1
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-------------------------------------
FORM 10 - Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM_________TO _________
COMMISSION FILE NUMBER: 0-22689
----------------------------------
SCM MICROSYSTEMS, INC
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0444317
STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION IDENTIFICATION NUMBER)
131 ALBRIGHT WAY, LOS GATOS, CA 95032
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)
(408) 370-4888
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
N/A
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE
LAST REPORT)
------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No
At November 3, 1998, 13,158,146 shares of common stock were
outstanding.
================================================================================
2
PART I. FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Quarter Ended Nine Months Ended
September 30 September 30
----------------------- ------------------------
1998 1997 1998 1997
-------- -------- -------- --------
Revenue:
Security and access products $ 14,234 $ 7,952 $ 32,642 $ 17,772
Other -- -- -- 163
-------- -------- -------- --------
Total revenue 14,234 7,952 32,642 17,935
Cost of revenue 8,350 5,108 19,677 11,234
-------- -------- -------- --------
Gross margin 5,884 2,844 12,965 6,701
-------- -------- -------- --------
Operating expenses:
Research and development 903 713 2,526 2,131
Sales and marketing 1,549 928 3,774 2,941
General and administrative 1,525 1,112 3,723 2,245
In process research and development -- -- 5,941 --
Other acquisition integration expenses -- -- 581 --
-------- -------- -------- --------
Total operating expenses 3,977 2,753 16,545 7,317
-------- -------- -------- --------
Income (loss) from operations 1,907 91 (3,580) (616)
Interest income and other, net 2,030 273 4,418 570
-------- -------- -------- --------
Income (loss) before income taxes 3,937 364 838 (46)
Provision for income taxes 1,150 30 2,020 30
-------- -------- -------- --------
Net income (loss) 2,787 334 (1,182) (76)
Accretion on redeemable convertible preferred stock -- (324) -- (802)
-------- -------- -------- --------
Net income (loss) attributable to common stockholders $ 2,787 $ 10 $ (1,182) $ (878)
======== ======== ======== ========
Net income (loss) per share:
Basic $ 0.22 $ 0.01 $ (0.10) $ (0.50)
======== ======== ======== ========
Diluted $ 0.21 $ 0.00 $ (0.10) $ (0.50)
======== ======== ======== ========
Shares used in computing net income (loss) per share:
Basic 12,917 1,866 12,166 1,739
======== ======== ======== ========
Diluted 13,538 3,249 12,166 1,739
======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements.
1
3
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
September 30, December 31,
ASSETS 1998 1997
--------- ---------
Current assets:
Cash and cash equivalents $ 33,275 $ 25,552
Short-term investments 98,107 30,336
Accounts receivable, net 18,942 6,607
Inventories 8,345 3,392
Prepaids and other current assets 1,169 302
--------- ---------
Total current assets 159,838 66,189
Property, equipment and other assets, net 2,664 1,176
Goodwill 6,993 --
========= =========
Total assets $ 169,495 $ 67,365
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable $ -- $ 9
Accounts payable 7,819 4,308
Accrued expenses 2,974 1,271
Income taxes payable 2,325 305
--------- ---------
Total current liabilities 13,118 5,893
Stockholders' equity:
Capital stock 13 11
Additional paid-in capital 165,541 69,902
Accumulated deficit (8,896) (7,714)
Deferred compensation (83) (125)
Other cumulative comprehensive loss (198) (602)
--------- ---------
Total stockholders' equity 156,377 61,472
--------- ---------
$ 169,495 $ 67,365
========= =========
See accompanying notes to condensed consolidated financial statements.
2
4
SCM MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
1998 1997
-------- --------
Cash flows from operating activities:
Net loss $ (1,182) $ (76)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 883 266
Charge off of in-process research and development 5,941 --
Amortization of deferred employee compensation 42 52
Non-cash charges from issuance of warrants -- 493
Changes in operating assets and liabilities:
Accounts receivable (8,301) (2,993)
Inventories (3,389) (1,264)
Prepaid expenses (514) (463)
Accounts payable 415 1,637
Accrued expenses 884 423
Income taxes payable 2,020 --
-------- --------
Net cash used in operating activities (3,201) (1,925)
-------- --------
Cash flows used in investing activities:
Capital expenditures (918) (497)
Businesses acquired, net of cash received (9,875) --
Proceeds from short-term investments 26,612 --
Purchases of short-term investments (94,383) --
-------- --------
Net cash used in investing activities (78,564) (497)
-------- --------
Cash flows from financing activities:
Payments on notes payable (9) (1,309)
Principal payments on long-term debt (288) (63)
Proceeds from issuance of redeemable convertible preferred stock -- 12,148
Proceeds from issuance of common stock, net 89,665 --
-------- --------
Net cash provided by financing activities 89,368 10,776
-------- --------
Effect of exchange rates on cash 120 (776)
Net increase in cash 7,723 7,578
Cash at beginnning of period 25,552 2,593
-------- --------
Cash at end of period $ 33,275 $ 10,171
======== ========
Supplemental disclosures of cash flow information:
Cash paid during the period - interest $ 2 $ 96
======== ========
Noncash financing activities:
Businesses acquired for common stock $ 5,976 $ --
======== ========
Accretion on redeemable convertible preferred stock $ -- $ 802
======== ========
Conversion of related party and non-related party debt
into redeemable convertible preferred stock $ -- $ 4,240
======== ========
See accompanying notes to condensed consolidated financial statements.
3
5
SCM MICROSYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulations S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management,
all adjustments (consisting of normal recurring adjustments) considered for
a fair presentation have been included. Operating results for the
three-month period ended September 30, 1998 are not necessarily indicative
of the results that may be expected for the year ending December 31, 1998.
For further information, refer to the financial statements and footnotes
thereto included in the Company's December 31, 1997 annual report on Form
10-K.
2. NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed using the weighted average
number of common shares outstanding during the period. Diluted net income
(loss) per share is computed using the weighted average number of common
and dilutive common equivalent shares outstanding during the period, using
the treasury stock method for options and warrants. The following is a
reconciliation of the shares used in the computation of basic and diluted
net income for the three- and nine-month periods ended September 30, 1998
and 1997 (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
1998 1997 1998 1997
------ ------ ------ ------
Basic - weighted average number of common shares 12,917 1,866 12,166 1,739
Effect of dilutive common equivalent shares:
Stock options outstanding 606 443 -- --
Stock warrants outstanding 15 86 -- --
Series A convertible preferred stock -- 854 -- --
------ ------ ------ ------
Diluted - weighted average number of common shares
and common equivalent shares outstanding 13,538 3,249 12,166 1,739
====== ====== ====== ======
The diluted net income per share for the three-month period ended September
30, 1998 does not include the effect of 134,900 shares issuable under stock
options, because the effect of their inclusion would be antidilutive. Such
options had an average exercise price of $61.78 per share. The diluted net
loss per share for the nine-month periods ended September 30, 1998 and 1997
does not include the effect of 869,724 and 1,620,971 shares issuable under
stock options and warrants, respectively, because the effect of their
inclusion would be antidilutive. Such options and warrants had an average
exercise price of $17.42 per share as of September 30, 1998 and $7.91 per
share as of September 30, 1997. In addition, diluted net loss per share for
the three - and nine-month periods ended September 30, 1997 does not
include 3,945,000 shares of redeemable convertible preferred stock because
the effect of their inclusion would be antidilutive.
4
6
3. COMPREHENSIVE INCOME
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial accounting Standard (SFAS) No. 130, "Reporting
Comprehensive Income", which establishes standards for reporting and
disclosure of comprehensive income and its components (revenues, expenses,
gains and losses) in a full set of general-purpose financial statements.
SFAS No. 130 is effective for fiscal years beginning after December 15,
1997 and requires reclassification of financial statements for earlier
periods to be provided for comparative purposes. The Company has not
determined the manner in which it will present the information required by
SFAS No. 130 in its annual financial statements for the year ending
December 31, 1998. The Company's total comprehensive income for the three-
and nine-month periods ended September 30, 1998 was $329,000 and $404,000,
respectively. The Company's total comprehensive loss for the three- and
nine-month periods ended September 30, 1997 was $257,000 and $664,000,
respectively. In all periods, total comprehensive income (loss) consists
entirely of changes in the Company's cumulative translation adjustment
account.
4. SALE OF STOCK
In April 1998, the Company completed a follow-on public offering of 3.45
million shares of Common Stock at a price to the public of $61.00 per
share. Of the total number of shares sold, 2.0 million shares were sold by
shareholders and 1.45 million shares were sold by the Company. The net
proceeds to the Company approximated $83 million.
5. BUSINESS COMBINATIONS
In the second quarter of 1998, the Company acquired all of the outstanding
capital stock of Intermart Systems K.K. ("Intermart") and Intellicard
Systems Pte. Ltd. ("ICS"). A summary of the purchase price for the
acquisitions is as follows (in thousands):
Intermart ICS
------- -------
Cash $ 4,860 $14,891
Common stock 2,826 3,150
Direct acquisition costs 281 152
------- -------
Total $ 7,967 $18,193
======= =======
In addition, the former shareholders of Intermart can potentially earn an
additional $4 million in common stock if certain performance criteria are
met during the year ending April 30, 1999.
5
7
A summary of the allocation of the purchase price is as follows (in
thousands):
Intermart ICS
------- -------
In-process research and development $ 5,241 $ 700
Cash acquired 664 9,212
Other net assets (liabilities) acquired (assumed) (582) 3,562
Goodwill 2,644 4,719
------- -------
Total $ 7,967 $18,193
======= =======
The acquisitions of Intermart and ICS were both accounted for pursuant to
the purchase method of accounting. Accordingly, the historical financial
statements of the Company exclude the assets and liabilities, results of
operation and cash flows of Intermart and ICS for all periods ending at or
prior to the respective dates of acquisition. The assets and liabilities of
Intermart and ICS were recorded at their fair values at the respective
acquisition dates. The aggregate fair value of Intermart's and ICS'
research and development efforts that had not reached technological
feasibility as of the respective dates of acquisition and had no
alternative future uses was determined by appraisal to be $5.9 million, and
was expensed at the respective dates of the acquisitions. Goodwill for the
acquisitions of approximately $7.4 million represents the excess of the
purchase price over the fair value of identifiable tangible and intangible
assets acquired and is amortized using the straight-line method over its
estimated life of six years.
The following summary, prepared on a pro forma basis, combines the
Company's consolidated results of operations with Intermart's and ICS'
results of operations for the nine-month periods ended September 30, 1998
and 1997, as if each company had been acquired as of the beginning of the
periods presented. The table includes the impact of certain adjustments
including the elimination of the non-recurring charge for acquired
in-process research and development, elimination of intercompany profit and
additional amortization relating to intangible assets acquired (in
thousands, except per share data):
Nine Months Ended September 30,
-------------------------------
1998 1997
---- ----
Revenues $ 36,896 $ 23,223
Net income (loss) $ 6,140 $ (1,523)
Net income (loss) per share:
Basic $ 0.50 $ (0.83)
Diluted $ 0.47 $ (0.83)
Shares used in per
share computation
Basic 12,224 1,847
Diluted 12,996 1,847
The pro forma results are not necessarily indicative of what would have
occurred if the acquisitions had been effected for the periods presented.
In addition, they are not intended to be a projection of future results and
do not reflect any synergies that might be achieved from combined
operations.
6
8
6. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In June 1998, the FASB issued SFAS No 133 "Accounting for Derivative
Instruments and Hedging Activities". SFAS No 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity
recognize all derivatives as either assets or liabilities in the statement
of financial position and measure those instruments at fair value. If
certain conditions are met, a derivative may be specifically designated and
accounted for as (a) a hedge of the exposure to changes in the fair value of
a recognized asset or liability or an unrecognized firm commitment, (b) a
hedge of the exposure to variable cash flows of a forecasted transaction, or
(c) a hedge of the foreign currency exposure of a net investment in a
foreign operation, an unrecognized firm commitment, an available-for-sale
security, or a foreign-currency-denominated forecasted transaction. For a
derivative not designated as a hedging instrument, changes in the fair value
of the derivative are recognized in earnings in the period of change. This
statement will be effective for all annual and interim periods beginning
after June 15, 1999 and management does not believe the adoption of SFAS No.
