UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended December 31, 2005

LASERCARD CORPORATION
---------------------
(Exact name of registrant as specified in its charter)

DELAWARE 0-6377 77-0176309
-------- ------ ----------
(State or other jurisdiction of (Commission File Number) (I.R.S. Employer
incorporation or organization) Identification No.)

1875 North Shoreline Boulevard, Mountain View, California 94043-1319
--------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)

(650) 969-4428
--------------
(Registrant's telephone number, including area code)

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

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

Number of outstanding shares of common stock, $.01 par value, at January 31,
2006: 11,485,276

Exhibit Index is on Page 36

Total number of pages is 40

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION Page Number

Item 1. Condensed Consolidated Financial Statements (Unaudited) 2
Condensed Consolidated Balance Sheets 3
Condensed Consolidated Statements of Operations 4
Condensed Consolidated Statements of Cash Flows 5
Notes to Condensed Consolidated Financial Statements 6

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 15

Item 3. Quantitative and Qualitative Disclosures about Market Rate Risks 33

Item 4. Controls and Procedures 34

PART II. OTHER INFORMATION

Item 1. Legal Proceedings 34

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 34

Item 3. Defaults Upon Senior Securities 34

Item 4. Submission of Matters to a Vote of Security Holders 34

Item 5. Other Information 34

Item 6. Exhibits 34

SIGNATURES 35

EXHIBIT INDEX 36
- --------------------------------------------------------------------------------------------------

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

LASERCARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS)

DECEMBER 31, MARCH 31,
2005 2005 *
---- ----

ASSETS
Current assets:
Cash and cash equivalents $ 756 $ 3,965
Short-term investments 20,350 6,150
Accounts receivable, net 1,766 1,934
Inventories 8,242 7,909
Prepaid and other current assets 1,319 1,352
------------ -----------
Total current assets 32,433 21,310

Property and equipment, net 11,999 12,532
Long-term investments -- 6,300
Equipment held for resale 5,673 4,061
Patents and other intangibles, net 903 923
Goodwill 3,321 3,321
Note receivable 202 220
Other non-current assets 163 101
------------ -----------
Total assets $ 54,694 $ 48,768
============ ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,618 $ 2,105
Accrued liabilities 1,918 2,312
Deferred tax liability 587 641
Advance payments from customers 3,122 1,167
Deferred revenue 473 539
------------ -----------
Total current liabilities 7,718 6,764

Advance payments from customers 18,500 13,000
Deferred revenue 2,000 2,000
Deferred rent 517 326
------------ -----------
Total liabilities 28,735 22,090
------------ -----------

Commitments and contingencies

Stockholders' equity:
Common stock 114 114
Additional paid-in capital 54,316 54,155
Accumulated deficit (28,249) (27,145)
Accumulated other comprehensive income 13 209
Treasury stock (235) (655)
------------ -----------
Total stockholders' equity 25,959 26,678
------------ -----------

Total liabilities and stockholders' equity $ 54,694 $ 48,768
============ ===========

* Amounts derived from audited financial statements at the date indicated.
The accompanying notes are an integral part of these condensed consolidated financial statements.

LASERCARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

Three Months Ended Nine Months Ended
December 31, December 31,
2005 2004 2005 2004
---- ---- ---- ----

Revenues
Total revenues..................................... $ 10,077 $ 6,282 $ 25,770 $ 22,765
---------- ---------- ---------- ----------

Cost of product sales.................................. 5,890 5,477 17,250 17,685
---------- ---------- ---------- ----------

Gross profit ...................................... 4,187 805 8,520 5,080
---------- ---------- ---------- ----------

Operating expenses:
Selling, general, and administrative expenses........ 2,517 3,063 8,260 8,906
Research and engineering expenses.................... 557 655 1,608 2,229
---------- ---------- ---------- ----------
Total operating expenses........................... 3,074 3,718 9,868 11,135
---------- ---------- ---------- ----------

Operating income (loss).......................... 1,113 (2,913) (1,348) (6,055)
---------- ---------- ---------- ----------

Other income, net...................................... 109 64 313 149
---------- ---------- ---------- ----------

Income (loss) before income taxes................ 1,222 (2,849) (1,035) (5,906)

Income tax expense (benefit)........................... 68 (8) 69 --
---------- ---------- ---------- ----------

Net income (loss)................................ $ 1,154 $ (2,841) $ (1,104) $ (5,906)
========== ========== ========== ==========

Net income (loss) per share:
Basic............................................ $ .10 $ (.25) $ (.10) $ (.52)
========== ========== ========== ==========
Diluted.......................................... $ .10 $ (.25) $ (.10) $ (.52)
========== ========== ========== ==========

Weighted-average shares of common stock used in
computing net income (loss) per share:
Basic............................................ 11,375 11,334 11,358 11,370
Diluted.......................................... 11,577 11,334 11,358 11,370

The accompanying notes are an integral part of these condensed consolidated financial statements.

LASERCARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

NINE MONTHS ENDED
DECEMBER 31,
2005 2004
---- ----

Cash flows from operating activities:
Net loss ............................................................................ $ (1,104) $ (5,906)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization.................................................... 1,895 2,021
Provision for doubtful accounts receivable....................................... -- 3
Provision for excess and obsolete inventory...................................... 203 272
Provision for product return reserve............................................. 234 355
Stock-based compensation......................................................... 101 85
Loss on disposal of equipment.................................................... -- 5
Changes in operating assets and liabilities:
Increase in accounts receivable.................................................. (209) (774)
Decrease (increase) in inventories............................................... (635) 124
Increase in prepaid and other current assets..................................... (10) (33)
Increase in equipment held for resale............................................ (1,613) (1,278)
Increase in other non-current assets............................................. (62) --
Decrease in accounts payable and accrued liabilities............................. (914) (2,188)
Decrease in deferred income tax liabilities...................................... -- (166)
Increase in advance payments from customers...................................... 7,480 5,144
Decrease in deferred revenue..................................................... (27) (2,448)
Increase in deferred rent........................................................ 191 --
------------ ------------

Net cash provided by operating activities................................... 5,530 112
------------ ------------

Cash flows from investing activities:
Purchases of property and equipment.................................................. (1,427) (2,717)
Proceeds from sale of equipment...................................................... -- 2
Investment in patents and other intangibles.......................................... (86) (90)
Purchases of investments............................................................. (19,500) (500)
Proceeds from maturities of investments.............................................. 11,600 2,427
Note receivable...................................................................... -- (221)
------------ ------------

Net cash used in investing activities....................................... (9,413) (1,099)
------------ ------------

Cash flows from financing activities:
Proceeds from sale of treasury stock through stock plans............................. 582 --
Proceeds from sale of common stock through stock plans............................... -- 255
Payment of bank loan................................................................. (108) (766)
Increase (decrease) in short-term and long-term debt................................. 143 (466)
Stock repurchases.................................................................... -- (656)
------------ ------------

Net cash provided by (used in) financing activities......................... 617 (1,633)
------------ ------------

Effect of exchange rate changes on cash..................................... 57 145
------------ ------------

Net decrease in cash and cash equivalents............................................... (3,209) (2,475)

Cash and cash equivalents:
Beginning of period.................................................................. 3,965 11,688
------------ ------------
End of period........................................................................ $ 756 $ 9,213
============ ============

The accompanying notes are an integral part of these condensed consolidated financial statements.

LASERCARD CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements contained
herein include the accounts of LaserCard Corporation and its wholly owned
subsidiaries. All significant intercompany accounts and transactions have been
eliminated in consolidation.

The condensed consolidated financial statements included herein have
been prepared by the Company, without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been condensed or omitted pursuant to such rules and regulations,
although the Company believes the disclosures which are made are adequate to
make the information presented not misleading. Further, the condensed
consolidated financial statements reflect, in the opinion of management, all
adjustments (which include only normal recurring adjustments) necessary to
present fairly the financial position and results of operations as of and for
the periods indicated.

These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and the notes thereto for
the fiscal year ended March 31, 2005, included in the Company's Annual Report on
Form 10-K.

The results of operations for the three and nine-month periods ended
December 31, 2005 are not necessarily indicative of results to be expected for
the entire fiscal year ending March 31, 2006.

FISCAL PERIOD: For purposes of presentation, the Company labels its
annual accounting period end as March 31 and its interim quarterly periods as
ending on the last day of the corresponding month. The Company, in fact,
operates and reports based on quarterly periods ending on the Friday closest to
month end. The 13-week third quarter of fiscal 2006 ended on December 30, 2005,
and the 13-week third quarter of fiscal 2005 ended on December 31, 2004.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

USE OF ESTIMATES. The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.

FOREIGN CURRENCY TRANSACTIONS. The functional currency of the Company's
foreign subsidiaries is the local currency. The financial statements of these
subsidiaries are translated to United States dollars using period-end rates of
exchange for assets and liabilities and average rates of exchange for each
quarter for revenues and expenses. Translation gains (losses) are recorded in
accumulated other comprehensive income as a component of stockholders' equity.
Net gains and losses resulting from foreign exchange transactions are included
in selling, general and administrative expenses and were not significant during
the periods presented.

