1
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------------------
FORM 10 - Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999
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)
160 KNOWLES DRIVE, LOS GATOS, CA 95032
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)
(408) 370-4888
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
N/A
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR,
IF CHANGED SINCE LAST REPORT)
------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No
At May 7, 1999, 14,066,997 shares of common stock were outstanding.
================================================================================
1
2
SCM Microsystems, Inc. and Subsidiaries
Index
PART I
Financial Information Page
----
Item 1 Financial Statements
Condensed Consolidated Statements of Operations
for the three months ended March 31, 1999 and 1998 3
Condensed Consolidated Balance Sheets as of
March 31, 1999 and December 31, 1998 4
Condensed Consolidated Statements of Cash Flows
for the three months ended March 31, 1999 and 1998 5
Notes to Condensed Consolidated Financial Statements 6
Item 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 20
Part II
Other Information
Item 5 Other Information 22
Item 6 Exhibits and Reports on Form 8-K 22
Signatures 22
2
3
ITEM 1. FINANCIAL STATEMENTS
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Three months ended March 31,
----------------------------
1999 1998
------- -------
Revenues $24,361 $13,925
Cost of revenues 16,016 8,898
------- -------
Gross margin 8,345 5,027
------- -------
Operating expenses:
Research and development 1,849 1,331
Sales and marketing 2,629 1,835
General and administrative 1,923 1,290
------- -------
Total operating expenses 6,401 4,456
------- -------
Income from operations 1,944 571
Interest and other, net 1,606 696
------- -------
Income before income taxes 3,550 1,267
Provision for income taxes 1,140 274
------- -------
Net income $2,410 $ 993
======= =======
Net income per share:
Basic $ 0.17 $ 0.09
======= =======
Diluted $ 0.16 $ 0.08
======= =======
Shares used in computing net income per share:
Basic 14,014 11,582
======= =======
Diluted 15,121 12,950
======= =======
See accompanying notes to condensed consolidated financial statements.
3
4
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
March 31, December 31,
ASSETS 1999 1998
--------- ------------
Current assets:
Cash, cash equivalents and short-term investments $123,076 $129,918
Accounts receivable, net 23,237 25,535
Inventories 15,186 12,159
Prepaids and other current assets 4,555 3,879
--------- ---------
Total current assets 166,054 171,491
Property and equipment, net 4,493 4,063
Goodwill, net 4,645 4,847
Other assets 5,361 2,919
--------- ---------
Total assets $180,553 $183,320
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 11,862 $ 15,046
Accrued expenses 5,568 4,941
Income taxes payable 2,666 4,554
--------- ---------
Total current liabilities 20,096 24,541
Stockholders' equity:
Capital stock 14 14
Additional paid-in capital 169,631 168,897
Accumulated deficit (8,788) (11,198)
Deferred compensation (57) (72)
Other cumulative comprehensive income (loss) (343) 1,138
--------- ---------
Total stockholders' equity 160,457 158,779
--------- ---------
$180,553 $183,320
========= =========
See accompanying notes to condensed consolidated financial statements.
4
5
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
Three months
ended March 31,
-------------------------
1999 1998
-------- --------
Cash flows from operating activities:
Net income $ 2,410 $ 993
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 533 272
Amortization of deferred stock compensation 15 13
Changes in operating assets and liabilities:
Accounts receivable 1,182 (1,074)
Inventories (3,759) (93)
Prepaid expenses (743) (901)
Accounts payable (2,716) (1,843)
Accrued expenses 843 (103)
Income taxes payable (2,354) 164
-------- --------
Net cash used in operating activities (4,589) (2,572)
-------- --------
Cash flows used in investing activities:
Capital expenditures (1,144) (309)
Proceeds from investments 20,311
9,162
Purchases of investments (23,402)
(13,541)
-------- --------
Net cash used in investing activities (4,235) (4,688)
-------- --------
Cash flows from financing activities:
Proceeds from notes payable -- (9)
Payments on line of credit and other current debt -- (142)
Proceeds from issuance of equity, net 734 5,739
-------- --------
Net cash provided by financing activities 734 5,588
Effect of exchange rates on cash 420 (44)
-------- --------
Net decrease in cash (7,670) (1,716)
Cash at beginning of period 48,012 25,727
-------- --------
Cash at end of period $40,342 $24,011
======== ========
Supplemental disclosures of cash flow information:
Cash paid for income taxes $ 3,416 $ 86
======== ========
Cash paid for interest $ 10 $ 2
======== ========
See accompanying notes to condensed consolidated financial statements.
5
6
SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1999
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulations S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring adjustments) considered for a fair presentation
have been included. Operating results for the three-month period ended March 31,
1999 are not necessarily indicative of the results that may be expected for the
year ending December 31, 1999. For further information, refer to the financial
statements and footnotes thereto included in the Company's December 31, 1998
annual report on Form 10-K.
2. EARNINGS PER SHARE
Basic earnings per share (EPS) is computed using the weighted-average
number of common shares outstanding during the period. Diluted EPS is computed
using the weighted-average number of common and, when dilutive, common
equivalent shares outstanding during the period. Dilutive common equivalent
shares consist of common stock issuable upon exercise of stock options and
warrants using the treasury stock method. The following is a reconciliation of
the shares use in the computation of basic and diluted EPS for the three months
ended March 31, 1999 and 1998 (in thousands, except per share amounts):
Three months ended
March 31,
----------------------
1999 1998
------- -------
Basic Earnings Per Share:
Net income $2,410 $ 993
======= =======
Basic net income per share $ 0.17 $ 0.09
======= =======
Weighted average common shares outstanding 14,014 11,582
======= =======
Diluted Earnings Per Share:
Net income $2,410 $ 993
======= =======
Diluted net income per share $ 0.16 $ 0.08
======= =======
Shares used:
Weighted average common shares outstanding 14,014 11,582
Stock options outstanding 1,091 1,335
Stock warrants outstanding 16 33
======= =======
15,121 12,950
======= =======
3. RECENT ACCOUNTING PRONOUNCEMENT
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. Under SFAS No. 133, entities are
required to carry all derivatives on the balance at fair value. The accounting
for changes in the fair value of a derivative instrument depends on whether it
has been designated and qualifies as part of a hedging relationship and, if so,
the reason for holding it. This statement will be effective for all annual and
interim periods beginning after December 15, 1999 and management does not
believe the adoption of SFAS No. 133 will have a material effect on the
consolidated financial position of the Company.