133 will have a material effect on the financial position of the Company.
7. SUBSEQUENT EVENT
On November 4, 1998, the Company issued approximately 828,000 shares of its
common stock to the shareholders of Shuttle Technology Group Ltd.
("Shuttle"), a privately-held company based in Wokingham, England, in
exchange for all of the outstanding share capital of Shuttle. The
transaction is valued at approximately $33 million and will be accounted for
as a pooling of interests.
7
9
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. 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.
8
10
ACQUISITIONS
On May 19, 1998, the Company completed its acquisition of Intermart
Systems K.K. ("Intermart") based in Tokyo, Japan. Intermart designs and sells
memory card readers and adapters used primarily in digital photography and other
digital media transfers. Total consideration paid was $8 million, with $4.9
million paid in cash and the balance paid through the issuance of 46,551 shares
of the Company's stock. In addition, the former shareholders of Intermart can
potentially earn an additional $4 million in stock if certain performance
criteria are met during the year ended March 31, 1999.
On June 3, 1998, the Company completed its acquisition of Intellicard
Systems Pte. Ltd. ("ICS"), based in Singapore. ICS is a contract manufacturing
company that manufactures certain of the Company's products, including smart
card readers, DVB conditional access modules, and PC Card adapters. Total
consideration paid was $18.4 million, of which $14.9 million was paid in cash
and $3.5 million was paid through the issuance of 61,185 shares of the Company's
stock. Approximately $11.4 million of the cash portion of the consideration was
paid in exchange for cash and a $2.0 million shareholder note held by ICS at the
closing of the transaction. The note was repaid by the shareholder prior to June
30, 1998.
The acquisitions of Intermart and ICS were both accounted for pursuant
to the purchase method of accounting. Accordingly, the historical financial
statements of the Company exclude the assets and liabilities, results of
operation and cash flows of Intermart and ICS for all periods ending at or prior
to the respective dates of acquisition. The assets and liabilities of Intermart
and ICS were recorded at their fair values at the respective acquisition dates.
In connection with these acquisitions, the Company allocated
approximately $5.9 million of the $26.2 million purchase price to in-process
research and development projects. This allocation represents the estimated fair
value based on risk-adjusted cash flows related to the incomplete research and
development projects. At the date of acquisition, this amount was expensed as a
non-recurring charge as the in-process technology had not yet reached
technological feasibility and had no alternative future uses. ICS and Intermart
had approximately 10 projects in progress at the time of the acquisition
including USB interface readers for the three major types of digital transfer
media (compact flash, mini-card and smart media), higher speed digital media
readers for compact flash, mini-card and smart media formats, reader
compatibility with DVD standards, and improved high-speed PC card modems. Costs
to complete these projects, as well as several other projects acquired,
aggregate approximately $565,000 and $156,000 in fiscal 1998 and 1999,
respectively. The Company currently expects to complete the development of these
projects at various dates through fiscal 1999.
The nature of the efforts required to develop the acquired in-process
technology into commercially viable products principally relate to the
completion of all planning, designing and testing activities necessary to
establish that the product can be produced to meet its design requirements
including functions, features and technical performance requirements. Though the
Company currently expects that the acquired in process technology will be
successfully developed, there can be no assurance that commercial or technical
viability of these products will be achieved. Furthermore, future industry
developments, changes in network security and conditional access environments,
changes in other product offerings or other developments may cause the Company
to alter or abandon these plans.
The value assigned to purchased in-process technology was determined by
estimating the completion percentage of research and development efforts at the
acquisition date, forecasting risk
9
11
adjusted revenues considering the completion percentage, estimating the
resulting net cash flows from the projects and discounting the net cash flows to
their present values. The completion percentages were estimated based on cost
incurred to date, importance of completed development tasks and the elapsed
portion of the total project time. The revenue projection used to value the
in-process research and development is based on unit sales forecasts for
worldwide sales territories and adjusted to consider only the revenue related to
development achievements in progress at the acquisition date. Net cash flow
estimates include cost of goods sold and sales, marketing and general and
administrative expenses and taxes forecasted based on historical operating
characteristics. In addition, net cash flow estimates were adjusted to allow for
fair return on working capital and fixed assets, charges for franchise and
technology leverage and return on other intangibles. A risk-adjusted discount
rate was used to discount the net cash flows back to their present value. If
these projects are not successfully developed, the Company may not realize the
value assigned to the in-process research and development projects.
On November 3, 1998, the Company completed its acquisition of Shuttle
Technology Group Limited ("Shuttle"). Shuttle is a developer and supplier of
access and interface technology based in the United Kingdom. Total consideration
paid was approximately $33 million, paid through the issuance of 827,792 shares
of the Company's common stock. The acquisition of Shuttle will be accounted for
as pooling of interests.
The following discussion of the Company's results of operations for the
quarter and nine months ended September 30, 1998 reflect the results of SCM
Microsystems, Inc. for the entire periods, together with the results of
Intermart and ICS from their respective dates of acquisition.
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 quarter ended September 30, 1998 were $14.2 million compared to $8.0 million
in the second quarter of 1997, an increase of 79%. For the first nine months of
1998, net sales were $32.6 million compared to $17.9 million in the first six
months of 1997, an increase of 82%. The increase in third quarter revenues in
1998 over 1997 was due primarily to revenues from the companies acquired by the
Company in the second quarter of 1998 (Intermart and ICS) of $3.9 million, an
increase in shipments of the Company's SwapSmart readers in the U.S. of $2.1
million, and an increase in SwapBox revenues in the U.S. of $0.7 million,
primarily to OEM customers supplying U.S. government agencies. The increase in
revenues for the first nine months of 1998 over 1997 was primarily due to an
increase in shipments of DVB-CAM products and services in Europe of $2.0
million, in addition to the reasons previously discussed. In the three - and
nine month periods ended September 30, 1998, sales to the Company's top 10
customers accounted for 50% and 66% of total net sales, respectively.