CONCENTRATION OF CREDIT RISK. The following customers accounted for more
than 10% of accounts receivable at December 31, 2005 and March 31, 2005
respectively:

DECEMBER 31, MARCH 31,
2005 2005
---- ----

Customer A 38% 27%
Customer B 15% --

MAJOR CUSTOMERS. The following customers accounted for more than 10% of
revenues for the periods shown below. The revenue from these customers was
attributable to both the optical memory card and the optical card drive
segments. No other customer accounted for more than 10% of revenues during these
periods.

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

Customer A 30% 45% 35% 27%
Customer B 38% 4% 21% 33%

CASH AND CASH EQUIVALENTS, SHORT-TERM INVESTMENTS AND LONG-TERM
INVESTMENTS. The Company considers all highly liquid investments, consisting
primarily of commercial paper, discount notes and U.S. government bonds, with
maturities of three months or less at the date of purchase, to be cash
equivalents. Cash and cash equivalents at December 31, 2005 and March 31, 2005
were $0.8 million and $4 million, respectively. As of December 31, 2005 and
March 31, 2005, the Company held auction rate securities which have been
accounted for as available-for-sale and classified as short-term investments.
The fair values of the auction rate securities, based on quoted market prices,
were substantially equal to their carrying costs due to the frequency of the
reset dates. Short-term investments also include investments with maturities at
date of purchase of more than three months and up to one year and investments
initially classified as long-term with remaining maturities of less than one
year. All investments with maturities of greater than one year are classified as
long-term investments. Management determines the appropriate classification of
debt securities at the time of purchase and reevaluates the classification of
investments as of each balance sheet date.

All short-term investments, except for auction rate securities which are
recorded at fair value, and long-term investments are classified as held to
maturity and are stated in the balance sheet at amortized cost. As such
investments are classified as held to maturity, no unrealized gains or losses
are recorded. The carrying amounts of individual held to maturity securities are
reviewed at the balance sheet date for potential impairment. As of December 31,
2005 and March 31, 2005, the Company has determined that an impairment which was
"other than temporary" has not occurred.

DERIVATIVE FINANCIAL INSTRUMENTS. The Company uses short-term foreign
exchange forward contracts to mitigate foreign currency risk associated
primarily with intercompany loans (denominated in Euros) to its German
subsidiaries. Our foreign exchange forward contracts are not designated for
accounting purposes as hedging instruments under SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended. Accordingly, any
gains or losses resulting from changes in the fair value of the forward contract
are reported in selling, general and administrative expenses. The gains and
losses on these forward contracts generally offset gains and losses associated
with the underlying foreign currency denominated intercompany loans. At December
31, 2005 we had a foreign exchange forward contract with a maturity of less than
30 days to purchase 1.7 million euros. The fair value of the forward contract
was not material at December 31, 2005.

INVENTORIES: Inventories are stated at the lower of cost or market, with
cost determined on a first-in, first-out basis and market based on the lower of
replacement cost or estimated realizable value. The components of inventories
are (in thousands):

DECEMBER 31, MARCH 31,
2005 2005
---- ----

Raw materials $ 4,711 $ 4,891
Work-in-process 1,419 739
Finished goods 2,112 2,279
---------- ----------
$ 8,242 $ 7,909
========== ==========

NET INCOME (LOSS) PER SHARE: Basic net income (loss) per share is
computed by dividing net income (loss) by the weighted average number of shares
of common stock outstanding during the period. Diluted net loss per share is
computed by dividing net loss by the weighted average number of shares of common
stock outstanding. As the effect of common stock equivalents would be
antidilutive, stock options and warrants were excluded from the calculation of
diluted net loss per share for the nine-month period ended December 31, 2005 and
the three and nine-month periods ended December 31, 2004. Accordingly, basic and
diluted net loss per share were the same for these periods. Diluted net income
per share is computed by dividing net income by the weighted average number of
shares of common stock outstanding plus common stock equivalent shares. Common
stock equivalent shares consist of the shares issuable upon the exercise of
stock options using the treasury stock method. Due to the market value of the
stock at the time of calculation for the three-month period ended December 31,
2005, shares of common stock equivalents of approximately 1.8 million were not
included in the diluted calculation because they were antidilutive.

The reconciliation of the denominators of the basic and diluted net
income (loss) per share computation for the periods shown is in the following
table (in thousands, except per share data):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

Net income (loss), as reported................................. $ 1,154 $ (2,841) $ (1,104) $ (5,906)
========= ========= ========= =========

Basic net income (loss) per share:
Weighted average common shares outstanding.............. 11,375 11,334 11,358 11,370
--------- --------- --------- ---------
Basic net income (loss) per share.............................. $ 0.10 $ (0.25) $ (0.10) $ (0.52)
========= ========= ========= =========

Diluted net income (loss) per share:
Weighted average common shares outstanding................. 11,375 11,334 11,358 11,370
Weighted average common shares from stock options grants... 202 -- -- --
--------- --------- --------- ---------
Weighted average common shares and common stock
equivalents outstanding................................. 11,577 11,334 11,358 11,370
--------- --------- --------- ---------
Diluted net income (loss) per share............................ $ 0.10 $ (0.25) $ (0.10) $ (0.52)
========= ========= ========= =========

REVENUE RECOGNITION. Product sales primarily consist of optical cards,
optical card drives and specialty cards and card printers. The Company
recognizes revenue from product sales when the following criteria are met: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the
fee is fixed or determinable; and (4) collectibility is reasonably assured. The
Company recognizes revenue on product sales at the time of shipment when
shipping terms are F.O.B. shipping point, orders are placed pursuant to a
pre-existing sales arrangement and there are no post-shipment obligations other
than warehousing under a U.S. government subcontract or customer acceptance
criteria. Where appropriate, provision is made at the time of shipment for
estimated warranty costs and estimated returns. The total amounts of actual
warranty costs and returns activity were $277,000 and $240,000 for the
three-month periods ended December 31, 2005 and 2004, respectively. The total
amount of actual warranty costs and returns activity were $383,000 and $463,000
for the nine-month periods ended December 31, 2005 and 2004, respectively.

The Company's U.S. government subcontract requires delivery into a
secure vault located on Company premises. Shipments are made from the vault on a
shipment schedule provided by the prime contractor, which is subject to
revision, but generally not subject to cancellation, at the option of the prime
contractor. At the time the cards are delivered into the vault, title to the
cards is transferred to the government and all risks of ownership are
transferred as well. The prime contractor is invoiced, with payment due within
thirty days and the contract does not contain any return (other than for
warranty) or cancellation provisions. Pursuant to the provisions of SEC Staff
Accounting Bulletin No. 104 (SAB 104), revenue is recognized on delivery into
the vault as the Company has fulfilled its contractual obligations and the
earnings process is complete. If the Company does not receive a shipment
schedule for shipment of cards from the vault, revenue is deferred and
recognized upon shipment from the vault. In addition, revenue recognition for
future deliveries into the vault would be affected if the U.S. government
cancels the shipment schedule. As a result, the Company's revenues may fluctuate
from period to period if the Company does not continue to obtain shipment
schedules under this subcontract or if the shipment schedules are cancelled.

In May 2003, the Emerging Issues Task Force ("EITF") finalized the terms
of EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables,"
(EITF 00-21) which provides criteria governing how to identify whether goods or
services that are to be delivered separately in a bundled sales arrangement
should be accounted for separately. Deliverables are accounted for separately if
they meet all of the following criteria: a) the delivered items have stand-alone
value to the customer; b) the fair value of any undelivered items can be
reliably determined; and c) if the arrangement includes a general right of
return, delivery of the undelivered items is probable and substantially
controlled by the seller. In situations where the deliverables fall within
higher-level literature as defined by EITF 00-21, the Company applies the
guidance in that higher-level literature. Deliverables that do not meet these
criteria are combined with one or more other deliverables. The Company adopted
EITF 00-21 for any new arrangements entered into after July 1, 2003 and now
assesses all revenue arrangements against the criteria set forth in EITF 00-21.

The Company applies the provisions of Statement of Position 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1) in applicable contracts. Revenues on time and materials
contracts are recognized as services are rendered at contract labor rates plus
material and other direct costs incurred. Revenues on fixed price contracts are
recognized on the percentage of completion method based on the ratio of total
costs incurred to date compared to estimated total costs to complete the
contract. Estimates of costs to complete include material, direct labor,
overhead and allowable general and administrative expenses. In circumstances
where estimates of costs to complete a project cannot be reasonably estimated,
but it is assured that a loss will not be incurred, the percentage-of-completion
method based on a zero profit margin, rather than the completed-contract method,
is used until more precise estimates can be made. The full amount of an
estimated loss is charged to operations in the period it is determined that a
loss will be realized from the performance of a contract. During both of the
three-month periods ended December 31, 2005 and 2004, the Company recognized
approximately $10,000 of revenues based on a zero profit margin. During the
nine-month periods ended December 31, 2005 and 2004, the Company recognized
approximately $76,000 and $96,000 of revenues based on a zero profit margin,
respectively.