6
7
4. BUSINESS COMBINATIONS
Intermart and ICS
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) in separate transactions that were accounted for under
the purchase method of accounting. 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 three months ended March 31,
1998, as if each company had been acquired as of the beginning of the period
presented. The table includes the impact of certain adjustments including the
elimination of the nonrecurring 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):
Three months ended
March 31, 1998
------------------
Revenues $17,046
Net income $ 1,514
Net income per share:
Basic $ 0.13
Diluted $ 0.12
Shares used in per share computations:
Basic 11,689
Diluted 13,057
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.
Shuttle
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 England, in exchange for all of
the outstanding share capital of Shuttle ("the Shuttle merger"). The Shuttle
merger has been accounted for as a pooling of interests and, accordingly, the
Company's consolidated financial statements have been restated for all periods
prior to the merger to include the results of operations, financial position and
cash flows of Shuttle. No significant adjustments were required to conform the
accounting policies of the Company and Shuttle. In connection with the merger
with Shuttle, in the fourth quarter of 1998, the Company recorded nonrecurring
charges totaling $9,683,000, of which $757,000 had not been settled as of
December 31, 1998. Changes in these accruals during the first quarter of 1999
were as follows (in thousands):
Decrease during
Accrued as of three months ended Accrued as of
December 31, 1998 March 31, 1999 March 31, 1999
----------------- ------------------ --------------
Legal, accounting, regulatory and other due diligence costs $597 $394 $203
Costs relating to closure of redundant facilities 160 56 104
---- ---- ----
$757 $450 $307
==== ==== ====
The remaining amounts accrued as of March 31, 1999 are expected to be settled in
the second and third quarters of 1999.
As separate companies, total revenues and net income for the individual
entities for the three months ended March 31, 1998 were as follows (in
thousands):
Total revenue:
SCM $ 7,815
Shuttle 6,110
-------
$13,925
=======
Total net income:
SCM $ 789
Shuttle 204
-------
$ 993
=======
7
8
5. SEGMENT REPORTING, GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS
Prior to 1999, the executive staff, the Company's chief operating
decision making body, reviewed financial information presented on a geographic
basis for purposes of making operating decisions and assessing financial
performance. Beginning January 1, 1999, the executive staff realigned the
Company's organization along three product segments: Digital TV, digital media,
and PC and network security. Effective with this realignment, the executive
staff began reviewing financial information and business performance along these
three product segments. The Company evaluates the performance of its segments
based on the operating profit for each segment, excluding any nonrecurring
charges such as in-process research and development, restructuring and asset
impairment charges and merger-related costs. The Company does not include
intercompany transfers between segments for management reporting purposes.
Capital expenditures for long-lived assets are not reported to management by
segment and are excluded, as presenting such information is not practicable.
Summary information by segment as of and for the three months ended March 31,
1999 and 1998, is as follows (in thousands):
1999 1998
-------- --------
Digital TV:
Revenues $ 8,954 $ 5,689
Gross margin 3,137 2,403
Segment operating profit 1,499 1,452
Segment assets 11,879 5,675
Long-lived assets 3,292 455
Digital Media:
Revenues $ 12,409 $ 6,250
Gross margin 3,951 2,268
Segment operating profit 617 7
Segment assets 47,312 17,663
Long-lived assets 8,998 2,312
PC and Network Security:
Revenues $ 2,998 $ 1,986
Gross margin 1,257 356
Segment operating loss (172) (888)
Segment assets 7,970 4,709
Long-lived assets 2,209 377
A reconciliation of the Company's segment assets and segment operating
profit (loss) as of and for the three months ended March 31, 1999 and 1998
follows (in thousands):
March 31
------------------------
1999 1998
-------- --------
Segment assets - Digital TV $ 11,879 $ 5,675
Segment assets - Digital Media 47,312 17,663
Segment assets - PC and Network Security 7,970 4,709
-------- --------
Total segment assets 67,161 28,047
Corporate cash, cash equivalents and short-term
investments 113,392 51,540
-------- --------
Total assets $180,553 $ 79,587
======== ========
Three months ended March 31,
----------------------------
1999 1998
-------- --------
Segment operating profit - Digital TV $ 1,499 $ 1,452
Segment operating profit - Digital Media 617 7
Segment operating loss - PC and Network Security (172) (888)
-------- --------
Total income from operations $ 1,944 $ 571
======== ========
8
9
Additional information regarding revenues by geographic region for the
three months ended March 31, 1999 and 1998 follows (in thousands):
1999 1998
------- -------
United States $ 9,408 $ 4,269
Europe 10,448 7,558
Asia-Pacific 4,505 2,098
------- -------
$24,361 $13,925
======= =======
A summary of the net sales to major customers that exceeded 10% of total
net sales during the three months ended March 31, 1999 and 1998, and the amount
due from these customers as of March 31, 1999, follows (accounts receivable in
thousands):
Accounts
1999 1998 receivable
---- ---- ----------
Customer 1......... 15% 28% $2,454
Customer 2......... 14% -- $1,009
6. RELATED PARTY TRANSACTIONS
As discussed in Note 4, the Company acquired ICS, a Singapore-based
contract manufacturer in June of 1998. Prior to the acquisition, ICS had made an
investment of approximately $350,000 in one of its customers, a company that
designs and markets video editing and conversion products for PC and internet
applications (the ICS Customer). During 1998, revenue from the ICS Customer
amounted to $3,609,000, and the amount receivable from this customer was
$1,608,000 as of December 31, 1998. During the fourth quarter of 1998, the
Company made an additional investment in the ICS Customer in the form of a
convertible note in the amount of $2,500,000. This note, which is included with
other assets on the accompanying condensed consolidated balance sheet as of
March 31, 1999, is secured by all assets of the ICS Customer and automatically
converts to preferred stock upon the closing of at least $5,000,000 in
additional equity by the ICS Customer on or before June 30, 1999. In the event
that the ICS Customer is unable to obtain at least $5,000,000 in equity
financing prior to this date, then SCM has the right to acquire, for an
incremental payment of approximately $100,000, additional equity of the ICS
Customer which would result in SCM obtaining a controlling interest of the ICS
Customer. The ICS Customer is currently in negotiations with third parties
regarding the raising of additional equity financing through private or public
means, or a possible merger with another company. In connection with their
financing efforts, the ICS Customer obtained a recent valuation of their company
which indicates that the value of the ICS Customer is approximately $12,000,000.