Gross Profit. Gross profit for the third quarter of 1998 was $5.9
million, or 41% of total net sales, compared to $2.8 million, or 36% of total
net sales for the third quarter of 1997. Gross profit for the first nine months
of 1998 was $13.0 million, or 40% of total net sales, compared to $6.7 million
or 37% in the first nine months of 1997. The increases in gross profit, both in
absolute dollars and as a percentage of total net sales, for the third quarter
and the first nine months of 1998, were primarily due to the aforementioned
increase in shipments of DVB-CAM products and services, including development
test tools, software and engineering services, all of which carry gross profit
levels higher than the Company's other products. The Company believes that its
gross profit in absolute dollars during 1998 will continue to be above the
levels experienced in 1997. The Company's gross profit has been and will
continue to be affected by a variety of factors, including competition, product
configuration and mix, the availability of new products, product enhancements,
software and services, all of which tend to carry higher gross profit than older
products, and the cost and availability of components.
Accordingly, gross profit percentages are expected to fluctuate from period to
period.
10
12
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 quarter of
1998 were $903,000, compared with $713,000 in the third quarter of 1997, an
increase of 27%. As a percentage of total net sales, research and development
expenses were 6% and 9% in the third quarter of 1998 and 1997, respectively. For
the first nine months of 1998, research and development expenses were $2.5
million, compared with $2.1 million in the comparable period of 1997, an
increase of 19%. As a percentage of total net sales, research and development
expenses were 8% in the first nine months 1998 compared to 12% for the
comparable period in 1997. The increases in absolute amounts for the third
quarter and first nine months of 1998 were primarily due to engineering
headcount and related product development costs of Intermart and ICS, the
companies acquired by the Company in the second quarter of 1998. The Company
believes that the absolute amount of research and development expenses during
the remainder of 1998 will be higher than the last quarter of 1997 due to a
higher number of personnel involved in the Company's new product development and
customer projects, but that such expenses will fluctuate as a percentage of
total net sales.
Sales and Marketing. Sales and marketing expenses consist primarily of
employee compensation and trade show and other marketing costs. Sales and
marketing expenses for the third quarter of 1998 were $1.5 million, compared
with $0.9 million in the third quarter of 1997, an increase of 67%. As a
percentage of total net sales, these expenses were 11% in the third quarter of
1998, compared with 12% in the comparable period of 1997. For the first nine
months of 1998, sales and marketing expenses were $3.8 million, or 12% of
revenues, compared with $2.9 million in the comparable period of 1997, or 16% of
revenues, an increase of 28%. These increases in absolute amounts in 1998 were
primarily due to sales and marketing costs of the companies acquired by the
Company in the second quarter of 1998, including personnel, trade show and
collateral material costs. Sales and marketing expenses in the remainder of 1998
are expected to increase in absolute amounts as the Company continues to expand
its sales and business development efforts on a worldwide basis
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 $1.5 million
in the third quarter of 1998, or 11% of total net sales, compared with $1.1
million, or 14% of total net sales in the third quarter of 1997, an increase of
37%. For the nine month period, general and administrative expenses were $3.7
million in 1998, an increase of 66% compared with $2.2 million in 1997,
representing 11% and 13% of total net sales in the nine months period in 1998
and 1997, respectively. These increases in absolute amounts were primarily due
to increases in administrative headcount in the Company's U.S. and Pfaffenhofen,
Germany offices to support higher levels of business activities, increased costs
relating to the Company operating as a public company subsequent to its IPO in
October 1997, and administrative costs of the companies acquired by the Company
in the second quarter of 1998. Also in the third quarter of 1998, the Company
increased its accrual for doubtful accounts receivable by approximately
$400,000, primarily as a result of cash flow difficulties experienced by one its
customers. The Company continues to evaluate the collectibility of the
receivable balance from this customer and there can be no certainty that further
increases to the provision for doubtful receivables may not be necessary in
future periods. The Company believes general and administrative expenses in the
remainder of 1998 will continue to increase in absolute amount for all of the
aforementioned reasons, but will fluctuate as a percentage of total net sales.
Interest Income and Other, Net. Interest income and other, net consists
of interest earned on
11
13
invested cash, offset by interest paid or accrued on outstanding debt. In the
third quarter of 1998, interest income and other, net was $2.0 million, compared
to $273,000 in the third quarter of 1997. In the first nine months of 1998,
interest income and other, net, was $4.4 million, compared to $570,000 in the
comparable period of 1997. In April 1998, the Company completed a secondary
offering of 3.45 million shares of its common stock (2.0 million shares sold by
selling stockholders and 1.45 million shares sold by the Company), which
generated net proceeds to the Company of approximately $83 million. Higher
average investable cash balances in 1998 as a result of the aforementioned stock
offering and no debt service requirements resulted in the increase in interest
income and other, net in 1998 over 1997. Continued investment of the net
proceeds from this offering will generate future net investment income in the
remainder of 1998 at levels higher than experienced in 1997.
Income Taxes. A provision for income taxes of $1.2 million was booked
in the third quarter of 1998, an effective tax rate of 29% resulting principally
from tax liabilities associated with foreign operations of the Company and
minimum state income taxes. As of December 31, 1997, the Company had German net
operating loss carry forwards of approximately $1.4 million available for an
indefinite period to offset income from the Company's German operations. In
addition, the Company had net operating loss carry forwards of approximately
$3.3 million and $1.6 million for United States federal and California income
tax purposes, respectively. The Company's utilization of United States federal
operating loss carry forwards is limited to approximately $340,000 per year.
LIQUIDITY AND CAPITAL RESOURCES
Prior to the Company's initial public stock offering, the Company had
financed its operations principally through private placements of debt and
equity securities and, to a lesser extent, borrowings under bank lines of
credit. In October 1997, the Company completed the sale of 3.8 million shares of
Common Stock in an initial public offering ("IPO"), resulting in net proceeds of
$43.7 million. In April 1998, the Company completed a secondary offering of 3.45
million shares of its Common Stock at a price to the public of $61.00 per share.
Of the total number of shares sold, 2.0 million shares were sold by shareholders
and 1.45 million shares were sold by the Company. The net proceeds to the
Company from the secondary offering were $83.1 million.
