licenses its products through a direct sales and
marketing organization primarily to OEMs and also through distributors, VARs,
system integrators and resellers worldwide.
From the Company's inception through 1994, the Company focused primarily
on PCMCIA peripheral products, including flash memory and fax/modem devices,
which carried a significantly lower gross margin than the Company's current
products. In 1994, the Company began emphasizing security and access products.
The Company made the final shipment of PCMCIA peripheral products in the quarter
ended March 31, 1997, completing its exit from this business.
The Company experiences substantial seasonality in its business, with
approximately one-third of annual net sales being realized in the first half of
the year and the remaining two-thirds being realized in the second half of the
year. In recent periods, this seasonality has been primarily the result of the
Company's reliance on sales of its SwapBox products to OEMs that in turn are
selling to U.S. government agencies. The buying pattern of U.S. government
agencies tend to be substantially weighted to the third quarter and, to a
somewhat lesser extent, the fourth quarter of the calendar year. The strength in
net sales in the third quarter which results from the U.S. government buying
patterns is somewhat offset by relatively weaker sales in Europe in the same
quarter as a result of the traditional European summer vacation patterns. The
Company expects that as sales of its DVB products, which are sold to OEMs mainly
in Europe for the consumer market, begin to represent a larger percentage of net
sales, the seasonality that the Company experiences may be further exacerbated
as such sales are likely to be strongest in the fourth quarter of the year. In
contrast to net sales, operating expenses tend to be spread relatively evenly
across the year. As a result, the Company's operating results have tended to be
weakest in first and second quarter of the year.
In April 1997, Gemplus served the Company with a complaint alleging that
the Company's SwapSmart product infringes certain claims of a French patent held
by Gemplus. In September 1997, the Company entered into a license agreement and
memorandum of
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understanding, and settled this dispute, with Gemplus. In connection with these
transactions, the Company issued warrants to Gemplus to purchase up to 200,000
shares of Common Stock at an exercise price of $13.00 per share and up to
200,000 shares of Common Stock at an exercise price of $14.00 per share. The
Company also agreed to sell 200,000 shares of Common Stock to Gemplus at a
purchase price of $9.00 per share. The Company's operating expenses for the
quarter ended September 30, 1997 include a one-time expense of approximately
$515,000 in connection with the foregoing agreements, approximately $453,000 of
which is non-cash consideration associated with the warrants.
RESULTS OF OPERATIONS
Net Sales. Net sales reflect the invoiced amount for goods shipped less
estimated returns. Revenue is recognized upon product shipment. Net sales for
the Company's quarter ended September 30, 1997 were $8.0 million compared to
$6.0 million in the third quarter of 1996, an increase of 33%. For the first
nine months of 1997, net sales were $17.9 million compared to $14.5 million in
the first nine months of 1996, an increase of 24%. Sales of security and access
products were $8.0 million and $17.8 million in the third quarter and first nine
months of 1997, respectively, compared to $4.9 million and $10.7 million for the
comparable periods of 1996. This represents year-over-year growth rates for
security and access products of 61% and 66% for the third quarter and nine month
periods, respectively. The increases in each period were primarily due to the
introduction of the Company's DVB conditional access module (CAM) products,
which commenced shipment in the fourth quarter of 1996. The Company made the
final shipment of PCMCIA peripheral products in the quarter ended March 31,
1997, completing its exit from this business.
Gross Profit. Gross profit for the third quarter of 1997 was $2.8 million,
or 36% of total net sales, compared to $2.1 million, or 35% of total net sales
for the third quarter of 1996. Gross profit for the first nine months of 1997
was $6.7 million, or 37% of total net sales, compared to $4.4 million, or 31% of
total net sales for the first nine months of 1996. The increase in gross profit,
both in absolute amount and as a percentage of total net sales, was primarily
due to the aforementioned introduction of DVB-CAM products and the concurrent
business shift away from lower margin PCMCIA peripheral products. In addition,
the Company's transition from the PCMCIA peripheral products business resulted
in reduced labor requirements. The Company believes that its gross profit during
1997 will continue to be above the levels experienced in 1996. The Company's
gross profit has been and will continue to be affected by a variety of factors,
including competition, product configuration and mix, the availability of new
products and product enhancements which tend to carry higher gross profit than
older products and the cost and availability of components. Accordingly, gross
profits are expected to fluctuate from period to period.