During the first quarter of 1999, the Company made additional shipments to the
ICS customer but deferred recognition of the related revenue and gross margin
until such time as payments are remitted to the Company. As of March 31, 1999,
the ICS Customer owed $2,539,000 to the Company.
7. COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted the provisions of
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" (SFAS No. 130), which establishes standards for reporting and disclosure
of comprehensive income and its components (revenues, expenses, gains and
losses) in a full set of general-purpose financial statements. Comprehensive
income includes all changes in equity during a period except those resulting
from the issuance of shares of stock and distributions to stockholders. The
Company's total comprehensive income for the three months ended March 31, 1999
and 1998 was as follows (in thousands):
Three months ended March 31,
----------------------------
1999 1998
------- -------
Net income $ 2,410 $ 993
Changes in cumulative foreign currency
translation account, net of taxes (1,007) (236)
------- -------
Total comprehensive income $ 1,403 $ 757
======= =======
9
10
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. SCM'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"
and elsewhere in this document.
Overview
SCM Microsystems ("the Company") designs, develops and sells products
used to control access to computers, networks and digital television broadcasts,
conduct secure electronic commerce, and exchange digital information from
devices such as digital cameras and audio recorders. The Company's target
customers are manufacturers in the computer, telecommunications and digital
television industries. The Company sells and licenses our products through a
direct sales and marketing organization, primarily to original equipment
manufacturers (OEMs), and also through distributors, value-added resellers and
system integrators worldwide.
Acquisitions
In the second quarter of 1998, the Company completed its acquisitions
of Intermart Systems K.K. ("Intermart") based in Tokyo, Japan, and Intellicard
Systems Pte. Ltd. ("ICS"), based in Singapore. A summary of the purchase price
for the acquisitions is as follows (in thousands):
Cash $19,751
Common stock 5,976
Direct acquisition costs 433
-------
Total $26,160
=======
These acquisitions were 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. At the time of the
acquisitions, there were 10 incomplete development projects in various states
of completion ranging from 10% to 90% in process at Intermart and ICS, with an
estimated total cost to complete of approximately $721,000. Following a
voluntary restatement of its consolidated financial statements by the Company
as of September 30, 1998, the value of these incomplete research and
development projects associated was determined to be $3.1 million, based on
risk-adjusted cash flows related to the incomplete projects. 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. As of
March 31, 1999, six of the 10 projects were completed, and it is expected that
the remaining projects will be completed by the end of 1999 at a cost of
approximately $350,000.
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 England, in exchange for all of
the outstanding share capital of Shuttle ("the Shuttle merger"). The Shuttle
merger has been accounted for as a pooling of interests and, accordingly, the
Company's consolidated financial statements have been restated for all periods
prior to the merger to include the results of operations, financial position and
cash flows of Shuttle. No significant adjustments were required to conform the
accounting policies of the Company and Shuttle.
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 March 31, 1999 were $24.4 million compared to $13.9 million in
1998, an increase of 76%. The increase in revenues in 1999 over 1998 was due
primarily to an increase in shipments of the Company's digital media and
connectivity products of $5.4 million, an increase in shipments of DVB-CAM
products and services in Europe of $3.5 million, and an increase in SwapBox
revenues in the U.S., primarily to OEM customers supplying U.S. government
agencies. Sales to the Company's top 10 customers accounted for 61% and 63% of
total net sales in the first quarter of 1999 and 1998, respectively.
Gross Profit. Gross profit for the first quarter of 1999 was $8.3
million, or 34% of total net sales, compared to $5.0 million or 36% for the
first quarter of 1998. The increase in gross profit in absolute dollars for the
first quarter of 1999, was primarily due to the aforementioned increase in
shipments of digital media and connectivity products and an 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 decrease as a percentage of total net
sales was due primarily to a contractual change with one of our Digital TV
customers effective October 1, 1998 which resulted in a different cost structure
for that product. The Company believes that its gross profit in absolute dollars
during 1999 will continue to be above the levels experienced in 1998. 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.
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. For the first quarter of 1999, research and development
expenses were $1.8 million, compared with $1.3 million in the first quarter of
1998, an increase of 38%. As a percentage of total net sales, research and
development expenses were 7% in the first quarter of 1999 compared to 9% in the
first quarter of 1998. The increase in absolute amounts was primarily due to
engineering headcount and related product development costs at the Company's
development centers in France and India, and due to research and development
expenses of Intermart and ICS, companies acquired in May and June 1998,
respectively ("the acquired companies"). The Company believes that the absolute
amount of research and
10
11
development expenses during 1999 will be higher than in 1998 due to a higher
number of personnel involved in the Company's new product development and
customer projects, but that such expenses will fluctuate as a percentage of
total net sales.
Sales and Marketing. Sales and marketing expenses consist primarily of
employee compensation and trade show and other marketing costs. Sales and
marketing expenses for the first quarter of 1999, were $2.6 million, or 11% of
revenues, compared with $1.8 million in the first quarter of 1998, or 13% of
revenues, an increase of 44%. These increases in absolute amounts in 1999 were
primarily due to sales and marketing costs of the acquired companies, including
personnel, trade show and collateral material costs. Sales and marketing
expenses in 1999 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. In the first quarter of 1999, general and
administrative expenses were $1.9 million, an increase of 46% compared with $1.3
million in the first quarter of 1999, representing 8% and 9% of total net sales
in the first quarter of 1999 and 1998, respectively. This increase in absolute
amount in 1999 were primarily due to an increase in administrative headcount in
the Company's U.K. office and administrative costs of the acquired companies.