As of September 30, 1998, the Company's working capital was $146.7
million, compared to a working capital of $60.3 million as of December 31, 1997.
Working capital increased in the first nine months of 1998 due primarily to the
net proceeds from the follow-on offering of $83.1 million and the Company's
receipt of $6.6 million in net proceeds from the exercise of warrants and
options, partially offset by the acquisitions of Intermart and ICS, working
capital used in operations, and capital expenditures.
During the first nine months of 1998, cash and cash equivalents
increased by $7.7 million due primarily to net proceeds of $89.7 million from
the issuance of common stock and $26.6 million proceeds from maturities of
short-term investments, partially offset by $94.4 million used to purchase
short-term investments, $9.9 million for the businesses acquired in the second
quarter (net of cash received), $3.2 million used in operations, and $918,000
used for capital expenditures. Cash was used in operations primarily for an
increase in accounts receivable of $8.3 million and an increase in inventories
of $3.4 million, both increases were due primarily to higher levels of business
activity and the aforementioned acquisitions in the second quarter, partially
offset by increases in accrued expenses and income taxes.
The Company has revolving lines of credit with three banks in Germany
providing total
12
14
borrowings of up to 1.5 million DM each (approximately $2.7 million in total at
September 30, 1998). Two of these lines of credit expired on September 30, 1998,
and the Company and the banks are in negotiations to extend such lines for an
additional 12 month period. The third line of credit has no fixed expiration
date. The German lines of credit bear interest at rates ranging from 7.0% to
8.75% per annum. 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 (8.25% as of
Sept 30, 1998), and expires in May 1999. At September 30, 1998, no amounts were
outstanding under any of the Company's lines of credit.
The Company presently expects that its current capital resources and
available borrowings should be sufficient to meet its operating and capital
requirements through at least the end of 2000. The Company may, however, seek
additional debt or equity financing prior to that time. There can be no
assurance that additional capital will be available to the Company on favorable
terms or at all. The sale of additional debt or equity securities may cause
dilution to existing stockholders.
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
HISTORY OF OPERATING LOSSES; POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS;
SEASONALITY
Although the Company was profitable for each of the four fiscal
quarters ended September 30, 1998 (before interest accretion on preferred stock
and non-recurring adjustments), the Company incurred a net loss of $72,000
(before interest accretion on preferred stock and non-recurring adjustments) for
the nine months ended September 30, 1997 and net operating losses on an annual
basis from its inception in 1993 through the year ended December 31, 1996. As of
September 30, 1998, 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.
The Company has experienced significant seasonality in its business,
and the Company's business and operating results are likely to be affected by
seasonality in the future. The Company has typically experienced higher net
sales in the third quarter and fourth quarter of each calendar year followed by
lower net sales and operating income in the first quarter and second quarter of
the following year. The Company believes that this trend has been principally
due to budgeting requirements of the U.S.
13
15
government which influence the purchasing patterns of OEMs which supply PCs and
workstations incorporating the Company's data security products to the U.S.
government. The Company expects that as sales of its DVB products, which are
currently sold to OEMs mainly in Europe for the consumer market, begin to
represent a larger percentage of net sales, the seasonality that the Company
experiences may be further exacerbated as these sales are likely to be strongest
in the fourth quarter of the year.
Initial sales of the Company's products to a new customer typically
involve a sales cycle which can range from six to nine months during which the
Company may expend substantial financial resources and management time and
effort with no assurance that a sale will ultimately result. The length of the
sales cycle may vary depending on a number of factors over which the Company may
have little or no control, including product and technical requirements, and the
level of competition which the Company encounters in its selling activities. Any
delays in the sales 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.
DEPENDENCE ON EMERGING PRODUCT MARKETS; UNCERTAINTY OF MARKET
ACCEPTANCE OF THE COMPANY'S PRODUCTS
From the Company's inception through 1994, the Company focused on PCMCIA
peripheral products, including flash memory and fax/modem devices. In 1994, the
Company began emphasizing security and access products. The Company made the
final shipment of PCMCIA peripheral products in the quarter ended March 31,
1997, completing its exit from this business. As a result of the Company's
strategic shift in product focus, the proportion of security and access product
sales increased from 22.1% of total net sales in 1994 to 99.4% of total net
sales in 1997, and to 100% of total net sales thereafter. The Company's net
sales are now and will continue to be dependent upon the success of its security
and access products.
The Company's future growth and operating results will depend to a large
extent on the successful marketing and commercial viability of the Company's
security and access product families. Each of these product families addresses
needs in different emerging markets. Smart card token-based security
applications are able to provide protection from unauthorized access to digital
information. The Company believes that smart cards are ideally suited to serve
as tokens for network and electronic commerce security. Accordingly, the
Company's SwapBox and SwapSmart product families are designed to provide smart
card token-based security for PCs. However, there can be no assurance that the
smart card will become the industry standard for network and electronic commerce
security applications. The Company's DVB product family provides a means of
controlling access to digital television broadcasts. The Company's SwapAccess
DVB-CAM product implements the DVB-CI and NRSS-B standards. To date, the
Company's DVB-CAM product has been implemented in a relatively limited number of
DVB set-top boxes in Europe. Although the Company believes that the DVB-CI
standard will eventually become the European standard for DVB conditional access
applications, there can be no assurance that the standard will be adopted, that
the European DVB market will further develop or that even if such standard is
adopted and the market further develops, the Company's DVB-CAM products will be
widely adopted. Furthermore, the market for DVB products in the United States
has only recently begun to develop. There
14
16
can be no assurance whether, or to what extent, the United States DVB market
will grow. In addition, the substantial installed base of analog set-top boxes
in the United States may cause the market for DVB products in general, and the
Company's SwapAccess products in particular, to grow slower than expected, if at
all.
If the market for the products described above or any of the Company's
other products fails to develop or develops more slowly than expected or if any
of the standards supported by the Company do not achieve or sustain market
acceptance, the Company's business and operating results would be materially and
adversely affected.