The Company applies the provisions of Statement of Position (SOP) No.
97-2, "Software Revenue Recognition," as amended by Statement of Position 98-9,
"Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" to all transactions involving the sale of software products.
Revenue from the license of the Company's software products is recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered, the fee is fixed or determinable and collectibility is probable, and,
if applicable, upon acceptance when acceptance criteria are specified or upon
expiration of the acceptance period. Software revenue was immaterial for
three-month and nine-month periods ended December 31, 2005 and 2004.

License revenue, which may consist of up-front license fees and
long-term royalty payments, is recognized as revenue when earned. There were no
license revenue and cost of license revenue recorded for the three-month and
nine-month periods ended December 31, 2005 and 2004.

In the fiscal 2005 first quarter, the Company sold a card-manufacturing
license, effective April 3, 2004, to Global Investments Group (GIG), based in
Auckland, New Zealand, for card manufacturing in Slovenia. This agreement
provides for payments to the Company of $14 million for a 20-year license and
five-year training support package, followed by $15 million paid $1 million
annually for ongoing support for an additional 15 years. Additionally, the
Company is to sell approximately $12 million worth of the required manufacturing
equipment and installation support for the new facility to be built by GIG to
provide a targeted initial manufacturing capacity of 10 million optical cards
annually. As of December 31, 2005 the Company had $5.7 million of this equipment
classified as equipment held for resale on its balance sheet. The Company has
received $20.5 million of payments called for in the agreements, consisting of a
partial payment for the equipment of $6.5 million and $14 million for the
license fee and support. For the $20.5 million the Company received, $18.5
million was recorded as advance payments from customers and $2 million for the
licensing fee was recorded as deferred revenue, which were both classified as
long term liabilities within the consolidated balance sheets. In addition to the
$41 million discussed above, GIG is to pay the Company royalties for each card
produced under the license. The territories covered by the license include most
of the European Union and eastern European regions. GIG has exclusive marketing
rights in certain territories, with performance goals to maintain these rights.
The Company will assign a person on site during the license term to assist with
quality, security and operational procedures, with the mutual goal that the
facility and the cards made in the facility conform to the Company's standards.
The Company also retains rights to utilize up to 20% of the new facility
capacity as backup and capacity buffer to augment its own card manufacturing
facilities in Mountain View, California and its German

subsidiary. The granting of this license to GIG establishes a potential second
source supplier of optical memory cards for existing and prospective customers
who may request multiple sources for cards. Revenue will be recognized over the
remaining term of the agreement beginning when operation of the factory
commences which GIG has targeted for late in calendar year 2006.

ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
condensed consolidated financial statements, the Company is required to estimate
income taxes in each jurisdiction in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the condensed consolidated
balance sheets. The Company must then assess the likelihood that the deferred
tax assets will be recovered from future taxable income and to the extent that
management believes recovery is not likely, the Company must establish a
valuation allowance. To the extent that a valuation allowance is established or
increased in a period, the Company includes an expense within the tax provision
in the condensed consolidated statements of operations.

Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. The Company determined as of December 31,
2003, that it was necessary to increase the valuation allowance under SFAS No.
109 to the full amount of the deferred tax asset due to the Company's recent
cumulative tax loss history, income statement loss history over the previous
four quarters and the difficulty in forecasting the timing of future revenue as
evidenced by the deviations in achieved revenues from expected revenues during
the previous few quarters and taking into account the newness of certain
customer relationships. As a result, the Company determined that a full
valuation allowance was required. As of December 31, 2005, the Company continues
to provide for a full valuation allowance of $18.5 million relating to its U.S.
operations. Income tax expense for the nine-month period ended December 31, 2005
resulted from estimated alternative minimum taxes.

STOCK-BASED COMPENSATION. The Company accounts for its stock-based
compensation plans using the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees."
Compensation cost for stock options, if any, is measured by the excess of the
quoted market price of the Company's stock at the date of grant over the amount
an employee must pay to acquire the stock. SFAS No. 123, "Accounting for
Stock-Based Compensation," established accounting and disclosure requirements
using a fair-value based method of accounting for stock-based employee
compensation plans. The following table illustrates the effect on net income
(loss) and income (loss) per share as if the Company had applied the fair value
recognition provisions of SFAS No. 123 (in thousands except per share amounts):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

Net income (loss), as reported................................. $ 1,154 $ (2,841) $ (1,104) $ (5,906)
========= ========= ========= =========

Add: stock-based employee compensation expense
included in reported net income (loss)..................... 34 32 101 85

Deduct: total stock-based employee compensation
determined under fair value based method for all awards.... (520) (435) (1,222) (1,401)
--------- --------- --------- ---------
Pro forma net income (loss).................................... $ 668 $ (3,244) $ (2,225) $ (7,222)
========= ========= ========= =========

Income (loss) per common share:
Basic - as reported........................................ $ .10 $ (.25) $ (.10) $ (.52)
========= ========= ========= =========
Basic - pro forma.......................................... $ .06 $ (.29) $ (.20) $ (.64)
========= ========= ========= =========
Diluted - as reported...................................... $ .10 $ (.25) $ (.10) $ (.52)
========= ========= ========= =========
Diluted - pro forma........................................ $ .06 $ (.29) $ (.20) $ (.64)
========= ========= ========= =========

Shares used in computing basic and diluted pro forma
net income (loss) per share:
Basic ..................................................... 11,375 11,334 11,358 11,370
Diluted.................................................... 11,577 11,334 11,358 11,370

The Company computed the fair value of each option grant on the date of
grant using the Black-Scholes option valuation model with the following
assumptions:

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

Risk-free interest rate................................ N/A N/A 3.81-4.23% 4.79%
Average expected life of option........................ N/A N/A 5 years 5 years
Dividend yield......................................... N/A N/A 0% 0%
Volatility of common stock............................. N/A N/A 55% 50%
Weighted average fair value of options grants.......... N/A N/A $3.35 $4.75

There were no options granted during the three-month periods ended
December 31, 2005 and 2004, respectively. There were 434,800 and 39,000 options
granted during the nine-month periods ended December 31, 2005 and 2004,
respectively.

3. SEGMENT REPORTING

The Company's three reportable segments are: (1) optical memory cards,
(2) optical memory card drives, maintenance and related accessories ("optical
card drives") and (3) specialty cards and card printers. The segments were
determined based on the information used by the chief operating decision maker.
The optical memory cards and optical card drives reportable segments are not
strategic business units which offer unrelated products and services; rather
these reportable segments utilize compatible technology and are marketed
jointly. Specialty cards and card printers is a strategic business unit offering
at times unrelated products and at times related products with the other
reportable segments.

The accounting policies used to derive reportable segment results are
the same as those described in the "Summary of Significant Accounting Policies."
Resources are allocated to the optical memory card and optical card drive
segments in a manner that optimizes optical memory card revenues and to the
specialty card and card printers segment in a manner that optimizes consolidated
income as determined by the chief operating decision maker. Segment revenues are
comprised of sales to external customers. Segment gross profit (loss) includes
all segment revenues less the related cost of sales. Accounts receivable, cash,
deferred income taxes, prepaid expenses, fixed assets and inventory are not
separately reported by segment to the chief operating decision maker. Therefore,
the amount of assets by segment is not meaningful. There are no inter-segment
sales or transfers. All of the Company's long-lived assets are attributable to
the operations in United States except for $3.0 million as of December 31, 2005
and $3.4 million as of March 31, 2005 that are attributable to the operations in
Germany.

The Company's chief operating decision maker is currently the Company's
Chief Executive Officer. The chief operating decision maker reviews financial
information presented on a consolidated basis that is accompanied by
disaggregated information about revenues and gross profit (loss) by segment.