The Company believes general and administrative expenses in 1999 will continue
to increase in absolute amount for all of the aforementioned reasons, but will
fluctuate as a percentage of total net sales.
In the second half of 1998, general and administrative expenses included
charges for additions to the Company's allowance for doubtful accounts totaling
$2.6 million, $2.3 million of which was the result of cash flow difficulties
experienced by one its customers. As of December 31, 1998 and March 31, 1999,
the gross trade accounts receivable balance due from this customer was $4.2
million. During the first quarter of 1999, the Company made an advance of
$170,000 to this customer related to channel promotion costs. The Company
continues to aggressively pursue collection, including negotiating a structured
repayment program. Although the Company has reserved a significant portion of
the outstanding exposure relating to this customer, management believes there
can be no assurance that further increases to the provision for doubtful
receivables for this customer may not be necessary in future periods.
Interest Income and Other, Net. Interest income and other, net consists
of interest earned on invested cash, offset by interest paid or accrued on
outstanding debt. In the first quarter of 1999, interest income and other, net,
was $1.6 million, compared to $0.7 million in the first quarter of 1998. 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 1999 as
a result of the aforementioned stock offering and no debt service requirements
resulted in the increase in interest income and other, net in the first quarter
of 1999 over the first quarter of 1998.
Income Taxes. The provision for income taxes was $1.1 million in the
first quarter of 1999 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.
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 March 31, 1999, the Company's working capital was $146.0 million,
compared to a working capital of $147.0 million as of December 31, 1998. Working
capital decreased in the first three months of 1999 primarily due
11
12
to working capital used in operations and capital expenditures.
During the first three months of 1999, cash and cash equivalents
decreased by $7.7 million due primarily to $4.6 million used in operations, $3.1
million increase in investments and $1.1 million used for capital expenditures,
partially offset by proceeds from issuance from equity. Cash was used in
operations primarily for an increase in inventories of $3.8 million, a decrease
in accounts payable of $2.7 million, and payment of income taxes.
As of March 31, 1999 and December 31, 1998, the Company's other
cumulative comprehensive income (loss) balances were ($343,000) and $1,138,000,
respectively, and consisted entirely of cumulative foreign currency translation
amounts. The reduction in this amount during the first quarter of 1999 was due
primarily to changes in the conversion rates between the DM and the U.S. dollar.
The Company has revolving lines of credit with two banks in Germany
providing total borrowings of up to 1.5 million DM each (approximately $2.7
million in total at March 31, 1999). One of these lines of credit expires on
September 30, 1999. The second 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. In the United
Kingdom, the Company has a pound sterling L1.5 million (approximately $2.4
million as of March 31, 1999) overdraft facility with a bank secured by the
assets of the U.K. subsidiary, which bears interest at 2% over the bank's base
rate (5.5% as of March 31, 1999) and expires on May 31, 1999. 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 (7.75% as of March 31, 1999),
and expires in May 1999. The Company is currently negotiating the terms with its
U.S. bank under which the term of the U.S. line of credit will be extended. At
March 31, 1999, 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
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Additional risks and uncertainties not presently
known to us or that we currently deem immaterial may also impair our business
operations.
If any of the following risks actually occur, our business, financial
condition or results of operations could be materially adversely affected. In
such case, the trading price of our common stock could decline and you could
lose all or part of your investment.
We Have Incurred Prior Operating Losses and May Not Sustain Profitability.
Although SCM was profitable for the quarters ended March 31, 1999 and
the year ended December 31, 1997, SCM incurred net operating losses on an annual
basis from our inception in 1993 through the year ended December 31, 1996 and in
1998. As of March 31, 1999, SCM had an accumulated deficit of $8.8 million. In
view of our loss history, we cannot assure you that SCM will be able to achieve
or sustain profitability on an annual or quarterly basis in the future.
There Are Many Factors, Including Some Beyond Our Control, That May Cause
Fluctuations in Our Quarterly Operating Results.
Our quarterly operating results depend on a number of factors that are
difficult to forecast. If our future quarterly operating results fall below the
expectations of securities analysts or investors, the trading price of our
common stock will likely drop. Our quarterly operating results have fluctuated
in the past and may continue to fluctuate in the future as a result of many
factors, including:
- size, timing, cancellation or rescheduling of significant
orders;
- new product announcements or introductions by us or our
competitors;
12
13
- our ability to develop, introduce and market new products and
product enhancements on a timely basis, if at all;
- our success in expanding our sales and marketing organization
and programs;
- technological changes in the market for our products;
- our level of expenditures on research and development; and
- general economic trends.
In addition, because a high percentage of our operating expenses are fixed, a
small variation in revenue can cause significant variations in our operating
results from quarter to quarter.
Seasonal Trends in Sales of Our Products May Affect Our Quarterly Operating
Results.
Our business and operating results reflect seasonal trends. We have
typically experienced lower net sales and operating income in the first quarter
and second quarter and higher net sales in the third quarter and fourth quarter
of each calendar year. Seasonal business trends may be caused by a number of
factors, including higher consumer sales during the holiday season and the
fiscal year end for companies. We believe that the seasonal trends in our
business and operating results are principally due to the U.S. government's
budgeting requirements. This government related seasonality occurs because
original equipment manufacturers, or OEMs incorporate our data security products
into personal computers, or PCs, and workstations which are then sold to the
U.S. government. The back-ended nature of the U.S. government's budgetary cycle
encourages OEMs to purchase our products in the second half of each fiscal year.
Another reason for our seasonality is that we currently sell our digital video
broadcasting, or DVB products mainly to OEMs for the European consumer market.
We expect these sales to increase. Because consumer market's sales are highest
in the third and fourth quarter of the year, we expect the seasonal trends in
our business and operating results to continue.
Any Delays in Our Normally Lengthy Sales Cycle Could Result in Significant
Fluctuations in Our Quarterly Operating Results.
When we obtain a new customer, our initial sales to that customer
usually take six to nine months. During this sales cycle, we may expend
substantial financial resources and our management's time and effort with no
assurance that a sale will ultimately result. The length of a new customer's
sales cycle depends on a number of factors that we may not be able to control.