Research and Development. Research and development expenses consist
primarily of employee compensation and prototype expenses. To date, the period
between achieving technological feasibility and completion of software has been
short, and software development costs qualifying for capitalization have been
insignificant. Accordingly, the Company has not capitalized any software
development costs. Research and development expenses for the third
8
quarter of 1997 were $713,000, compared with $598,000 in the third quarter of
1996, an increase of 19%. As a percentage of total net sales, research and
development expenses were 9% and 10% in the third quarter of 1997 and 1996,
respectively. For the first nine months of 1997, research and development
expenses were $2.1 million, compared with $1.8 million in the comparable period
of 1996, an increase of 20%. As a percentage of total net sales, research and
development expenses were 12% in the nine month periods in both 1997 and 1996.
These increases for the third quarter and nine month periods in absolute amounts
were due primarily to higher headcount in the Company's La Ciotat, France
facility and a rise in prototype and related expenses for the Company's DVB-CAM
product development. The Company believes that research and development expenses
during the fourth quarter of 1997 will be higher than the fourth quarter of
1996, due to a higher number of personnel involved in the Company's new product
development and customer projects.
Sales and Marketing. Sales and marketing expenses consist primarily of
employee compensation and trade show and other marketing costs. Sales and
marketing expenses for the third quarter of 1997 were $928,000, compared with
$889,000 in the third quarter of 1996, an increase of 4%. For the first nine
months of 1997, sales and marketing expenses were $2.9 million, compared with
$2.3 million in the comparable period of 1996, an increase of 28%. As a
percentage of total net sales, these expenses were 12% and 16% in the third
quarter and first nine months of 1997, compared with 15% and 16% of total net
sales in the comparable periods of 1996. These increases in absolute amounts
were due primarily to growth of the Company's sales and marketing headcount in
the U.S. and initial promotional efforts in the Asia-Pacific regions. The
decrease in sales and marketing expenses as a percentage of total net sales in
the third quarter of 1997 compared to the third quarter of 1996 was due to the
33% increase in total net sales discussed above. Sales and marketing expenses in
the fourth quarter of 1997 are expected to increase in absolute amounts as the
Company continues to expand its sales and business development efforts, but to
generally remain consistent with or decline slightly from the 1996 results as a
percentage of total net sales.
General and Administrative. General and administrative expenses consist
primarily of compensation expenses for employees performing the Company's
administrative functions. General and administrative expenses were $597,000 in
the third quarter of 1997, or 8% of total net sales, compared with $605,000, or
10% of total net sales in the third quarter of 1996. For the nine month period,
general and administrative expenses were $1.7 million in 1997, an increase of
14% compared with $1.5 million in 1996, representing 10% of total net sales in
both nine month periods. General and administrative expenses increased in
absolute amount in the first nine months of 1997 primarily as a result of an
increase of administrative headcount in the Company's U.S. and Pfaffenhofen,
Germany offices to support higher levels of business activities. The Company
believes general and administrative expenses in 1997 will continue to increase
in absolute amount as a result of operating as a public company.
Settlement of Patent Claim. In September 1997, the Company settled a
patent infringement claim with a third party. In connection therewith, the
Company incurred a one-time charge of $515,000, of which $453,000 was a non-cash
charge related to the imputed cost of warrants issued.
9
Interest and Other Income (Expense), Net. Interest and other income
(expense), net consists of interest earned on invested cash, offset by interest
paid or accrued on outstanding debt. In the third quarter and first nine months
of 1997, net investment income was $111,000 and $169,000, respectively. During
the comparable periods of 1996, the Company incurred $70,000 and $218,000 of
interest expense on outstanding debt. During the first six months of 1997, the
Company raised $12.1 million through the sale of preferred stock, resulting in a
reduction of debt and corresponding interest expense and investable cash
balances. In future periods, the Company expects net interest income to increase
due to the investment of the proceeds of the Company's IPO received in October
1997.
Income Taxes. A provision for income taxes of $30,000 was booked in the
third quarter of 1997, relating primarily to anticipated alternative minimum tax
requirements. As of December 31, 1996, the Company had German net operating loss
carry forwards of approximately $4.6 million available for an indefinite period
to offset income from the Company's German operations. In addition, the Company
had operating loss carry forwards of approximately $1.9 million and $800,000 for
United States federal and California income tax purposes, respectively. The
Company's utilization of United States federal operating loss carry forwards is
limited to approximately $340,000 per year.
LIQUIDITY AND CAPITAL RESOURCES
Prior to the Company's IPO in October of 1997, the Company had financed
its operations principally through private placements of debt and equity
securities and, to a lesser extent, borrowings under bank lines of credit. As of
September 30, 1997, the Company's working capital was $14.1 million, compared to
a working capital deficit of $1.8 million as of December 31, 1996. Working
capital increased during the first nine months of 1997 due primarily to the
Company's receipt of $12.1 million in net proceeds from the private placement of
redeemable convertible preferred stock and the conversion of approximately $4.2
million of notes payable into redeemable convertible preferred stock.