The table below presents information for optical memory cards, optical
card drives and specialty cards and card printers for the three and nine-month
periods ended December 31, 2005 and 2004 (in thousands):

THREE MONTHS ENDED DECEMBER 31, 2005 THREE MONTHS ENDED DECEMBER 31, 2004
------------------------------------ ------------------------------------

OPTICAL OPTICAL SPECIALTY OPTICAL OPTICAL SPECIALTY
MEMORY CARD CARDS & SEGMENT MEMORY CARD CARDS & SEGMENT
CARDS DRIVES PRINTERS TOTAL CARDS DRIVES PRINTERS TOTAL
----- ------ -------- ----- ----- ------ -------- -----

Revenue $ 7,651 $ 219 $ 2,207 $ 10,077 $ 3,596 $ 279 $ 2,407 $ 6,282
Cost of sales 3,747 458 1,685 5,890 2,947 716 1,814 5,477
Gross profit (loss) 3,904 (239) 522 4,187 649 (437) 593 805
Depreciation and
amortization expense 360 29 83 472 391 34 65 490

NINE MONTHS ENDED DECEMBER 31, 2005 NINE MONTHS ENDED DECEMBER 31, 2004
----------------------------------- -----------------------------------

Revenue $ 17,128 $ 902 $ 7,740 $ 25,770 $ 14,345 $ 723 $ 7,685 $ 22,753
Cost of sales 10,195 1,410 5,645 17,250 10,293 1,630 5,738 17,661
Gross profit (loss) 6,933 (508) 2,095 8,520 4,052 (907) 1,947 5,092
Depreciation and
amortization expense 1,143 93 219 1,455 1,125 112 194 1,431

The following is a reconciliation of segment results to amounts included
in the Company's condensed consolidated financial statements:

THREE MONTHS ENDED DECEMBER 31, 2005 THREE MONTHS ENDED DECEMBER 31, 2004
------------------------------------ ------------------------------------

SEGMENT SEGMENT
TOTAL OTHER (a) TOTAL TOTAL OTHER (a) TOTAL
----- ----- ----- ----- ----- -----

Revenue $10,077 $ -- $10,077 $ 6,282 $ -- $ 6,282
Cost of sales 5,890 -- 5,890 5,477 -- 5,477
Gross profit 4,187 -- 4,187 805 -- 805
Depreciation and
amortization expense 472 137 609 490 179 669

NINE MONTHS ENDED DECEMBER 31, 2005 NINE MONTHS ENDED DECEMBER 31, 2004
----------------------------------- -----------------------------------

SEGMENT SEGMENT
TOTAL OTHER (a) TOTAL TOTAL OTHER (a) TOTAL
----- ----- ----- ----- ----- -----

Revenue $25,770 $ -- $25,770 $22,753 $ 12 $22,765
Cost of sales 17,250 -- 17,250 17,661 24 17,685
Gross profit (loss) 8,520 -- 8,520 5,092 (12) 5,080
Depreciation and
amortization expense 1,455 440 1,895 1,431 590 2,021

(a) Other revenue consists of miscellaneous items not associated with
segment activities. Other cost of sales, depreciation and amortization expense
represents corporate and other costs not directly associated with segment
activities.

5. OTHER COMPREHENSIVE INCOME (LOSS)

The following are the components of other comprehensive income (loss)
(in thousands):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
------------ ------------

2005 2004 2005 2004
---- ---- ---- ----

Net income (loss) $ 1,154 $ (2,841) $ (1,104) $ (5,906)
Net change in cumulative foreign
currency translation adjustments (8) 296 (196) 390
---------- ---------- ---------- ----------
Other comprehensive income (loss) $ 1,146 $ (2,545) $ (1,300) $ (5,516)
========== ========== ========== ==========

As of December 31, 2005 and March 31, 2005, the components of
accumulated other comprehensive income (loss) mainly consist of cumulative
foreign currency translation adjustments of approximately $13,000 and $209,000,
respectively.

6. RECENT ACCOUNTING PRONOUNCEMENTS

On June 1, 2005, the Financial Accounting Standards Board (FASB) issued
Statement No. 154, "Accounting Changes and Error Corrections" (FAS 154), a
replacement of APB No. 20, "Accounting Changes and FASB Statement No. 3,
Reporting Accounting Changes in Interim Financial Statements." FAS 154 applies
to all voluntary changes in accounting principles and changes the requirements
for accounting for and reporting of a change in accounting principle. This
statement establishes, that unless impracticable, retrospective application is
the required method for reporting a change in accounting principle in the
absence of explicit transition requirements specific to the newly adopted
accounting principle. It also requires the reporting of an error correction
which involves adjustments to previously issued financial statements similar to
those generally applicable to reporting an accounting change retrospectively.
FAS 154 is effective for accounting changes and corrections of errors made in
fiscal years beginning after December 15, 2005. The Company does not expect the
adoption of FAS 154 will have a material impact on its results of operations or
financial condition.

In March 2005, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 47, "Accounting for Conditional Asset Retirement
Obligations." Interpretation No. 47 clarifies that an entity must record a
liability for a "conditional" asset retirement obligation if the fair value of
the obligation can be reasonably estimated. Interpretation No. 47 also clarifies
when an entity would have sufficient information to reasonably estimate the fair
value of an asset retirement obligation. Interpretation No. 47 is effective no
later than the end of the fiscal year ending after December 15, 2005. The
Company has evaluated the provision and does not expect the adoption in the
fourth quarter of fiscal 2006 will have a material impact on its results of
operations or financial condition.

On October 22, 2004, the American Jobs Creation Act of 2004 (the "Act")
was signed into law. The Act contains numerous changes to U.S. tax law, both
temporary and permanent in nature, including a potential tax deduction with
respect to certain qualified domestic manufacturing activities, changes in the
carryback and carryforward utilization periods for foreign tax credits and a
dividend received deduction with respect to accumulated income earned abroad.
The new law could potentially have an impact on the Company's effective tax
rate, future taxable income and cash and tax planning strategies, amongst other
affects. In December 2004, the FASB issued Staff Position No. 109-1 ("FSP
109-1"), "Application of FASB Statement No. 109, Accounting for Income Taxes, to
the Tax Deduction on Qualified Production Activities Provided by the American
Jobs Creation Act of 2004" and Staff Position No. 109-2 ("FSP 109-2"),
"Accounting and Disclosure Guidance for the Foreign Earnings Repatriation
Provision within the American Jobs Creation Act of 2004." FSP 109-1 clarifies
that the manufacturer's tax deduction provided for under the Act should be
accounted for as a special deduction in accordance with SFAS No. 109 and not as
a tax rate reduction. FSP 109-2 provides accounting and disclosure guidance for
the repatriation of certain foreign earnings to a U.S. taxpayer as provided for
in the Act. The Company is currently studying the impact of the one-time
favorable foreign dividend provision. Accordingly, the Company has not adjusted
its income tax expense or deferred tax liability to reflect the tax impact of
any repatriation of non-U.S. earnings it may make.

In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment"
to revise SFAS No. 123, "Accounting for Stock-Based Compensation" and supersede
APB Opinion No. 25, "Accounting for Stock Issued to Employees" and its related
implementation guidance. It requires companies to recognize their compensation
costs

related to share-based payment transactions in financial statements. These costs
are to be measured based on the fair value of the equity or liability
instruments issued. The Company will apply SFAS No. 123(R) in the first quarter
of the fiscal year ending March 31, 2007. The Company has not yet evaluated the
impact that the adoption of SFAS No. 123(R) will have on its financial
statements.

In December 2004, the FASB issued SFAS No. 153, "Exchanges of
Nonmonetary Assets -- an Amendment of APB Opinion No. 29," which eliminates the
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. SFAS No. 153 will be effective for nonmonetary asset exchanges
occurring in fiscal periods beginning after June 15, 2005. The Company is
currently evaluating SFAS No. 153 and does not expect the adoption will have a
material impact on its results of operations or financial condition.

In November 2004, the FASB issued SFAS No. 151, "Inventory Costs -- an
Amendment of ARB No. 43, Chapter 4," which clarifies the accounting for abnormal
amounts of idle facility expense, freight, handling costs and wasted material
(spoilage) be recognized as current period charges. In addition, SFAS No. 151
requires that allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production facilities. SFAS
No. 151 will be effective for inventory costs incurred in fiscal years beginning
after June 15, 2005. The Company has not evaluated the impact of SFAS No. 151 to
its overall result of operations or financial condition and does not expect the
adoption will have a material impact on its result of operations or financial
condition.

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

The following discussion and analysis of the Company's financial
condition and results of operations should be read in conjunction with the
condensed consolidated financial statements and related notes included elsewhere
in this Form 10-Q Report and the consolidated financial statements and notes
thereto for the year ended March 31, 2005, included in the Company's fiscal 2005
Annual Report on Form 10-K.