These factors include the customer's product and technical requirements and the
level of competition we face for that customer's business. Any delays in the
sales cycle for new customers could have a material adverse effect on our
business and operating results.
We believe that our operating results may vary significantly in future
periods and that our historical results are not reliable indicators of future
performance. It is possible that, in the future, our operating results will be
below the expectations of stock market analysts and investors. In such event,
the market price of our Common Stock could decline significantly.
Our Emerging Markets May Not Accept Our Products.
SCM's future growth and operating results will depend on whether our
security and connectivity product families are commercially successful. As
described below, each of our product families address needs in different
emerging markets. We may not succeed in these emerging markets. In addition, as
these markets develop, industry standards may be established. Our products may
not comply with the industry standards ultimately adopted in these emerging
markets.
From SCM's inception through 1994, we focused on Personal Computer
Memory Card Industry Association, or PCMCIA, peripheral products, including
flash memory and fax/modem devices. In 1994, we began emphasizing security and
access products. We made our final shipment of PCMCIA peripheral products in the
quarter ended March 31, 1997, completing our exit from this business. We have
since strategically shifted our product focus to security and connectivity
products, which have increased from 13% of our total net sales in 1994 to 100%
of total net sales in 1998. Therefore, our net sales are now and will continue
to be dependent upon the success of our security and connectivity products.
13
14
We believe that smart cards are ideally suited to serve as tokens for
network and electronic commerce security. Smart card token-based security
applications are designed to provide protection from unauthorized access to
digital information. Our SwapBox and SwapSmart product families are designed to
provide smart card token-based security for PCs. However, the market for network
and electronic commerce security applications is still emerging and the smart
card may not become the industry standard for these applications.
Our Digital TV products provide a means of controlling access to digital
television broadcasts. Our SwapAccess DVB-CAM product implements the DVB-CI and
Opencable standards. To date, our DVB-CAM product has been implemented in a
relatively limited number of digital TV set-top boxes in Europe. However, the
European standard for digital TV conditional access applications is still
emerging. Although we believe that the DVB-CI standard will eventually become
the European standard for digital TV conditional access applications, this
standard may not be adopted and the European digital TV market may fail to
further develop. The market for digital TV products in the United States has
only recently begun to develop and may not grow. In addition, the substantial
base of analog set-top boxes already installed in the United States may cause
the market for digital TV products in general, and our SwapAccess products in
particular, to grow more slowly than expected or not at all.
If the market for the products described above or any of our other
products fail to develop or develop more slowly than expected, or if any of the
standards supported by us do not achieve or sustain market acceptance, our
business and operating results would be materially and adversely affected.
We Depend On Our Continued Sales To Original Equipment Manufacturers.
Most of our products are intended for use as components or subsystems in
systems manufactured and sold by third party OEMs. In order to convince an OEM
to incorporate our products into its systems, we must demonstrate that our
products provide significant commercial advantages over our competitor's
products. We may fail to successfully demonstrate these advantages or our
products may cease to provide any advantages. Even if we are able to demonstrate
that our products are superior, OEMs may still choose not to incorporate our
products into their systems. OEMs may also change their business strategies and
manufacturing practices, which could cause them to purchase fewer of our
products, find other sources for products we currently manufacture or
manufacture these products internally. Our OEM customers may also seek price
concessions from us. Failure of OEMs to incorporate our products into their
systems, the failure of such OEMs' systems to achieve market acceptance or any
other event causing a decline in our sales to OEMs would have a material adverse
effect on our business and operating results.
In the first quarter of 1999, almost all of our sales were to OEMs and
we expect this dependence on OEM sales to continue. In the first quarter of
1999, sales to BetaDigital (a division of the Kirch Group) accounted for 15% of
total net sales, sales to Solectron Corporation accounted for 14% of our net
sales, and sales to our top 10 customers (all of which were OEMs) accounted for
61% of total net sales.
Our Sales To Government Contractors Are Subject to Uncertainties and May
Decrease.
Approximately 12%, 17%, 28% and 8% of our net sales for the years ended
1998, 1997, 1996 and the first three months of 1999, respectively, were derived
from sales of our SwapBox product for use by the U.S. government. These sales
were made under contracts between SCM and major OEMs that sell PCs to the United
States Department of Defense, or DOD. We believe that indirect sales to the DOD
are subject to a number of significant uncertainties, including timing and
availability of funding, unpredictable changes in the timing and quantity of
government orders and the generally competitive nature of government
contracting. Furthermore, the DOD has been reducing total expenditures over the
past few years in several areas. Accordingly, funding for the purchase of our
products may be reduced in the future. In addition, we may not 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 our business and
operating results.
Our Sales to Distributors Are Subject to Uncertainties and May Fluctuate.
Sales of some of our Digital Media and PC and Network Security products
are made to distributors, some of whom are smaller companies with limited
working capital for marketing and promotion efforts and whose cash flow is
dependent on payment from their customers. We believe that delays in shipments
by and payments to our distribution customers by their customers may have a
material adverse effect on our business and operating results.
We Rely On Our Strategic Relationships and Investments to Generate Revenue.
SCM collaborates with a number of corporations, has made strategic
investments in certain customers, and is a member of key industry consortia. Our
future success will depend significantly on the success of our current
14
15
arrangements and our ability to establish additional arrangements. We have
formed strategic relationships, including technology sharing agreements, with a
number of key industry players such as Intel, Gemplus and Telenor. We evaluate,
on an ongoing basis, potential strategic alliances and investment opportunities
and intend to continue to pursue such relationships. These arrangements may not
result in commercially successful products. Furthermore, investments made to
date may result in losses if our customers' efforts are not successful.
Our Markets Are Highly Competitive.
The market for our products is intensely competitive and characterized
by rapidly changing technology. We believe that competition in this market is
likely to intensify as a result of increasing demand for security products. We
currently experience competition from a number of sources, including:
- ActionTec, Carry Computer Engineering, Greystone and Litronic in
PC Card adapters;
- SmartDisk Corporation, Philips and PubliCard in smart card
readers and universal smart card reader interfaces; and
- Gemplus in DVB-CAM modules.