In October 1997, the Company completed its IPO with the sale of 3.8
million shares of Common Stock at a price to the public of $13.00 per share.
Additionally in October, the Company sold 200,000 shares of Common Stock to
Gemplus at $9.00 per share pursuant to a patent infringement settlement
agreement between the companies which was executed on September 4, 1997. The net
proceeds to the Company from these two transactions approximated $45.8 million,
raising its cash and cash equivalents to $55.6 million as of September 30, 1997
on a pro forma basis.
The Company maintains its current excess cash balances in a variety of
interest bearing investment-grade financial investments such as U.S. treasury,
federal agency and state government securities, and corporate debt and bank
certificates of deposit. Principal preservation, liquidity and safety are the
primary investment objectives.
During the first nine months of 1997, cash and cash equivalents increased
by $7.6 million due primarily to financing activities which included preferred
stock sales totaling $12.1 million,
10
partially offset by repayments of short- and long-term debt of $1.4 million.
Investing activities in the first nine months of 1997 consisted of $497,000 in
capital equipment expenditures. Operating activities in the period used $1.9
million of cash, including increases in receivables and inventories of $3.0
million and $1.3 million, respectively, due primarily to higher revenue and
backlog levels, partially offset by a $1.6 million increase in accounts payable.
The Company has revolving lines of credit with three banks in Germany
providing total borrowings of up to 4.5 million DM (approximately $2.5 million
at September 30, 1997). One of these lines expired as of September 30, 1997, and
the Company and the bank are in negotiations to extend such line for an
additional 12 month period. The remaining two German lines of credit expire on
March 31, 1998. The German lines of credit bear interest at rates ranging from
8.0% to 8.75%. Borrowings under the German lines of credit are unsecured. The
Company also has a $3.0 million U.S. line of credit which is secured by all
assets of the Company, bears interest at the bank's prime rate, and expires in
May 1999. At September 30, 1997, no amounts were outstanding under any of the
Company's lines of credit. In addition to the lines of credit, the Company had
outstanding debt at September 30, 1997 totaling approximately $2.3 million,
consisting of a term loan from a German bank. This debt bears interest at rates
ranging from 5.0% to 6.0%. The Company expects to repay this term loan in the
fourth quarter of 1997. As of September 30, 1997, the Company had no material
commitments for capital expenditures.
The Company presently expects that its current capital resources and
available borrowings should be sufficient to meet its operating and capital
requirements through at least the end of 1999. The Company may, however, seek
additional debt or equity financing prior to that time. There can be no
assurance that additional capital will be available to the Company on favorable
terms or at all. The sale of additional debt or equity securities may cause
dilution to existing stockholders.
11
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
HISTORY OF OPERATING LOSSES; POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS;
SEASONALITY
Although the Company was profitable for the fiscal quarter ended September
30, 1997, the Company incurred a net loss of $410,000 for the six months ended
June 30, 1997 and net operating losses on an annual basis since its inception in
1993. As of September 30, 1997, the Company had an accumulated deficit of $8.9
million. In view of the Company's loss history, there can be no assurance that
the Company will be able to achieve or sustain profitability on an annual or
quarterly basis in the future.
The Company's quarterly operating results have in the past varied and may
in the future vary significantly. Factors affecting operating results include:
the level of competition; the size, timing, cancellation or rescheduling of
significant orders; market acceptance of new products and product enhancements;
new product announcements or introductions by the Company or its competitors;
adoption of new technologies and standards; changes in pricing by the Company or
its competitors; the ability of the Company to develop, introduce and market new
products and product enhancements on a timely basis, if at all; hardware
component costs and availability, particularly with respect to hardware
components obtained from sole or limited source suppliers; the Company's success
in expanding its sales and marketing organization and programs; technological
changes in the market for digital information security products; levels of
expenditures on research and development; foreign currency exchange rates; and
general economic trends. In addition, because a high percentage of the Company's
operating expenses are fixed, a small variation in revenue can cause significant
variations in operating results from quarter to quarter.
Initial sales of the Company's products to a new customer typically
involve a sales cycle which can range from six to nine months during which the
Company may expend substantial financial resources and management time and
effort with no assurance that a sale will ultimately result. The length of the
sales cycle may vary depending on a number of factors over which the Company may
have little or no control, including product and technical requirements, and the
level of competition which the Company encounters in its selling activities. Any
delays in the sales cycle for new customers could have a material adverse effect
on the Company's business and operating results.