FORWARD-LOOKING STATEMENTS

ALL STATEMENTS CONTAINED IN THIS REPORT THAT ARE NOT HISTORICAL FACTS
ARE FORWARD-LOOKING STATEMENTS. THE FORWARD-LOOKING STATEMENTS IN THIS REPORT
ARE MADE PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995. THEY ARE NOT HISTORICAL FACTS OR GUARANTEES OF
FUTURE PERFORMANCE OR EVENTS. RATHER, THEY ARE BASED ON CURRENT EXPECTATIONS,
ESTIMATES, BELIEFS, ASSUMPTIONS, AND GOALS AND OBJECTIVES AND ARE SUBJECT TO
UNCERTAINTIES THAT ARE DIFFICULT TO PREDICT. AS A RESULT, THE COMPANY'S ACTUAL
RESULTS MAY DIFFER MATERIALLY FROM THE STATEMENTS MADE. OFTEN SUCH STATEMENTS
CAN BE IDENTIFIED BY THEIR USE OF WORDS SUCH AS "MAY," "WILL," "INTENDS,"
"PLANS," "BELIEVES," "ANTICIPATES," "VISUALIZES," "EXPECTS," AND "ESTIMATES."
FORWARD-LOOKING STATEMENTS MADE IN THIS REPORT INCLUDE STATEMENTS THAT THE
GERMAN SUBSIDIARIES WILL SUCCESSFULLY COMPLETE THE CONTRACT FOR A CONVENTIONAL
NON-OPTICAL CARD PRODUCTION FACILITY ON OR ABOUT DECEMBER 2006; THE COMPANY'S
BELIEF THAT THE EXPIRED U.S. GOVERNMENT CONTRACT WILL BE REPLACED WITH A NEW
CONTRACT OR PURCHASE ORDER PRIOR TO DELIVERY OF THOSE CARDS ORDERED PRIOR TO THE
CONTRACT EXPIRATION IN NOVEMBER 2005; THE COMPANY'S BELIEFS AS TO CURRENT AND
POTENTIAL MARKET SEGMENTS, CUSTOMERS, AND APPLICATIONS FOR AND DEPLOYMENT OF THE
PRODUCTS OF THE COMPANY; THE ADVANTAGES OF, POTENTIAL INCOME FROM, AND DUTIES TO
BE PERFORMED UNDER THE SALE OF A SECOND-SOURCE CARD MANUFACTURING LICENSE TO
GLOBAL INVESTMENTS GROUP (GIG); FUTURE SCHEDULED PAYMENTS AND CONTINGENT
ROYALTIES UNDER THE GIG CONTRACT, GIG'S TARGETED STARTUP DATE AND PRODUCTION
CAPACITY, AND THAT THE COMPANY WILL SELL EQUIPMENT TO GIG, PROVIDE GIG WITH
INSTALLATION SUPPORT, AND HAVE ON-SITE PERSONNEL; PRODUCTION QUANTITIES,
DELIVERY RATES AND EXPECTED DELIVERY SCHEDULE, BACKLOG, AND REVENUE RECOGNITION
FOR COMPANY PRODUCTS FOR U.S. OR FOREIGN GOVERNMENT PROGRAMS; PLANS TO INCREASE
CARD PRODUCTION CAPACITY FOR ANTICIPATED INCREASES IN ORDERS INCLUDING $8.5
MILLION IN CAPITAL EQUIPMENT AND LEASEHOLD IMPROVEMENTS DURING THE NEXT NINE TO
TWELVE MONTHS; ANTICIPATED CONTINUED USE OF THE COMPANY'S PRODUCTS BY THE
GOVERNMENTS OF THE UNITED STATES, CANADA, A MIDDLE EASTERN COUNTRY, INDIA, COSTA
RICA AND ITALY; THE NEED FOR, EXPECTED SUCCESS OF, AND POTENTIAL BENEFITS FROM
THE COMPANY'S RESEARCH AND ENGINEERING EFFORTS AND WHETHER THEY CAN STIMULATE
CARD SALES GROWTH, THE EFFECTS OF READ/WRITE DRIVE PRICES AND SALES VOLUME ON
GROSS PROFITS OR GROSS MARGINS FROM READ/WRITE DRIVE SALES; EXPECTATIONS
REGARDING REVENUES, MARGINS, SG&A AND R&D EXPENSES, STATE INCOME TAXES, CAPITAL
RESOURCES, AND CAPITAL EXPENDITURES AND INVESTMENTS, AND THE COMPANY'S DEFERRED
TAX ASSET AND RELATED VALUATION ALLOWANCE; EXPECTED CARD ORDERS (INCLUDING THAT
AN ORDER FROM THE MIDDLE EASTERN COUNTRY IS ANTICIPATED DURING FISCAL 2006
FOURTH QUARTER) DELIVERY VOLUMES, ESTIMATES OF OPTICAL CARD PRODUCTION CAPACITY,
EXPECTED CARD YIELDS THERE FROM, THE COMPANY'S ABILITY TO EXPAND PRODUCTION
CAPACITY, AND THE COMPANY'S PLANS AND EXPECTATIONS REGARDING THE GROWTH AND
ASSOCIATED CAPITAL COSTS OF SUCH CAPACITY; ESTIMATES THAT REVENUES AND ADVANCE
PAYMENTS WILL BE SUFFICIENT TO GENERATE CASH FROM OPERATING ACTIVITIES OVER THE
NEXT 12 MONTHS DESPITE EXPECTED QUARTERLY FLUCTUATIONS; EXPECTATIONS REGARDING
MARKET GROWTH, PRODUCT DEMAND, AND THE CONTINUATION OF CURRENT PROGRAMS;
POTENTIAL EXPANSION OR IMPLEMENTATION OF GOVERNMENT PROGRAMS UTILIZING OPTICAL
MEMORY CARDS, INCLUDING WITHOUT LIMITATION, THOSE IN ITALY, INDIA, AND A MIDDLE
EASTERN COUNTRY, AND THE TIMING OF THE AWARD OF ANY PRIME CONTRACTS FOR SUCH
PROGRAMS AND THE AMOUNT OF CARD ORDERS IN SUCH PROGRAMS; AND THE COMPANY'S
PLANS, OBJECTIVES, AND EXPECTED FUTURE ECONOMIC PERFORMANCE INCLUDING WITHOUT
LIMITATION, ITS MARKETING OBJECTIVES AND DRIVE PRICING STRATEGY.

THESE FORWARD-LOOKING STATEMENTS ARE BASED UPON THE COMPANY'S
ASSUMPTIONS ABOUT AND ASSESSMENT OF THE FUTURE, WHICH MAY OR MAY NOT PROVE TRUE,
AND INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES INCLUDING, BUT NOT LIMITED TO,
WHETHER THERE IS A MARKET FOR CARDS FOR HOMELAND SECURITY IN THE U.S. AND
ABROAD, AND IF SO WHETHER SUCH MARKET WILL UTILIZE OPTICAL MEMORY CARDS AS
OPPOSED TO OTHER TECHNOLOGY; CUSTOMER CONCENTRATION AND RELIANCE ON CONTINUED
U.S. AND ITALIAN GOVERNMENT BUSINESS; RISKS ASSOCIATED WITH DOING BUSINESS IN
AND WITH FOREIGN COUNTRIES; WHETHER THE COMPANY CAN SUCCESSFULLY INTEGRATE AND
OPERATE ITS RECENTLY ACQUIRED GERMAN SUBSIDIARIES AND WHETHER THE COMPANY
ENCOUNTERS DELAYS IN EFFECTING THEIR MERGER; WHETHER THE COMPANY WILL BE
SUCCESSFUL IN ASSISTING GIG WITH FACTORY STARTUP AND TRAINING; WHETHER GIG WILL
HAVE THE FINANCIAL WHEREWITHAL TO MAKE THE BALANCE OF ITS REQUIRED PAYMENTS TO
THE COMPANY AND TO OPERATE THE FACILITY; WHETHER THE FACILITY WILL EFFICIENTLY
PRODUCE HIGH QUALITY OPTICAL MEMORY CARDS IN VOLUME AND THAT MEETS OUR
STANDARDS; LENGTHY SALES CYCLES AND CHANGES IN AND DEPENDENCE ON GOVERNMENT
POLICY-MAKING; RELIANCE ON VALUE-ADDED RESELLERS AND SYSTEM INTEGRATORS TO
GENERATE SALES, PERFORM CUSTOMER SYSTEM INTEGRATION, DEVELOP APPLICATION
SOFTWARE, INTEGRATE OPTICAL CARD SYSTEMS WITH OTHER TECHNOLOGIES, TEST PRODUCTS,
AND WORK WITH GOVERNMENTS TO IMPLEMENT CARD PROGRAMS; RISKS AND DIFFICULTIES
ASSOCIATED WITH DEVELOPMENT, MANUFACTURE, AND DEPLOYMENT OF OPTICAL CARDS,
DRIVES, AND SYSTEMS; THE IMPACT OF LITIGATION; THE ABILITY OF THE COMPANY OR ITS
CUSTOMERS TO INITIATE AND DEVELOP NEW PROGRAMS UTILIZING THE COMPANY'S CARD
PRODUCTS; RISKS AND DIFFICULTIES ASSOCIATED WITH DEVELOPMENT, MANUFACTURE, AND
DEPLOYMENT OF OPTICAL CARDS, DRIVES, AND SYSTEMS; POTENTIAL MANUFACTURING
DIFFICULTIES AND COMPLICATIONS ASSOCIATED WITH INCREASING MANUFACTURING CAPACITY
OF CARDS AND DRIVES, IMPLEMENTING NEW MANUFACTURING PROCESSES, AND OUTSOURCING
MANUFACTURING; THE COMPANY'S ABILITY TO PRODUCE AND SELL READ/WRITE DRIVES IN
VOLUME; THE UNPREDICTABILITY OF CUSTOMER DEMAND FOR PRODUCTS AND CUSTOMER
ISSUANCE AND RELEASE OF CORRESPONDING ORDERS; GOVERNMENT RIGHTS TO WITHHOLD
ORDER RELEASES, REDUCE THE QUANTITIES RELEASED, AND EXTEND SHIPMENT DATES;
WHETHER THE COMPANY RECEIVES A FIXED SHIPMENT SCHEDULE, ENABLING THE COMPANY TO
RECOGNIZE REVENUES ON CARDS DELIVERED TO THE VAULT INSTEAD OF WHEN CARDS LATER
ARE SHIPPED FROM THE VAULT; THE IMPACT OF TECHNOLOGICAL ADVANCES, GENERAL
ECONOMIC TRENDS, AND COMPETITIVE PRODUCTS; THE IMPACT OF CHANGES IN THE DESIGN
OF THE CARDS; AND THE POSSIBILITY THAT OPTICAL MEMORY CARDS WILL NOT BE
PURCHASED FOR THE FULL IMPLEMENTATION OF CARD PROGRAMS IN ITALY, A MIDDLE
EASTERN COUNTRY AND INDIA, OR FOR DHS PROGRAMS IN THE U.S., OR WILL NOT BE
SELECTED FOR OTHER GOVERNMENT PROGRAMS IN THE U.S. AND ABROAD; UNANTICIPATED
DELAYS IN OBTAINING U.S. GOVERNMENT APPROVALS TO EXTEND OR REPLACE ITS EXPIRING
CONTRACT; THE RISKS SET FORTH IN THE SECTION ENTITLED "RISKS FACTORS AND FACTORS
THAT MAY AFFECT FUTURE OPERATING RESULTS" AND ELSEWHERE IN THIS REPORT; AND
OTHER RISKS DETAILED FROM TIME TO TIME IN THE COMPANY'S SEC FILINGS. THESE
FORWARD-LOOKING STATEMENTS SPEAK ONLY AS TO THE DATE OF THIS REPORT, AND, EXCEPT
AS REQUIRED BY LAW, THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE
UPDATES OR REVISIONS TO THESE STATEMENTS WHETHER AS A RESULT OF NEW INFORMATION,
FUTURE EVENTS, OR OTHERWISE.