We also experience indirect competition from some of our customers which
sell alternative products or are expected to introduce competitive products in
the future. We may in the future face competition from these competitors and new
competitors, such as Motorola, that develop digital information security
products. In addition, the market for digital data security, access control and
connectivity products may ultimately include technological solutions other than
ours.
Many of our current and potential competitors have significantly greater
financial, technical, marketing, purchasing and other resources than we do. As a
result, our competitors may be able to respond more quickly to new or emerging
technologies or standards and to changes in customer requirements. Our
competitors may also be able to devote greater resources to the development,
promotion and sale of products, and may be able 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 our
prospective customers. Therefore, 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 these factors could have a
material adverse effect on our business and operating results.
We believe that the principal competitive factors affecting the market
for digital data security products include:
- the extent to which products comply with existing industry
standards;
- technical features;
- ease of use;
- quality and reliability;
- level of security;
- strength of distribution channels; and
- price.
We may not be able to successfully compete as to these or other factors
and the competitive pressures may cause our business and operating results to
suffer.
We May Not Be Able to Integrate Recently Acquired Companies.
We continually evaluate potential acquisitions of complementary
businesses, products and technologies. SCM acquired Shuttle Technology Group
Limited, based in the U.K., in November 1998, Intermart Systems K.K., based in
Japan, in May 1998 and Intellicard Systems Pte. Ltd., based in Singapore, in
June 1998. We may not realize the
15
16
desired benefits of these recent transactions or of future transactions. In
order to successfully integrate acquired companies, we must, among other things:
- continue to attract and retain key management and other
personnel;
- integrate, from both an engineering and sales and marketing
perspective, the acquired products;
- establish a common corporate culture; and
- integrate geographically distant facilities and employees.
If our management's attention to day-to-day operations is diverted to
integrating acquired companies or if problems in the integration process arise,
these difficulties could have a material adverse effect on our business and
operating results. In addition, any acquisition, depending on its size, could
result in the use of a significant portion of our available cash. If an
acquisition is made utilizing our securities, a significant dilution to our
stockholders and significant acquisition related charges to earnings could
occur. During 1998, SCM incurred significant non-recurring charges associated
with the acquisitions of Shuttle, Intermart and Intellicard. SCM may also incur
additional material charges in the future resulting from redundancies in product
lines, customer lists and sales channels associated with these acquisitions.
Acquisitions may also result in the incurrence or the assumption of liabilities,
including liabilities that are unknown or not fully known to us at the time of
acquisition, which could have a material adverse effect on us. Furthermore, we
cannot assure you that any products we acquire in connection with any
acquisition will gain acceptance in our markets.
We Have Experienced Significant Growth in Our Business in Recent Periods and Our
Ability to Manage This Growth and Any Future Growth Will Affect Our Business.
Our business has grown substantially in recent periods, with net sales
increasing from $10.9 million in 1994 to $85.0 million in 1998. The growth of
our business has placed a significant strain on our management and operations.
In 1993, we commenced operations in North America, which included the
establishment of a U.S. management team. As a result, we have a limited
operating history under our current U.S. management. In addition, the number of
employees has increased from 67 at December 31, 1995 to 260 as of December 31,
1998.
If we are successful in achieving our growth plans, our growth is likely
to place a significant burden on our operating and financial systems and
increased responsibility for senior management and other personnel. Existing
management or any new members of management may not be able to improve existing
systems and controls or implement new systems and controls in response to
anticipated growth. Our failure to do so could have a material adverse effect on
our business and operating results.
We Must Integrate Our Global Locations.
SCM's U.S. headquarters are located in Los Gatos, California, European
headquarters are located in Pfaffenhofen, Germany, and research and development
facilities are located in Erfurt, Germany, La Ciotat, France, Wokingham,
England, Pondicherry, India and Madras, India. In Asia, we are located in
Singapore, Taiwan and Tokyo, Japan. Operating in diverse geographic locations
imposes a number of risks and burdens on us, 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 these difficulties can be reduced through the use of
electronic mail and teleconferencing, unforeseen difficulties or logistical
barriers in operating in diverse locations may occur. Operating in widespread
geographic locations requires us to implement and operate complex information
systems. Although we believe that our information systems are adequate, we may
in the future have to implement new information systems. Implementation of new
information systems may be costly and may require us to train 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
could have a material adverse effect on our business and operating results.
We May Be Exposed To Risks Of Intellectual Property Infringement.
SCM's success depends significantly upon our proprietary technology. We
currently rely on a combination of patent, copyright and trademark laws, trade
secrets, confidentiality agreements and contractual provisions to protect our
proprietary rights. Our software, documentation and other written materials are
protected under trade secret and copyright laws, which afford only limited
protection. SCM generally enters into confidentiality and non-disclosure
agreements with our employees and with key vendors and suppliers. Our SwapBox
and SwapSmart trademarks are
16
17
registered in the United States. We continuously evaluate the registration of
additional trademarks as appropriate. We currently have seven United States
patents issued and three German patents issued. We also have nineteen patent
applications pending worldwide. In addition, we have exclusive licenses under
four other United States patents, and licenses for two United States patents
associated with our products. Although we often seek to protect our proprietary
technology through patents, it is possible that no new patents will be issued,
that our proprietary products or technologies are not patentable, and that any
issued patent will fail to provide us with any competitive advantages.
There has been a great deal of litigation in the technology industry
regarding intellectual property rights. Litigation may be necessary to protect
our proprietary technology. SCM has from time to time received claims that it is
infringing upon third parties' intellectual property rights. In April 1997,
Gemplus served SCM with a complaint alleging that our SwapSmart product
infringes certain claims of a French patent held by Gemplus. Although this
dispute was settled on terms acceptable to us, future disputes with third
parties may arise and these disputes may not be resolved on terms acceptable to
us. As the number of products and competitors in our target markets grows, the
likelihood of infringement claims also increases. Any claims or litigation may
be time-consuming and costly, cause product shipment delays, or require us to
redesign our products or require us to enter into royalty or licensing
agreements. Any of these events could have a material adverse effect on our
business and operating results. Despite our efforts to protect our proprietary
rights, unauthorized parties may attempt to copy aspects of our products or to
use our proprietary information and software. 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. Our means of protecting
our proprietary and intellectual property rights may not be adequate. There is a
risk that our competitors will independently develop similar technology,
duplicate our products or design around patents or other intellectual property
rights.