DEPENDENCE ON SALES TO OEMs
A substantial majority of the Company's products are intended for use
as components or subsystems in systems manufactured and sold by third party
OEMs. In 1997, almost all of the Company's sales were to OEMs and the Company
expects this dependence on OEM sales to continue. In 1997, sales to BetaDigital
(a division of the Kirch Group) accounted for 45% of total net sales and sales
to the Company's top 10 customers (all of which are OEMs) accounted for 80% of
total net sales. In the first nine months of 1998, sales to BetaDigital
accounted for 16% of total net sales, sales to Telenor Conax A.S. and
subsidiaries accounted for 13% of total net sales, and sales to the Company's
top 10 customers (8 of which are OEMs) accounted for 66% of total net sales. In
order for an OEM to incorporate the Company's products into its systems, the
Company must demonstrate that its products provide significant commercial
advantages to OEMs over competing products. There can be no assurance that the
Company can successfully demonstrate such advantages or that the Company's
products will continue to provide any advantages. Moreover, even if the Company
is able to demonstrate such advantages, there can be no assurance that OEMs will
elect to incorporate the Company's products into their current or future
systems. Further, the business strategies and manufacturing practices of the
Company's OEM customers are subject to change and any such change may result in
decisions by the customers to decrease their purchases of the Company's
products, seek other sources for products currently manufactured by the Company
or manufacture these products internally. The Company's OEM customers may also
seek price concessions from the Company. Failure of OEMs to incorporate the
Company's products into their systems, the failure of such OEMs' systems to
achieve market acceptance or any other event causing a decline in the Company's
sales to OEMs would have a material adverse effect on the Company's business and
operating results.
DEPENDENCE ON SALES TO GOVERNMENT CONTRACTORS
Approximately 51%, 39%, 28% and 18% of the Company's net sales during
1995, 1996, 1997 and the first nine months of 1998, respectively, were derived
from sales of the Company's SwapBox product for use by the U.S. government, all
of which were made under contracts between the Company and major OEMs that sell
PCs to the United States Department of Defense (the "DoD"). The Company believes
that indirect sales to the DoD are subject to a number of significant
uncertainties, including timing and availability of funding, unforeseen changes
in the timing and quantity of government orders and the competitive nature of
government contracting generally. Furthermore, the DoD has been reducing total
expenditures over the past few years in a number of areas and there can be no
assurance that such funding will not be reduced in the future. In addition,
there is no assurance that the Company will be able to modify existing products
or develop new products that will continue to meet the specifications of OEM
suppliers to the DoD. A significant loss of indirect sales to the U.S.
government would have a material adverse effect on the Company's business and
operating results.
15
17
DEPENDENCE ON DEVELOPMENT OF INDUSTRY RELATIONSHIPS
The Company is party to collaborative arrangements with a number of
corporations and is a member of key industry consortia. The Company has formed
strategic relationships, including technology sharing agreements, with a number
of key industry players such as Intel, Gemplus and Telenor. The Company
evaluates, on an ongoing basis, potential strategic alliances and intends to
continue to pursue such relationships. The Company's future success will depend
significantly on the success of its current arrangements and its ability to
establish additional arrangements. There can be no assurance that these
arrangements will result in commercially successful products.
COMPETITION
The market for digital data security and access control products is
intensely competitive and characterized by rapidly changing technology. The
Company believes that competition in this market is likely to intensify as a
result of increasing demand for security products. The Company currently
experiences competition from a number of sources, including: (i) ActionTec,
Carry Computer Engineering, Greystone and Litronic in PC Card adapters; (ii)
SmartDisk Corporation, Philips and Tritheim in smart card readers and universal
smart card reader interfaces; and (iii) Gemplus in DVB-CAM modules. The Company
also experiences indirect competition from certain of its customers which
currently offer alternative products or are expected to introduce competitive
products in the future. The Company may in the future face competition from
these and other parties including new entrants, such as Motorola, that develop
digital information security products based upon approaches similar to or
different from those employed by the Company. In addition, there can be no
assurance that the market for digital data security and access control products
will not ultimately be dominated by approaches other than the approach marketed
by the Company.
Many of the Company's current and potential competitors have
significantly greater financial, technical, marketing, purchasing and other
resources than the Company, and as a result, may be able to respond more quickly
to new or emerging technologies or standards and to changes in customer
requirements, or may be able to devote greater resources to the development,
promotion and sale of products, or to deliver competitive products at a lower
end user price. Current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties to
increase the ability of their products to address the needs of the Company's
prospective customers. Accordingly, it is possible that new competitors or
alliances among competitors may emerge and rapidly acquire significant market
share. Increased competition is likely to result in price reductions, reduced
operating margins and loss of market share, any of which could have a material
adverse effect on the Company's business and operating results.
The Company believes that the principal competitive factors affecting the
market for digital data security products include: the extent to which products
support industry standards and provide interoperability; technical features;
ease of use; quality/reliability; level of security; strength of distribution
channels; and price. There can be no assurance that the Company will be able to
compete as to these or other factors or that competitive pressures faced by the
Company will not materially and adversely affect its business and operating
results.
RISK ASSOCIATED WITH ACQUISITIONS
The Company (continually) evaluates potential acquisitions of
complementary businesses, products and technologies. In the last six months, the
company has acquired Shuttle in November 1998, Intermart in May 1998 and ICS in
June 1998. There can be no assurance that the Company will realize the desired
benefits of these recent transactions or of future transactions. In order to
successfully integrate acquired companies, the Company must, among other things,
continue to attract and retain key management and other personnel; integrate,
both from an engineering and a sales and marketing perspective, the acquired
products; establish a common culture; and integrate geographically distant
facilities and employees. the diversion of the attention of management from the
day-to-day operations of the Company, or difficulties encountered in the
integration process, could have a material adverse effect on the Company's
business, financial condition and results of operations. In addition, any
acquisition, depending on its size, could result in the use of a significant
portion of the Company's available cash or, if such acquisition is made
utilizing the Company's securities, could result in significant dilution to the
Company's stockholders, and could result in the incurrence of significant
acquisition related charges to earnings. Acquisitions by the Company may result
in the incurrence or the assumption of liabilities, including liabilities that
are unknown or not fully known at the time of acquisition, which could have a
material adverse effect on the Company, furthermore, there can be no assurance
that any products acquired in connection with any such acquisition will gain
acceptance in the Company's markets.