Based upon the factors enumerated above, the Company believes that its
operating results may vary significantly in future periods and that historical
results are not reliable indicators of future performance. It is likely that, in
some future quarter or quarters, the Company's operating results will be below
the expectations of stock market analysts and investors. In such event, the
market price of the Company's Common Stock could decline significantly.
12
DEPENDENCE ON EMERGING PRODUCT MARKETS; UNCERTAINTY OF MARKET ACCEPTANCE OF
THE COMPANY'S PRODUCTS
From the Company's inception through 1994, the Company focused on PCMCIA
peripheral products, including flash memory and fax/modem devices. In 1994, the
Company began emphasizing security and access products. The Company made the
final shipment of PCMCIA peripheral products in the quarter ended March 31,
1997, completing its exit from this business. As a result of the Company's
strategic shift in product focus, the proportion of security and access product
sales increased from 22.1% of total net sales in 1994 to 77.3% of total net
sales in 1996, and to 99.1% of total net sales in the first nine months of 1997.
The Company's net sales are now and will continue to be dependent upon the
success of its security and access products.
The Company's future growth and operating results will depend to a large
extent on the successful marketing and commercial viability of the Company's
security and access product families. Each of these product families addresses
needs in different emerging markets. Smart card token-based security
applications are able to provide protection from unauthorized access to digital
information. The Company believes that smart cards are ideally suited to serve
as tokens for network and electronic commerce security. Accordingly, the
Company's SwapBox and SwapSmart product families are designed to provide smart
card token-based security for PCs. However, there can be no assurance that the
smart card will become the industry standard for network and electronic commerce
security applications. The Company's DVB product family provides a means of
controlling access to digital television broadcasts. The Company's SwapAccess
DVB-CAM product implements the DVB-CI and NRSS-B standards. To date, the
Company's DVB-CAM product has been implemented in a relatively limited number of
DVB set-top boxes in Europe. Although the Company believes that the DVB-CI
standard will eventually become the European standard for DVB conditional access
applications, there can be no assurance that the standard will be adopted, that
the European DVB market will further develop or that even if such standard is
adopted and the market further develops, the Company's DVB-CAM products will be
widely adopted. Furthermore, the market for DVB products in the United States
has only recently begun to develop. While the NRSS Committee has proposed the
NRSS-B standard for use in the United States, there can be no assurance that
this standard will be adopted as currently proposed or at all. Moreover, even if
this or another standard is adopted, there can be no assurance whether, or to
what extent, the United States DVB market will grow. In addition, the
substantial installed base of analog set-top boxes in the United States may
cause the market for DVB products in general, and the Company's SwapAccess
products in particular, to grow slower than expected, if at all.
If the market for the products described above or any of the Company's
other products fails to develop or develops more slowly than expected or if any
of the standards supported by the Company do not achieve or sustain market
acceptance, the Company's business and operating results would be materially and
adversely affected.
13
DEPENDENCE ON SALES TO OEMs
A substantial majority of the Company's products are intended for use as
components or subsystems in systems manufactured and sold by third party OEMs.
In 1996, almost all of the Company's sales were to OEMs and the Company expects
this dependence on OEM sales to continue. In 1996, sales to IBM accounted for
12% of total net sales, sales to BetaDigital (a division of the Kirch Group)
accounted for 11% of total net sales and sales to the Company's top 10 customers
(all of which are OEMs) accounted for 55% of total net sales. In the first nine
months of 1997, sales to BetaDigital accounted for 37% of total net sales, sales
to Telenor Conax A.S. accounted for 12% of total net sales, and sales to the
Company's top 10 customers (eight of which are OEMs) accounted for 76% of total
net sales. In order for an OEM to incorporate the Company's products into its
systems, the Company must demonstrate that its products provide significant
commercial advantages to OEMs over competing products. There can be no assurance
that the Company can successfully demonstrate such advantages or that the
Company's products will continue to provide any advantages. Moreover, even if
the Company is able to demonstrate such advantages, there can be no assurance
that OEMs will elect to incorporate the Company's products into their current or
future systems. Further, the business strategies and manufacturing practices of
the Company's OEM customers are subject to change and any such change may result
in decisions by the customers to decrease their purchases of the Company's
products, seek other sources for products currently manufactured by the Company
or manufacture these products internally. The Company's OEM customers may also
seek price concessions from the Company. Failure of OEMs to incorporate the
Company's products into their systems, the failure of such OEMs' systems to
achieve market acceptance or any other event causing a decline in the Company's
sales to OEMs would have a material adverse effect on the Company's business and
operating results.