Our Business Could Suffer If We or Our Contract Manufacturers Cannot Meet
Production Requirements.
Most of our products are manufactured outside the United States because
we believe that global sourcing enables us to achieve greater economies of
scale, improve gross margins and maintain uniform quality standards for our
products. Any significant delay in our ability to obtain adequate supplies of
our products from our current or alternative sources would materially and
adversely affect our business and operating results. A significant portion of
our products are now manufactured by SCM Microsystems (Asia) Pte. Ltd., formerly
Intellicard, our wholly-owned subsidiary in Singapore, but we also source some
of our products through two contract manufacturers in Europe. If Intellicard or
any of our contract manufacturers cannot meet our production requirements, we
may have to rely on other contract manufacturing sources or identify and qualify
new contract manufacturers. In this regard, one of our contract manufacturers
has recently been involved in bankruptcy proceedings and may be unable to
continue manufacturing our products. Despite efforts to do so, we may not be
able to identify or qualify new contract manufacturers in a timely manner and
these new manufacturers may not allocate sufficient capacity to us in order to
meet our requirements.
In an effort to reduce our manufacturing costs, SCM has shifted volume
production of many of our product components to Singapore. We are currently
considering shifting the production of other product components to other
suppliers in Europe or Asia. Transferring production to these new locations
could disrupt our manufacturing process and increase overall production costs.
In addition, foreign manufacturing poses 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.
We Have A Limited Number Of Suppliers Of Key Components.
We rely upon a limited number of suppliers of several key components of
our products. For example, SCM purchases mechanical components for use in our
smart card reader product exclusively from Stocko, a German-based supplier. Our
reliance on only one supplier could impose several risks, including an
inadequate supply of components, price increases, late deliveries and poor
component quality. Disruption or termination of the supply of these components
could delay shipments of our products, which could have a material adverse
effect on our business and operating results. These delays could also damage
relationships with current and prospective customers.
The Markets For Our Products May Undergo Rapid Technological Change and Our
Future Success Will Depend on Our Ability to Meet the Sophisticated Needs of Our
Customers.
17
18
The markets for our products are characterized by rapidly changing
technology. Our customers' needs change and new products are introduced
frequently. Product life cycles are short and industry standards are still
evolving. These rapid changes in technology could render our existing products
obsolete and unmarketable. Therefore, our future success will depend upon our
ability to successfully develop and introduce new and enhanced products that
meet our customers' increasing expectations and incorporate the latest
technology. Product development is risky because it is difficult to foresee
developments in technology, coordinate technical personnel and identify and
eliminate design flaws. Any significant delay in releasing new products could
have a material adverse effect on the ultimate success of our products and could
reduce sales of predecessor products. We may not be able to introduce new
products on a timely basis. In addition, new products introduced by us may fail
to achieve a significant degree of market acceptance or, once accepted, may fail
to sustain for any significant period. These factors could have a material
adverse effect on our business and operating results.
Many of Our Customers are Located in Other Countries Which Exposes Our Business
to Risks Related To International Sales and Currency Fluctuations.
SCM was originally a German corporation and continues to conduct a
substantial portion of its business in Europe. Approximately 50%, 51%, 62% and
61% of our revenues for the years ended 1996, 1997, 1998 and in the first three
months of 1999, respectively, were derived from customers located outside the
United States. Because a significant number of our principal customers are
located in other countries, we anticipate that international sales will continue
to account for a significant portion of our revenues. As a result, a significant
portion of our 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;
- exchange controls; and
- potential adverse tax consequences.
These factors may have a material adverse effect on our business and
operating results.
We conduct operations and sell products in several different countries.
In addition, we recently acquired companies in Japan, Singapore, Great Britain
and India. Therefore, our operating results may be impacted by the fluctuating
exchange rates of foreign currencies, especially the German mark, the Japanese
yen, the Singapore dollar, the British pound and the Indian rupee, in relation
to the U.S. dollar. We do not currently engage in hedging activities with
respect to our foreign currency exposure. We continually monitor our exposure to
currency fluctuations and may use financial hedging techniques when appropriate
to minimize the effect of these fluctuations. Even so, exchange rate
fluctuations may still have a material adverse effect on our business and
operating results. In the future, we could be required to denominate our product
sales in other currencies, which would make the management of currency
fluctuations more difficult and expose us to greater currency risks.
We May Face Product Liability Risks.
Customers rely on our token-based security products to prevent
unauthorized access to their digital information. A malfunction of or design
defect in our products could result in legal or warranty claims. Although we
place warranty disclaimers and liability limitation clauses in our sales
agreements and maintain product liability insurance, we cannot assure you that
these measures will be effective in limiting our liability. Liability for
damages resulting from security breaches could be substantial and could have a
material adverse effect on our business and operating results. In addition, a
well-publicized security breach involving token-based and other security systems
could adversely affect the market's perception of products like ours in general,
or our products in particular, regardless of whether the breach is actual or
attributable to our products. In that event, the demand for our products could
decline, which would cause our business and operating results to suffer.
We Face Year 2000 Compliance Risks.
Many currently installed computer systems and software products are
coded to accept only two digit entries in the date code field. Beginning in the
year 2000, these date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates. As a result, during the
current year, computer systems and
18
19
software used by many companies may need to be upgraded to comply with such
"Year 2000" requirements. The Year 2000 problem could affect computers, software
and other equipment used, operated, or maintained by us, our business partners,
our suppliers and our customers. We have formed a committee (the Committee) to
oversee our computer system upgrade needs, including the specific assignment to
deal with Year 2000 issues.