16
18
MANAGEMENT OF GROWTH
The Company's business has grown substantially in recent periods, with net
sales increasing from $6.4 million in 1994 to $27.8 million in 1997. The growth
of the Company's business has placed a significant strain on the Company's
management and operations. In 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 increased from 50 at December 31, 1995
to 153 as of September 30, 1998. If the Company is successful in achieving its
growth plans, such growth is likely to place a significant burden on the
Company's operating and financial systems, resulting in increased responsibility
for senior management and other personnel within the Company. There can be no
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
Asia, the Company is located in Singapore and in Tokyo, Japan. Operating in
diverse geographic locations imposes a number of risks and burdens on the
Company, including the need to manage employees and contractors from diverse
cultural backgrounds and who speak different languages, and difficulties
associated with operating in a number of time zones. Although the Company seeks
to mitigate the difficulties associated with operating in diverse geographic
locations through the extensive use of electronic mail and teleconferencing,
there can be no assurance that it will not encounter unforeseen difficulties or
logistical barriers in operating in diverse locations. Furthermore, operations
in widespread geographic locations require the Company to implement and operate
complex information systems that are capable of providing timely information
which can readily be consolidated. Although the Company believes that its
information systems are adequate, the Company may in the future have to
implement new information systems. Implementation of such new information
systems may be costly and may require training of personnel. Any failure or
delay in implementing these systems, procedures and controls on a timely basis,
if necessary, or in expanding these areas in an efficient manner at a pace
consistent with the Company's business could have a material adverse effect on
the Company's business and operating results.
PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY
The Company's success depends significantly upon its proprietary
technology. The Company currently relies on a combination of patent, copyright
and trademark laws, trade secrets, confidentiality agreements and contractual
provisions to protect its proprietary rights. The Company seeks to protect its
software, documentation and other written materials under trade secret and
copyright laws, which afford only limited protection. The Company generally
enters into confidentiality and non-disclosure agreements with its employees and
with key vendors and suppliers. The Company's SwapBox trademark is registered in
the United States, and the SwapSmart trademark is the subject of an allowed,
pending application. The Company will continue to evaluate the registration of
additional trademarks as appropriate. The Company currently has one U.S. patent
issued, six U.S., one French and one Japanese patent applications pending, and
exclusive licenses under four other U.S. patents associated with its products.
Furthermore, the
17
19
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 achieve greater economies of scale, improve gross
margins and maintain uniform quality standards for its products. The majority of
the Company's products are now manufactured by its wholly-owned subsidiary in
Singapore, Intellicard, which was acquired in June 1998. In addition, the
Company currently sources some of its products through two contract
manufacturers in Europe. In the event the Company exceeds current capacity
levels at Intellicard and any of the Company's outside contract manufacturers
are unable or unwilling to continue to manufacture the Company's products, the
Company may have to rely on other contract 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.
18
20
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. 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 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.
DEPENDENCE ON NEW PRODUCTS; RAPID TECHNOLOGICAL CHANGE
The markets for the Company's products are characterized by rapid
technological change, changing customer needs, frequent new product introduction
and evolving industry standards and short product lifecycles. The introduction
by the Company or its competitors of products embodying new technologies and the
emergence of new industry standards could render the Company's existing products
obsolete and unmarketable. Therefore, the Company's future success will depend
upon its ability to successfully develop and to introduce on a timely and
continuous basis new and enhanced products that keep pace with technological
developments and emerging industry standards and address the increasingly
sophisticated needs of its customers. The timing and success of product
development is unpredictable due to the inherent uncertainty in anticipating
technological developments, the need for coordinated efforts of numerous
technical personnel and the difficulties in identifying and eliminating design
flaws prior to product release. Any significant delay in releasing new products
could have a material adverse effect on the ultimate success of a product and
other related products and could impede continued sales of predecessor products,
any of which could have a material adverse effect on the Company's business and
operating results. There can be no assurance that the Company will be able to
introduce new products on a timely basis, that new products introduced by the
Company will achieve any significant degree of market acceptance or that any
such acceptance will be sustained for any significant period. Failure of new
products to achieve or sustain market acceptance could have a material adverse
effect on the Company's business and operating results.
RISKS OF INTERNATIONAL SALES; CURRENCY FLUCTUATIONS
The Company was originally a German corporation and continues to
conduct a substantial portion of its business in Europe. Approximately 49%, 53%,
69% and 62% of the Company's revenues in 1995, 1996, 1997, and the first nine
months of 1998, respectively, were derived from customers located outside the
United States. Because a significant number of the Company's principal customers
are located in other
19
21
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, and
particularly since the Company's recent business acquisitions in Japan,
Singapore, England and India the Company's operating results are subject to
significant fluctuations based upon changes in the exchange rates of certain
currencies, particularly the German mark, the Japanese yen and the Singapore
dollar, in relation to the U.S. dollar. The Company does not currently engage in
hedging activities with respect to its foreign currency exposure. Although
management will continue to monitor the Company's exposure to currency
fluctuations, and, when appropriate, may use financial hedging techniques in the
future to minimize the effect of these fluctuations, there can be no assurance
that exchange rate fluctuations will not have a material adverse effect on the
Company's business and operating results. In the future, the Company could be
required to denominate its product sales in other currencies, which would make
the management of currency fluctuations more difficult and expose the Company to
greater risks in this regard.
PRODUCT LIABILITY RISKS
Customers rely on the Company's token-based security products to
prevent unauthorized access to their digital content. A malfunction of or design
defect in the Company's products could result in tort or warranty claims.
Although the Company attempts to reduce the risk of exposure from such claims
through warranty disclaimers and liability limitation clauses in its sales
agreements and by maintaining product liability insurance, there can be no
assurance that such measures will be effective in limiting the Company's
liability for any such damages. Any liability for damages resulting from
security breaches could be substantial and could have a material adverse effect
on the Company's business and operating results. In addition, a well-publicized
actual or perceived security breach involving token-based security systems could
adversely affect the market's perception of token-based security products in
general, or the Company's products in particular, regardless of whether such
breach is attributable to the Company's products. This could result in a decline
in demand for the Company's products, which would have a material adverse effect
on the Company's business and operating results.