CRITICAL ACCOUNTING POLICIES

REVENUE RECOGNITION. Product sales primarily consist of optical memory
cards, optical card drives and specialty cards and card printers. The Company
recognizes revenue from product sales when the following criteria are met: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the
fee is fixed or determinable; and (4) collectibility is reasonably assured. The
Company recognizes revenue on product sales at the time of shipment when
shipping terms are F.O.B. shipping point, orders are placed pursuant to a
pre-existing sales arrangement and there are no post-shipment obligations other
than warehousing under a U.S. government subcontract or customer acceptance
criteria. Where appropriate, provision is made at the time of shipment for
estimated warranty costs and estimated returns. The total amounts of actual
warranty costs and returns activity were $277,000 and $240,000 for the
three-month periods ended December 31, 2005 and 2004, respectively. The total
amount of actual warranty costs and returns activity were $383,000 and $463,000
for the nine-month periods ended December 31, 2005 and 2004, respectively.

method, is used until more precise estimates can be made. The full amount of an
estimated loss is charged to operations in the period it is determined that a
loss will be realized from the performance of a contract. During both of the
three-month periods ended December 31, 2005 and 2004, the Company recognized
approximately $10,000 of revenues based on a zero profit margin. During the
nine-month periods ended December 31, 2005 and 2004, the Company recognized
approximately $76,000 and $96,000 of revenues based on a zero profit margin,
respectively.

License revenue, which may consist of up-front license fees and royalty
payments, is recognized as revenue when earned. The second-source
card-manufacturing license sold in April 2004 to Global Investments Group
provides for an up front lincense fee, annual support fees, payments for
equipment and royalty payments to the Company for each card produced during the
20-year term of the license agreement. This is a multi-element arrangement as
described in Emerging Issues Task Force (EITF) Issue No. 00-21; revenue derived
from the payments will be recognized from time to time over the remaining term
of the agreement beginning when operation of the factory commences. There were
no license revenues or related costs recorded for three-month and nine-month
periods ended December 31, 2005 and 2004, respectively.

ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
condensed consolidated financial statements, the Company is required to estimate
income taxes in each of the jurisdictions in which it operates. This process
involves estimating the actual current tax exposure together with assessing
temporary differences resulting from differing treatment of items, such as
deferred revenue, for tax and accounting purposes. These differences result in
deferred tax assets and liabilities, which are included within the consolidated
balance sheets. The Company must then assess the likelihood that the deferred
tax assets will be recovered from future taxable income and to the extent that
management believes recovery is not likely, the Company must establish a
valuation allowance. To the extent that a valuation allowance is established or
increased in a period, the Company includes an expense within the tax provision
in the statements of operations.

Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. As of December 31, 2005, the Company
continues to provide for a full valuation allowance of $18.5 million relating to
its U.S. operations. Income tax expense for the nine-month period ended December
31, 2005 resulted from estimated alternative minimum taxes.

In the event that actual results differ from Company estimates or that
Company estimates are adjusted in future periods, the Company may need to adjust
the amount of the valuation allowance based on future determinations of whether
it is more likely than not that some or all of its deferred tax assets will be
realized. A decrease in the valuation allowance would be recorded as an income
tax benefit or a reduction of income tax expense or a credit to stockholders'
equity. The Company's net operating losses available to reduce future taxable
income expire on various dates from fiscal 2007 through fiscal 2024. To the
extent that the Company generates taxable income in jurisdictions where the
deferred tax asset relates to net operating losses that have been offset by a
full valuation allowance, the utilization of these net operating losses would
result in the reversal of the related valuation allowance.

INVENTORIES. The Company values its inventory at the lower of the actual
cost to purchase and/or manufacture the inventory or the current estimated
market value of the inventory. Management regularly reviews inventory quantities
on hand and records a provision for excess and obsolete inventory based
primarily on forecasts of product demand. Demand for optical card drives can
fluctuate significantly. In order to obtain favorable pricing, purchases of
certain drive parts are made in quantities that exceed the booked orders. The
Company purchases drive parts for its anticipated demand and takes into
consideration the order-to-delivery lead times of vendors and the economic
purchase order quantity for such parts. In addition, the Company keeps a supply
of card raw materials it deems necessary for anticipated demand.

Management's analysis of the carrying value of its inventory is
performed on a quarterly basis. With respect to inventory carrying values, the
Company follows the principles articulated in Accounting Research Bulletin 43,
Chapter 4, "Inventory Pricing," paragraphs 5 through 7 and 10 and other
authoritative guidance (SAB 100) as it relates to determining the appropriate
cost basis of inventory and determining whether firm, noncancelable purchase
commitments should be accrued as a loss if forecasted demand is not sufficient
to utilize all such committed inventory purchases. As part of the Company's
quarterly excess/obsolete analysis, management also determines whether lower of
cost or market adjustments (i.e., where selling prices less certain costs are
not sufficient to recover inventory carrying values) are warranted. During the
nine-month period ended December 31, 2005, the Company has not recorded any
significant lower of cost or market adjustments; during the nine-month period
ended December 31, 2004, the Company recorded a lower of cost or market
adjustment in the amount of $67,000. In those instances where the Company has
recorded charges for excess and obsolete inventory, management ensures that such
new cost basis is reflected in the statement of operations if that inventory is
subsequently sold. The Company's inventory reserves are based upon the lower of
cost or market for slow moving or obsolete items. The Company has not evaluated
the impact of SFAS No. 151 "Inventory Costs - Amendment of ARB No. 43, Chapter
4" but does not expect the adoption will have a material impact on its results
of operations or financial condition.

RESULTS OF OPERATIONS--FISCAL 2006 THIRD QUARTER AND FIRST NINE MONTHS COMPARED
WITH FISCAL 2005 THIRD QUARTER AND FIRST NINE MONTHS

OVERVIEW

Headquartered in Mountain View, California, LaserCard Corporation
manufactures LaserCard(R) optical memory cards and card related products,
chip-ready OpticalSmart(TM) cards, and other advanced-technology cards. In
addition, the Company operates a wholly owned German subsidiary acquired on
March 31, 2004, Challenge Card Design Plastikkarten GmbH, with offices in
Rastede and Ratingen, Germany, which manufactures advanced-technology cards and
markets cards, system solutions, and thermal card printers. The Company
completed the merger of cards & more GmbH (also acquired on March 31, 2004) into
Challenge Card Design Plastikkarten GmbH in January 2006.

In addition to using its own marketing staff in California, New York,
and Germany, the Company utilizes value added reseller (VAR) companies and card
distribution licensees, who generally have knowledge in specific markets, for
the development of markets and applications for LaserCard products. Product
sales to VARs and licensees consist primarily of the Company's optical memory
cards and optical card read/write drives. The Company also offers for sale, its
customized software applications and add-on peripherals made by other companies
(such as equipment for adding a digitized photo, fingerprint, or signature to
the cards). These peripherals have not generated significant revenue for the
Company but have demonstrated various system options. The VARs/licensees may add
application software, personal computers, and other peripherals, and then resell
these products as integrated solutions. The Company is continuing its efforts to
recruit new VARs and eliminate nonproductive VARs.