The Committee is composed of various members of our staff. The Committee
meets periodically and any findings are reviewed by our executive staff. We have
reviewed all of our current product offerings and believe that our current
products are Year 2000 compliant. The Committee's general plan of action
includes inventorying all essential internal equipment, contacting suppliers to
ascertain their readiness for Year 2000 compliance, testing all critical
systems, implementing a new Enterprise Resource Planning (ERP) system, and
resolving all critical problems by the end of the third quarter of 1999. We are
currently on schedule to complete all critical Year 2000 problems by the end of
the third quarter of 1999.
We estimate the total Year 2000 costs to be between $75,000 and
$100,000. In addition, we plan to implement a new ERP system to serve our
worldwide information system, which we estimate will cost $1.0 million to $1.3
million. As of December 31, 1998, we have not incurred any significant costs
related to Year 2000 issues. We have budgeted all Year 2000 costs independently
of our information technology department. All costs will be paid from our
operating funds.
SCM is currently in the process of completing a comprehensive inventory
and evaluation of our systems, equipment and facilities. We are in the process
of identifying all essential suppliers and plan to contact them, if required, to
determine that the suppliers' operations, products and services are Year 2000
compliant. We have a number of projects underway to replace or upgrade systems,
equipment and facilities that are not currently Year 2000 compliant. We do not
have a specific contingency plan should the replacement or upgrade of these
systems fail. We are working to develop such a contingency plan.
In addition, our sales could suffer if our customers divert resources
from purchasing our products to resolving their own Year 2000 issues. The Year
2000 problem may have a material adverse effect on our business and operating
results.
It Is Uncertain Whether The Adoption Of The Euro Will Affect Our Business.
On January 1, 1999, eleven of the fifteen member countries of the
European Union established a fixed conversion rates between their existing
currencies (the "old 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 old currencies or the Euro to transact business. By July 1, 2002, the
conversion to the Euro will be complete, at which time the old currencies will
no longer be legal tender. The conversion to the Euro will eliminate currency
exchange rate risk between the member countries.
We do not anticipate any material impact from the Euro conversion on our
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. Because there are many
uncertainties, we cannot reasonably estimate the effect that the Euro conversion
issue will have on our pricing or market strategies, and the impact, if any, it
will have on our financial condition and result of operations.
Our Key Personnel Are Critical to Our Business and Such Key Personnel May Not
Remain with SCM in the Future.
We depend on the continued employment of our senior executive officers
and other key management and technical personnel. If any of our key personnel
leave and are not adequately replaced, our business would be adversely affected.
In particular, we depend on the continued service of Robert Schneider, our
Chairman of the Board, Steven Humphreys, our President and Chief Executive
Officer, and Bernd Meier, our Chief Operating Officer. SCM 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, our 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 cannot work
for one of our competitors during the one-year period following his termination.
Non-compete agreements are, however, generally difficult to enforce. Therefore,
these provisions may not provide us with significant protection. SCM entered
into employment agreements with three employees of Shuttle, one of whom is
covered by a key man life insurance policy. We do not maintain key man life
insurance on any other employees.
19
20
We believe that our future success will depend in large part on our
continuing ability to attract and retain highly qualified technical and
management personnel. Competition for such personnel is intense, and we may not
be able to retain our key technical and management employees or to attract,
assimilate or retain other highly qualified technical and management personnel
in the future.
Our Stock Price Is Potentially Volatile.
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 our common stock has been highly volatile and is
likely to continue to be volatile. The future trading price for our common stock
will depend on a number of factors, including:
- variations in our financial results;
- comments and forecasts by security analysts;
- our ability to increase our manufacturing capability as required by
customer demand;
- any loss of key management;
- announcements of technological innovations or new products by us or
our competition; and
- patents or other proprietary rights or patent litigation.
In the past, companies that have experienced volatility in the market
price of their stock have been the object of securities class action litigation.
If we were the object of securities class action litigation, it could result in
substantial costs and a diversion of management's attention and resources.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currencies
The Company transacts business in various foreign currencies, primarily
in certain European countries, the United Kingdom, Singapore and Japan.
Accordingly, the Company is subject to exposure from adverse movements in
foreign currency exchange rates. This exposure is primarily related to yen
denominated sales in Japan and local currency denominated operating expenses in
the U.K., Europe and Singapore, where the Company sells in both local currencies
and U.S. dollars. The Company currently does not use financial instruments to
hedge local currency activity at any of its foreign locations. Instead, the
Company believes that a natural hedge exists, in that local currency revenues
substantially offsets the local currency denominated operating expenses. The
Company assesses the need to utilize financial instruments to hedge foreign
currency exposure on an ongoing basis.
Fixed Income Investments
The Company's exposure to market risk for changes in interest rates
relates primarily to its investment portfolio. The Company does not use
derivative financial instruments for speculative or trading purposes. The
Company places its investments in instruments that meet high credit quality
standards, as specified in the Company's investment policy. The policy also
limits the amount of credit exposure to any one issue, issuer and type of
instrument. The Company does not expect any material loss with respect to its
investment portfolio.
The Company does not use derivative financial instruments in its
investment portfolio to manage interest rate risk. The Company does, however,
limit its exposure to interest rate and credit risk by establishing and strictly
monitoring clear policies and guidelines for its fixed income portfolios. At the
present time, the maximum duration of all portfolios is limited to two years.
The guidelines also establish credit quality standards, limits on exposure to
one issue, issuer, as well as the type of instrument. Due to the limited
duration and credit risk criteria established in the Company's guidelines, the
exposure to market and credit risk is not expected to be material.
20
21
PART II: OTHER INFORMATION
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. No such proposals were received from
stockholders.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27 Financial Data Schedule
(b) Reports on Form 8-K
On January 19, 1999, the Company filed a report on Form 8-K/A
which contained the required financial information relating to
the Company's merger with Shuttle Technology Group Limited which
closed in November 1998.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCM MICROSYSTEMS, INC.
Date: May 13, 1999
/s/ JOHN G. NIEDERMAIER
-------------------------------------
John G. Niedermaier
Vice President-Finance,
Chief Financial Officer (Principal
Financial Accounting Officer)
21
22
INDEX TO EXHIBITS
Exhibit
Number Description
- ------ -----------
27 Financial Data Schedule