DEPENDENCE ON SALES TO GOVERNMENT CONTRACTORS
Approximately 51%, 39% and 31% of the Company's net sales during 1995,
1996 and the first nine months of 1997, respectively, were derived from sales of
the Company's SwapBox product for use by the U.S. government, all of which were
made under contracts between the Company and major OEMs that sell PCs to the
United States Department of Defense (the "DoD"). The Company believes that
indirect sales to the DoD are subject to a number of significant uncertainties,
including timing and availability of funding, unforeseen changes in the timing
and quantity of government orders and the competitive nature of government
contracting generally. Furthermore, the DoD has been reducing total expenditures
over the past few years in a number of areas and there can be no assurance that
such funding will not be reduced in the future. In addition, there is no
assurance that the Company will be able to modify existing products or develop
new products that will continue to meet the specifications of OEM suppliers to
the DoD. A significant loss of indirect sales to the U.S. government would have
a material adverse effect on the Company's business and operating results.
DEPENDENCE ON DEVELOPMENT OF INDUSTRY RELATIONSHIPS
The Company is party to collaborative arrangements with a number of
corporations and is a member of key industry consortia. The Company has formed
strategic relationships, including
14
technology sharing agreements, with a number of key industry players such as
Intel, France Telecom and Telenor. In addition, Intel and Telenor made equity
investments in the Company of $2.0 million and $5.5 million, respectively, in
early 1997. The Company evaluates, on an ongoing basis, potential strategic
alliances and intends to continue to pursue such relationships. The Company's
future success will depend significantly on the success of its current
arrangements and its ability to establish additional arrangements. There can be
no assurance that these arrangements will result in commercially successful
products.
COMPETITION
The market for digital data security and access control products is
intensely competitive and characterized by rapidly changing technology. The
Company believes that competition in this market is likely to intensify as a
result of increasing demand for security products. The Company currently
experiences competition from a number of sources, including: (i) ActionTec,
Carry Computer Engineering, Greystone and Litronics in PC Card adapters; (ii)
Gemplus, Hitachi and Toshiba in smart card readers and universal smart card
reader interfaces; and (iii) Gemplus in DVB-CAM modules. The Company also
experiences indirect competition from certain of its customers which currently
offer alternative products or are expected to introduce competitive products in
the future. The Company may in the future face competition from these and other
parties including new entrants, such as Motorola, that develop digital
information security products based upon approaches similar to or different from
those employed by the Company. In addition, there can be no assurance that the
market for digital data security and access control products will not ultimately
be dominated by approaches other than the approach marketed by the Company.
Many of the Company's current and potential competitors have significantly
greater financial, technical, marketing, purchasing and other resources than the
Company, and as a result, may be able to respond more quickly to new or emerging
technologies or standards and to changes in customer requirements, or may be
able to devote greater resources to the development, promotion and sale of
products, or to deliver competitive products at a lower end user price. Current
and potential competitors have established or may establish cooperative
relationships among themselves or with third parties to increase the ability of
their products to address the needs of the Company's prospective customers.
Accordingly, it is possible that new competitors or alliances among competitors
may emerge and rapidly acquire significant market share. Increased competition
is likely to result in price reductions, reduced operating margins and loss of
market share, any of which could have a material adverse effect on the Company's
business and operating results.
The Company believes that the principal competitive factors affecting the
market for digital data security products include: the extent to which products
support industry standards and provide interoperability; technical features;
ease of use; quality/reliability; level of security; strength of distribution
channels; and price. There can be no assurance that the Company will be able to
compete as to these or other factors or that competitive pressures faced by the
Company will not materially and adversely affect its business and operating
results.
15
MANAGEMENT OF GROWTH
The Company's business has grown substantially in recent periods, with net
sales increasing from $6.4 million in 1994 to $21.5 million in 1996, and to
$17.9 million in the first nine months of 1997. The growth of the Company's
business has placed a significant strain on the Company's management and
operations. In addition, a number of key members of the Company's management,
including its President and Chief Executive Officer, Chief Financial Officer,
Vice President-Operations, and Vice President-Marketing have joined the Company
within the past 16 months. Furthermore, in 1993 the Company commenced operations
in North America which included the establishment of a U.S. management team. As
a result, the Company has a limited operating history under its current U.S.
management. In addition, the number of employees has grown from 50 at December
31, 1995 to 75 as of September 30, 1997. If the Company is successful in
achieving its growth plans, such growth is likely to place a significant burden
on the Company's operating and financial systems, resulting in increased
responsibility for senior management and other personnel within the Company.