Major near term growth potential for LaserCard optical memory cards is
in government-sponsored identification programs in several countries. Since
governmental card programs typically rely on policy-making, which in turn is
subject to technical requirements, budget approvals, and political
considerations, there is no assurance that these programs will be implemented as
expected or that they will include optical cards. Objectives for long-term
revenue growth include: (1) broaden the "Optical Memory" ("OM") products range
to address lower-end applications characterized by higher price sensitivity, (2)
diversify OM products into, and effectively penetrate, industrial and commercial
markets, (3) expand hardware product offering to address new markets and add
value to current offerings, and (4) increase OM product revenues by selling more
application software and integrated solutions.

The table below presents condensed consolidated revenue, excluding
intercompany transactions, recorded by the U.S. and German operations for the
three-month and nine-month periods ended December 31, 2005 (in thousands):

THREE-MONTH ENDED NINE-MONTH ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

U.S operations $ 7,875 $ 4,021 $ 18,245 $ 15,318
German operations 2,202 2,261 7,525 7,447

Revenues recorded by the U.S. operations are generally to a small number
of government customers located throughout the world. Revenues recorded by the
German operations are mainly for a relatively large number of commercial
customers.

The largest purchaser of LaserCard products historically has been Anteon
International Corporation (Anteon), a value-added reseller (VAR) of the Company.
Anteon is the government contractor for LaserCard product sales to the U.S.
Department of Homeland Security (DHS), U.S. Department of State (DOS), U.S.
Department of Defense (DOD), and the government of Canada. Under government
contracts with Anteon, the DHS purchases Green Cards and DOS Laser Visa BCCs;
the DOD purchases Automated Manifest System cards; and the Canadian government
purchases Permanent Resident Cards. Encompassing all of these programs, the
Company's product sales to Anteon represented 30% and 35% for the three and
nine-month periods ended December 31, 2005, respectively, and 45% and 27% for
the same periods a year ago. Another unaffiliated VAR, Laser Memory Card SPA of
Italy, accounted for 38% and 21% for the three and nine-month periods ended
December 31, 2005, respectively, and 4% and 33% for the same periods a year ago
mainly for the program in Italy.

Revenues from the major programs are shown below as a percentage of
total Company revenues:

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2005 2004 2005 2004
---- ---- ---- ----

United States Green Cards and Laser Visa BCCs......... 23% 32% 27% 16%
Canadian Permanent Resident Cards..................... 5% 6% 6% 8%
Italian Carta d'Identita Elettronica (CIE) Cards...... 33% 4% 19% 32%
National ID cards in a Middle Eastern Country......... --% 9% 6% 4%

For the government of Italy, the Company recorded optical memory card
revenues in the three-month period ended December 31, 2005 of approximately $3.8
million for the Carta d'Identita Elettronica (CIE) and Permesso di Soggiorno
Elettronico (PSE) programs. Shipments of these cards were slightly slower than
expected, which is not unusual for a new product being ramped up, as
specification adjustments are being finalized with the end-customer. As card
issuance infrastructure is more fully developed and the national ID card system
functions as designed, CIE and PSE card orders could ramp toward their full
implementation level and could potentially result in annual revenues of $40
million when these two national ID programs are fully implemented. Backlog for
these programs totaled $9.8 million at December 31, 2005 and is deliverable
through April 2006. The Company believes that card revenue for these programs
will amount to $20 million to $30 million in its fiscal year ending March 31,
2007.

U.S. Laser Visa Border Crossing Cards (BCCs) and Green Cards for the
U.S. Department of Homeland Security (DHS) are an important part of the
Company's revenue base. For these programs, the Company recorded card revenues
of $2.3 million and $2.0 million in the third quarters, and $6.9 million and
$3.5 million in the first nine months, of fiscal 2006 and 2005, respectively.
The Company is currently delivering on orders placed prior to the expiration of
a U.S. government subcontract in November 2005. Backlog at December 31, 2005 for
these programs, which is deliverable through August 2006, totaled $6.5 million.
The Company expects that the U.S. government subcontract will be replaced with a
new subcontract or purchase order prior to when it makes its last shipment under
orders on hand although no assurance can be given. This subcontract was received
by the Company through Anteon, a LaserCard VAR that is a U.S. government prime
contractor.

For Canada's Permanent Resident Card program, the backlog at December
31, 2005 was $0.6 million deliverable

through May 2006 at the rate of approximately $.4 million per quarter. The
delivery rate is subject to increase or decrease by customer request.

For the first nine months period ended December 31, 2005, the Company
shipped optical memory cards valued at $1.5 million for the national ID card
program in a Middle Eastern country, with all of the shipments made during the
first six months of fiscal year 2006. The Company anticipates an additional
order for this program later this fiscal year.

Effective April 3, 2004, the Company sold a license to Global
Investments Group (GIG), based in Auckland, New Zealand, for card manufacturing
in Slovenia. This agreement provides for payments to the Company of $14 million
for a 20-year license and five-year training support package, followed by $15
million paid $1 million annually for ongoing support for an additional 15 years.
Additionally, the Company is to sell approximately $12 million worth of the
required manufacturing equipment and installation support for the new facility
to be built by GIG to provide a targeted initial manufacturing capacity of 10
million optical cards annually. As of December 31, 2005 the Company had acquired
$5.7 million of this equipment classified as equipment held for resale on its
balance sheet. The Company has received $20.5 million of payments called for in
the agreements, consisting of a partial payment for the equipment of $6.5
million and $14 million for the license fee and support. For the $20.5 million
the Company received, $18.5 million was recorded as advance payments from
customers and $2 million for the licensing fee was recorded as deferred revenue,
which were both classified as long term liabilities within the consolidated
balance sheets. In addition to the $41 million discussed above, GIG is to pay
the Company royalties for each card produced under the license. The territories
covered by the license include most of the European Union and eastern European
regions. GIG has exclusive marketing rights in certain territories, with
performance goals to maintain these rights. The Company will assign a person on
site during the license term to assist with quality, security and operational
procedures, with the mutual goal that the facility and the cards made in the
facility conform to the Company's standards. The Company also retains rights to
utilize up to 20% of the new facility capacity as backup and capacity buffer to
augment its own card manufacturing facilities in Mountain View, California and
at its German subsidiary. The granting of this license to GIG establishes a
potential second source supplier of optical memory cards for existing and
prospective customers who may request multiple sources for cards. Revenue will
be recognized over the remaining term of the agreement beginning when operation
of the factory commences, which GIG has targeted for late in calendar year 2006.

The Company plans to invest up to $8.5 million in additional capital
equipment and leasehold improvement expenditures at its facilities when
forecasts justify the investment. These expenditures could occur throughout the
next nine to twelve months, as more fully discussed under "Liquidity and Capital
Resources."

REVENUES

PRODUCT REVENUES. The Company's total revenues for the three and nine-
months periods ended December 31, 2005 and 2004 consisted of sales in its three
segments of (1) optical memory cards, (2) optical card drives, drive
accessories, and maintenance, and (3) specialty cards and card printers, as well
as in other miscellaneous items. Sales in all three segments increased during
the nine months ended December 31, 2005 as compared to the same period a year
ago, with the largest dollar increase in optical memory card product sales. The
increases were driven by increased card volumes. The decrease in optical card
drives revenue for the three months ended December 31, 2005 was due to a
decrease in sales volume. The decrease in specialty cards and card printer
revenue for the three months ended December 31, 2005 was mainly due to a
decrease in the value of U.S. dollar against Euro.

The following table presents product revenue by major segment (in
thousands, except for percentages):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,

2005 2004 CHANGE 2005 2004 CHANGE
---- ---- ------ ---- ---- ------

Optical memory cards $ 7,651 $ 3,596 $ 4,055 $17,128 $14,345 $ 2,783
% of total revenues 76% 57% 66% 63%

Optical card drives 219 279 (60) 902 723 179
% of total revenues 2% 5% 4% 3%

Specialty cards and card printers 2,207 2,407 (200) 7,740 7,685 55
% of total revenues 22% 38% 30% 34%

Other -- -- -- -- 12 (12)
% of total revenues --% --% --% --%
------- ------- ------- ------- ------- -------

Total revenues $10,077 $ 6,282 $ 3,795 $25,770 $22,765 $ 3,005
======= ======= ======= ======= ======= =======

Optical memory card revenues by major program are as follows (in
thousands):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,

2005 2004 2005 2004
---- ---- ---- ----

Green Cards & Laser Visas $ 2,310 $ 2,021 $ 6,930 $ 3,330
Italian Card Programs 3,816 265 5,010 7,199
Canadian Permanent Resident Cards 505 348 1,560 1,673
National ID Cards in a Middle Eastern country 0 442 1,477 621
All other programs 1,020 520 2,151 1,522
------- ------- ------- -------
Total optical memory card revenues $ 7,651 $ 3,596 $17,128 $14,345
======= ======= ======= =======

Sales of Green Cards and Laser Visas were low during the the first half
of fiscal 2005 and have increased since as the U.S. government resumed orders to
more closely match the issuance rate after reducing its inventory to
approximately six months worth of cards. Sales of Italian CIE cards decreased
during the first half of fiscal 2006 as the second experimental phase wound down
and have increased since as preparations began for full implementation in
calendar 2006. Sales of national ID cards for a Middle Eastern country fluctuate
quarter to quarter and this program is in the early stages where shipments are
sporadic.