YEAR 2000 COMPLIANCE
In the next two years, most companies could face a potential serious
information systems problem because many software applications and operational
programs written in the past were designed to handle date formats with two-digit
years and thus may not properly recognize calendar dates beginning in the Year
2000. This problem could result in computers either outputting incorrect data or
shutting down altogether when attempting to process a date such as "01/01/00."
In response to this, the Company has formed a committee ("the Committee") to
oversee the Company's computer system upgrade needs, including the specific
assignment to deal with Year 2000 issues.
The Committee is composed of various members of the Company Staff. The Committee
meets periodically and any finding are reviewed by the Company's Executive
Staff. The Company has reviewed all of its current product offerings and
believes that its current products are Year 2000 compliant. As such, the
Committee's general plan of action includes inventorying all essential internal
equipment, contacting suppliers to ascertain vendor readiness for Year 2000
compliance, testing all critical systems, implementing a new Enterprise Resource
Planning ("ERP") system, and resolving all mission critical problems be the end
of the third quarter of 1999. The Company is currently on schedule to complete
all mission critical Year 2000 problems by the end of the third quarter of 1999.
The Company estimates the total Year 2000 costs, including the costs of
implementing a new ERP system, to be between $1.0 million and $1.5 million. As
of September 30, 1998, the Company has not incurred any significant costs
related to Year 2000 issues. The Company has budgeted all Year 2000 costs
independently of the Company information technology department. All costs will
be paid from the Company's operating funds.
The Company is currently in the process of completing a comprehensive inventory
and evaluation of its systems, equipment and facilities. The Company is in the
process of identifying all essential suppliers and plans to contact them, if
required, to determine that the suppliers' operations, products and services are
Year 2000 compliant. The Company has a number of projects underway to replace or
upgrade systems, equipment and facilities that are not currently Year 2000
compliant. To date, the Company has not identified any specific contingency
plans should the replacement or upgrade of these systems not happen. The Company
is working to have contingency plans documented.
In addition, the Company could experience reduced revenues resulting from other
companies' allocation resources to resolve Year 2000 issues, thus reducing
amounts available to purchase the Company's products. There can be no assurance
that the Year 2000 problem will not have a material adverse effect of the
Company's business, operating results or financial condition.
20
22
EURO CONVERSION
On January 1, 1999, eleven of the fifteen member countries of the
European Union are scheduled to establish fixed conversion rates between their
existing currencies (the "legacy currency") and the one common legal currency
known as the "Euro". From January 1, 1999 through June 30, 2002 the countries
will be able to use their legacy currencies or the Euro to transact business. By
July 1, 2002, at the latest, the conversion to the Euro will be complete at
which time the legacy currencies will no longer be legal tender. The conversion
to the Euro will eliminate currency exchange rate risk between the member
countries.
The Company does not anticipate any material impact from the Euro
conversion on its financial information systems which currently accommodate
multiple currencies. Computer software changes necessary to comply with the Year
2000 issue are generally compliant to the Euro conversion issue. Due to numerous
uncertainties, the Company cannot reasonably estimate the effect that the Euro
conversion issue will have on its pricing or market strategies, and the impact,
if any, it will have on its financial condition and result of operations.
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.
21
23
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.
PART II: OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company's initial public offering of common stock was effected
through the Registration Statement on Form S-1 (File No. 333-29073) that was
declared effective by the SEC on October 6, 1997. Net proceeds to the Company
from this offering was approximately $44 million. The Company's secondary public
offering of common stock was effected through the Registration Statement on Form
S-1 (File No. 333-47635) that was declared effective by the SEC on April 16,
1998. Net proceeds to the Company from this offering was approximately $83
million.
As of September 30, 1998, the Company had used approximately $13.7
million of the aggregate net proceeds of the aforementioned two offerings of
$127 million as follows:
Repayment of indebtedness $ 2.6 million
Acquisition of businesses (net of cash acquired) $ 9.9 million
Purchases of equipment $ 1.2 million
No such payments were made to directors or officers of the Company or
their associates, holders of 10 percent or more of any class of equity
securities of the Company or to affiliates of the Company.
Appendix 4
On November 3, 1998, the Company acquired Shuttle Technology Group
Limited ("Shuttle"). In connection therewith, the Company issued an aggregate of
827,792 shares of the Company Common Stock to the shareholders of Shuttle. The
transaction was exempt from registration requirements of Section 5 of the
Securities Act pursuant to Section 4(2) thereof. The recipients of the
securities represented to their intentions to acquire the securities for
investment only and not with a view to or for sale in connection with any
distribution thereof and appropriate legends were affixed to the share
certificates issued in such transaction. All recipients had adequate access to
information regarding the Company.
Appendix 5
ITEM 5. OTHER INFORMATION
Pursuant to Rule 14a-4(c)(1) under the Securities Exchange Act of 1934,
the proxies of management would be allowed to use their discretionary voting
authority with respect to any non-Rule 14a-8 stockholder proposal (i.e, a
stockholder proposal not included in a company's proxy) raised at the Company's
annual meeting of stockholders, without any discussion of the matter in the
proxy statement. Unless the stockholder has notified the Company of such
proposal at least 45 days prior to the month and day on which the Company mailed
its prior year's proxy statement. Since the Company mailed its proxy statement
for the 1998 annual meeting of stockholders on June 5th, 1998, the deadline for
receipt of any such non-Rule 14a-8 stockholder proposal for the 1999 annual
meeting of stockholders is April 21, 1999.
22
24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27 Financial Data Schedule
(b) Reports on Form 8-K
None.
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 11, 1998
/s/ JOHN G. NIEDERMAIER
----------------------------------------
John G. Niedermaier
Vice President- Finance, Chief Financial
Officer (Principal Financial and
Accounting Officer)
23
25
INDEX TO EXHIBITS
Exhibit
Number Description
- ------ -----------
27 Financial Data Schedule