There can be no assurance that the Company's existing management or any new
members of management will be able to augment or improve existing systems and
controls or implement new systems and controls in response to anticipated future
growth. The Company's failure to do so could have a material adverse effect on
the Company's business and operating results.
INTEGRATION OF GLOBAL LOCATIONS
The Company's U.S. headquarters are located in Los Gatos, California, its
European headquarters are located in Pfaffenhofen, Germany, and its research and
development facilities are located in Erfurt, Germany and La Ciotat, France. In
addition, a significant portion of the Company's contract manufacturing occurs
in Singapore. Operating in diverse geographic locations imposes a number of
risks and burdens on the Company, including the need to manage employees and
contractors from diverse cultural backgrounds and who speak different languages,
and difficulties associated with operating in a number of time zones. Although
the Company seeks to mitigate the difficulties associated with operating in
diverse geographic locations through the extensive use of electronic mail and
teleconferencing, there can be no assurance that it will not encounter
unforeseen difficulties or logistical barriers in operating in diverse
locations. Furthermore, operations in widespread geographic locations require
the Company to implement and operate complex information systems that are
capable of providing timely information which can readily be consolidated.
Although the Company believes that its information systems are adequate, the
Company may in the future have to implement new information systems.
Implementation of such new information systems may be costly and may require
training of personnel. Any failure or delay in implementing these systems,
procedures and controls on a timely basis, if necessary, or in expanding these
areas in an efficient manner at a pace consistent with the Company's business
could have a material adverse effect on the Company's business and operating
results.
PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY
The Company's success depends significantly upon its proprietary
technology. The Company currently relies on a combination of patent, copyright
and trademark laws, trade
16
secrets, confidentiality agreements and contractual provisions to protect its
proprietary rights. The Company seeks to protect its software, documentation and
other written materials under trade secret and copyright laws, which afford only
limited protection. The Company generally enters into confidentiality and
non-disclosure agreements with its employees and with key vendors and suppliers.
The Company's SwapBox trademark is registered in the United States, and the
SwapSmart trademark is the subject of an allowed, pending application. The
Company will continue to evaluate the registration of additional trademarks as
appropriate. The Company currently has one U.S. patent issued, six U.S., one
French and one Japanese patent applications pending, and exclusive licenses
under four other U.S. patents associated with its products. Furthermore, the
Company intends to obtain an exclusive license from one of its employees to five
other patents relating to its products. There can be no assurance that any new
patents will be issued, that the Company will develop proprietary products or
technologies that are patentable, that any issued patent will provide the
Company with any competitive advantages or will not be challenged by third
parties, or that the patents of others will not have a material adverse effect
on the Company's business.
There has also been substantial litigation in the technology industry
regarding intellectual property rights, and litigation may be necessary to
protect the Company's proprietary technology. The Company has from time to time
received claims that it is infringing upon third parties' intellectual property
rights, and there can be no assurance that third parties will not in the future
claim infringement by the Company with respect to current or future products,
patents, trademarks or other proprietary rights. In April 1997, Gemplus served
the Company with a complaint alleging that the Company's SwapSmart product
infringes certain claims of a French patent held by Gemplus. Although such
dispute was settled on terms acceptable to the Company, there can be no
assurance that future disputes with third parties will not arise nor that any
such disputes can be resolved on terms acceptable to the Company. The Company
expects that companies in the computer and digital information security market
will increasingly be subject to infringement claims as the number of products
and competitors in the Company's target markets grows. Any such claims or
litigation may be time-consuming and costly, cause product shipment delays,
require the Company to redesign its products or require the Company to enter
into royalty or licensing agreements, any of which could have a material adverse
effect on the Company's business and operating results. Despite the Company's
efforts to protect its proprietary rights, unauthorized parties may attempt to
copy aspects of the Company's products or to obtain and use information and
software that the Company regards as proprietary. In addition, the laws of some
foreign countries do not protect proprietary and intellectual property rights to
as great an extent as do the laws of the United States. There can be no
assurance that the Company's means of protecting its proprietary and
intellectual property rights will be adequate or that the Company's competitors
will not independently develop similar technology, duplicate the Company's
products or design around patents issued to the Company or other intellectual
property rights of the Company.
DEPENDENCE ON CONTRACT AND OFFSHORE MANUFACTURING; LIMITED NUMBER OF
SUPPLIERS OF KEY COMPONENTS
The Company has implemented a global sourcing strategy that it believes
will enable it to
17
achieve greater economies of scale, improve gross margins and maintain uniform
quality standards for its products. The Company currently sources its products
through three contract manufacturers in Europe and Asia. In the event any of the
Company's contract manufacturers are unable or unwilling to continue to
manufacture the Company's products, the Company may have to rely on other
current manufacturing sources or identify and qualify new contract
manufacturers. In this regard, one of the Company's contract manufacturers has
recently been involved in bankruptcy proceedings and may be unable to continue
manufacturing the Company's products. In the event that such manufacturer (or
any other key supplier) were unable to meet the Company's requirements, there
can be no assurance that the Company would be able to identify or qualify new
contract manufacturers in a timely manner or that such manufacturers would
allocate sufficient capacity to the Company in order to meet its requirements.
Any significant delay in the Company's ability to obtain adequate supplies of
its products from its current or alternative sources would materially and
adversely affect the Company's business and operating results.
In an effort to reduce manufacturing costs, the Company has shifted volume
production of many components of its products to Singapore. The Company is
currently considering shifting the production of other components of its
products to other suppliers in Europe or Asia. Difficulties encountered in
transferring production may have a disruptive effect on the Company's
manufacturing process and increase overall production costs. Due to the
substantial concentration of the Company's manufacturing operations in
Singapore, a disruption of operations at its contractor's facilities there could
have a material adverse effect on the Company's business and operating results.
Foreign manufacturing is subject to a number of risks, including transportation
delays and interruptions, difficulties in staffing, currency fluctuations,
potentially adverse tax consequences and unexpected changes in regulatory
requirements, tariffs and other trade barriers, and political and economic
instability.
The Company relies upon a limited number of suppliers of several key
components utilized in the assembly of the Company's products. For example, the
Company purchases many of the components for use in its SwapSmart and SwapBox
products from Intellicard Systems, a Singapore-based supplier, and mechanical
components for use in its smart card reader product exclusively from Stocko, a
German-based supplier. The Company's reliance on sole source suppliers involves
several risks, including a potential inability to obtain an adequate supply of
required components, price increases, late deliveries and poor component
quality. Although to date the Company has been able to purchase its requirements
of such components, there can be no assurance that the Company will be able to
obtain its full requirements of such components in the future or that prices of
such components will not increase. In addition, there can be no assurance that
problems with respect to yield and quality of such components and timeliness of
deliveries will not occur. Disruption or termination of the supply of these
components could delay shipments of the Company's products and could have a
material adverse effect on the Company's business and operating results. Such
delays could also damage relationships with current and prospective customers.
18
DEPENDENCE ON NEW PRODUCTS; RAPID TECHNOLOGICAL CHANGE
The markets for the Company's products are characterized by rapid
technological change, changing customer needs, frequent new product introduction
and evolving industry standards and short product lifecycles. The introduction
by the Company or its competitors of products embodying new technologies and the
emergence of new industry standards could render the Company's existing products
obsolete and unmarketable. Therefore, the Company's future success will depend
upon its ability to successfully develop and to introduce on a timely and
continuous basis new and enhanced products that keep pace with technological
developments and emerging industry standards and address the increasingly
sophisticated needs of its customers. The timing and success of product
development is unpredictable due to the inherent uncertainty in anticipating
technological developments, the need for coordinated efforts of numerous
technical personnel and the difficulties in identifying and eliminating design
flaws prior to product release. Any significant delay in releasing new products
could have a material adverse effect on the ultimate success of a product and
other related products and could impede continued sales of predecessor products,
any of which could have a material adverse effect on the Company's business and
operating results. There can be no assurance that the Company will be able to
introduce new products on a timely basis, that new products introduced by the
Company will achieve any significant degree of market acceptance or that any
such acceptance will be sustained for any significant period. Failure of new
products to achieve or sustain market acceptance could have a material adverse
effect on the Company's business and operating results.
RISKS OF INTERNATIONAL SALES; CURRENCY FLUCTUATIONS
The Company was originally a German corporation and continues to conduct a
substantial portion of its business in Europe. Approximately 83%, 49%, 53% and
66% of the Company's revenues in 1994, 1995, 1996 and the nine months ended
September 30, 1997, respectively, were derived from customers located outside
the United States. Because a significant number of the Company's principal
customers are located in other countries, the Company anticipates that
international sales will continue to account for a significant portion of its
revenues. As a result, a significant portion of the Company's sales and
operations may continue to be subject to certain risks, including tariffs and
other trade barriers, difficulties in staffing and managing disparate branch
operations, currency exchange risks and exchange controls and potential adverse
tax consequences. These factors may have a material adverse effect on the
Company's business and operating results.
As a result of the Company's multinational operations and sales, the
Company's operating results are subject to significant fluctuations based upon
changes in the exchange rates of certain currencies, particularly the German
mark, in relation to the U.S. dollar. The Company does not currently engage in
hedging activities with respect to its foreign currency exposure. Although
management will continue to monitor the Company's exposure to currency
fluctuations, and, when appropriate, may use financial hedging techniques in the
future to minimize the effect of these fluctuations, there can be no assurance
that exchange rate fluctuations will not have a material adverse effect on the
Company's business and operating results. In the future, the Company could be
required to denominate its product sales in other currencies, which would
19
make the management of currency fluctuations more difficult and expose the
Company to greater risks in this regard.
PRODUCT LIABILITY RISKS
Customers rely on the Company's token-based security products to prevent
unauthorized access to their digital content. A malfunction of or design defect
in the Company's products could result in tort or warranty claims. Although the
Company attempts to reduce the risk of exposure from such claims through
warranty disclaimers and liability limitation clauses in its sales agreements
and by maintaining product liability insurance, there can be no assurance that
such measures will be effective in limiting the Company's liability for any such
damages. Any liability for damages resulting from security breaches could be
substantial and could have a material adverse effect on the Company's business
and operating results. In addition, a well-publicized actual or perceived
security breach involving token-based security systems could adversely affect
the market's perception of token-based security products in general, or the
Company's products in particular, regardless of whether such breach is
attributable to the Company's products. This could result in a decline in demand
for the Company's products, which would have a material adverse effect on the
Company's business and operating results.
DEPENDENCE ON KEY PERSONNEL; ABILITY TO RECRUIT PERSONNEL
The Company's future performance depends in significant part upon the
continued service of Robert Schneider, the Company's Chairman of the Board,
Steven Humphreys, the Company's President and Chief Executive Officer, and Bernd
Meier, the Company's Chief Operating Officer, as well as its other key technical
and senior management personnel. The Company provides compensation incentives
such as bonuses, benefits and option grants (which are typically subject to
vesting over four years) to attract and retain qualified employees. In addition,
the Company's German subsidiary has entered into substantially similar
employment agreements with each of Messrs. Schneider and Meier pursuant to which
each serves as a Managing Director of the subsidiary. Each of the respective
agreements has no set termination date, may be terminated by the subsidiary or
the officer with six months notice, and provides that the officer is bound by a
non-compete provision during the one-year period following his termination.
Non-compete agreements are, however, generally difficult to enforce and
therefore these provisions may not provide significant protection to the
Company. The Company also has an employment agreement with Jean-Yves Le Roux,
its Vice President, Engineering, that is terminable by either party at will. The
Company does not have employment agreements with any of its other key employees
and does not maintain key man life insurance on any of its employees. The loss
of the services of one or more of the Company's officers or other key employees
could have a material adverse effect on the Company's business and operating
results. The Company believes that its future success will depend in large part
on its continuing ability to attract and retain highly qualified technical and
management personnel. Competition for such personnel is intense, and there can
be no assurance that the Company can retain its key technical and management
employees or that it can attract, assimilate or retain other highly qualified
technical and management personnel in the future.
20
POTENTIAL VOLATILITY OF STOCK PRICE
The stock market has recently experienced significant price and volume
fluctuations unrelated to the operating performance of particular companies. In
addition, the market price of the Company's Common Stock has been highly
volatile and is likely to continue to be so. Factors such as variations in the
Company's financial results, comments by security analysts, the Company's
ability to increase its manufacturing capability as required by customer demand,
any loss of key management, announcements of technological innovations or new
products by the Company or its competition, patents or other proprietary rights
or product or patent litigation, may have a significant effect on the market
price of the Company's Common Stock.
21
PART II: OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
10.1 Revolving Credit Loan and Security Agreement between Comerica
Bank and SCM Microsystems, Inc.
11.1 Statement of computation of net income (loss) per share
27 Financial Data Schedule
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the quarter
ended September 30, 1997.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCM MICROSYSTEMS, INC.
Date: November 12, 1997
/s/ John G. Niedermaier .
--------------------------------------------
John G. Niedermaier
Vice President- Finance, Chief Financial
Officer (Principal Financial and Accounting
Officer)
23
INDEX TO EXHIBITS
Exhibit
Number Description
- ------ -----------
10.1 Revolving Credit Loan and Security Agreement between Comerica Bank and
SCM Microsystems, Inc.
11.1 Statement of computation of net income (loss) per share
27 Financial Data Schedule