Optical card drive revenues consisted of revenue on read/write drives,
drive maintenance, and related accessories. The changes in revenue in the third
quarter and first nine months of fiscal 2006 as compared to the same periods a
year ago were due primarily to changes in unit sales volume for read/write
drives.

Specialty card and card printer revenues increased in the first nine
months of fiscal 2006 compared with fiscal 2005 mainly due to sales of
non-optical cards to a Middle Eastern country partially offset by a decrease in
the euro/dollar exchange rate that occurred primarily during the three-months
ended December 31, 2005, which caused revenues during the third quarter of
fiscal 2006 to be less than in the third quarter of fiscal 2005.

LICENSE FEES AND OTHER REVENUES. There were no license revenues for the
three and nine-month periods ended December 31, 2005 and 2004. Effective April
3, 2004, the Company sold a second-source card-manufacturing license to the
Global Investments Group, based in Auckland, New Zealand, for card manufacturing
in Slovenia and began receiving cash payments discussed above in "Overview."
Revenue will begin to be recorded when operation of their factory commences.

BACKLOG

As of December 31, 2005, the backlog for LaserCard optical memory cards
totaled $17.2 million with about $11 million scheduled for delivery in fiscal
2006, compared with $3.6 million in total optical memeory card backlog at
December 31, 2004. Of the December 31, 2005 backlog, $9.8 million is for CIE and
PSE cards for the Italian Program that are deliverable through April 2006 while
backlog at December 31, 2005 for the U.S. LaserCard BCC and Green Card programs,
which is deliverable through August 2006, totaled $6.5 million. The Company has
only a few customers who generally place orders for a several-month period so
that variations in order placement from a single customer can materially affect
backlog. As a result, the relative size of our backlog has not been a reliable
indicator of future sales revenue trends.

The Company has no significant backlog for read/write drives.

In addition, the backlog for Challenge Card Design Plastikkarten GmbH as
of December 31, 2005 for specialty cards and card printers totaled $1.4 million
euros (approximately $1.7 million) and for a contract to develop a conventional
non-optical card production facility totaled $0.7 million euros (approximately
$0.8 million). Revenue on the contract for a conventional non-optical card
production facility is being booked on a zero profit margin basis. Therefore,
the total profit under this contract will be booked at completion on or about
December 2006 according to the contract. The backlog as of December 31, 2004 for
specialty cards and card printers totaled 0.3 million euros (approximately $0.4
million) and for a contract to develop a conventional non-optical card
production facility totaled 0.8 million euros ($1.1 million).

GROSS MARGIN

The following table represents gross margin in absolute amount and
percentage by segment (in thousands, except for percentages):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,

2005 2004 CHANGE 2005 2004 CHANGE
---- ---- ------ ---- ---- ------

Optical memory cards $ 3,904 $ 649 $ 3,255 $ 6,933 $ 4,052 $ 2,881

Percentage of optical memory cards
revenue 51% 18% 33% 40% 28% 12%

Optical card read/write drives (239) (437) 198 (508) (907) 399
Percentage of optical card
read/write drive revenue NM NM NM NM NM NM

Specialty cards and card printers 522 593 (71) 2,095 1,947 148

Percentage of specialty cards and
card printers revenue 24% 25% (1%) 27% 25% 2%

Other -- -- -- -- (12) 12
Percentage of other revenues NM NM NM NM NM NM
------- ------- ------- ------- ------- -------

Total gross margin $ 4,187 $ 805 $ 3,382 $ 8,520 $ 5,080 $ 3,440
======= ======= ======= ======= ======= =======

Percentage of total revenues 42% 13% 29% 33% 22% 11%

OPTICAL MEMORY CARDS. Optical memory card gross margin can vary
significantly based on average selling price, sales and production volume, mix
of card types, production efficiency and yields, and changes in fixed costs.
Unit volume affects gross margin due to the absorption of fixed costs. The gross
margin increase in the third quarter and first nine months of fiscal 2006 as
compared to the same period a year ago was mainly due to the increase in unit
sales volume. In addition, about six of the thirty-three percentage point
increase of optical memory card gross margin for the three months ended December
31, 2005, versus the three months ended December 31, 2004, was due to increases
in finished goods inventory and work in process increases resulting from the
ramp up to higher production volume.

Our gross margin was higher than typical for the amount of revenue during the
fiscal 2006 third quarter due to our increased inventory which absorbed some
overhead. The Company anticipates that the optical memory card gross margin will
continue at about 50% as production volume and revenue increases due to current
booked orders while capacity is ramped up for higher volumes.

READ/WRITE DRIVES, MAINTENANCE, AND RELATED ITEMS. Gross margin in this
segment can vary significantly based upon sales and production volume, changes
in fixed costs, and the inclusion of optional features and software licenses on
a per-drive basis. Drive gross margin is generally negative, inclusive of fixed
overhead costs, due to low sales volume. The decrease in negative gross margin
during the third quarter and first nine months of fiscal 2006 as compared to the
same periods a year ago were primarily due to an increase in revenues and the
$291,000 expense booked last year for the conversion of model 780 drives to
model Q-600. The Company anticipates that quarterly negative gross margins will
continue in the future unless sales volume is sufficient to cover fixed costs.
Also, unless per drive system software licenses are included in future orders,
the Company believes that margins will be below 10% when sales volume is
sufficient to result in positive gross margin due to the Company's strategy to
price drives at close to the cost in order to help promote optical memory card
sales.

SPECIALTY CARDS AND CARD PRINTERS. Specialty card and card printer gross
margins have historically fluctuated between 21% and 31% primarily depending
upon product mix.

OPERATING EXPENSES

The following table presents operating expenses (in thousands):

THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,

2005 2004 CHANGE 2005 2004 CHANGE
---- ---- ------ ---- ---- ------

Selling, general and administrative expenses $ 2,517 $ 3,063 $ (546) $ 8,260 $ 8,906 $ (646)
Research and engineering expenses $ 557 $ 655 $ (98) $ 1,608 $ 2,229 $ (621)

SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES (SG&A). The decrease of
SG&A expenses in the three-month period ended December 31, 2005 as compared to
the same period a year ago was due primarily to a $240,000 decrease in
consulting expense, a $60,000 decrease in legal expenses, and a $200,000
decrease in foreign currency exchange loss. For the nine-month period ended
December 31, 2005, the decrease of SG&A expenses as compared to the same period
a year ago, was due primarily to a $200,000 decrease in consulting expense, a
$215,000 decrease in legal expenses, and the decrease in foreign currency
exchange loss. The Company believes that SG&A expenses for the remainder fiscal
2006 will be higher than fiscal 2005 levels, mainly due to increases in
marketing and selling expenses and management incentives.

RESEARCH AND ENGINEERING EXPENSES (R&E). The Company is continuing its
efforts to develop new optical memory card features and structures, including
various sheet-lamination card structures, the insertion of contactless chips
with radio frequency (RF) capability, OptiChip(TM) (optical memory chips), OVD
(optically variable device) products, and associated media development; enhanced
optical memory card read/write drives and read-only drives (readers); and new
software products in an effort to provide new products that can stimulate
optical memory card sales growth. For example, the Company recently has
developed a prototype of a LaserCard portable reader that is being evaluated by
select value-added resellers. The Company anticipates that these ongoing
research and engineering efforts will result in new or enhanced card
capabilities, production-model read-only drives, or drives with advanced
security features and lower manufacturing costs; however, there is no assurance
that such product development efforts will be successful. These features are
important for the Company's existing and future optical memory card markets. The
decrease in R&E spending for fiscal 2006 is primarily due to the completion of
major spending for the LaserCard portable reader, coupled with being between
phases of the new card media development project and the completion of a card
material and other projects. The Company anticipates the R&E spending will
increase throughout the remainder of fiscal 2006 and could reach $1 million per
quarter in fiscal 2007 mainly for new media and commercial product development.

OTHER INCOME, NET

Other income, net for the third quarter of fiscal 2006 was $109,000
consisting of mainly $164,000 in interest income partially offset by $41,000 in
interest expense, compared with $64,000 for the third quarter of fiscal 2005
consisting of mainly $97,000 in interest income partially offset by $32,000 in
interest expense. The other income, net for the first nine months of fiscal 2006
was $313,000 mainly consisting of $385,000 of interest income partially offset
by $72,000 in interest and miscellaneous expenses, compared with $149,000
consisting of mainly $283,000 in interest income partially offset by $128,000 in
interest expense for the first nine months of fiscal 2005. The increase in
interest income was mainly due to the increase in interest rates on our invested
funds.

INCOME TAXES

The Company recorded an income tax expense of $68,000 for the third
quarter of fiscal 2006 compared with an income tax benefit of $8,000 for the
third quarter of fiscal 2005. For the first nine months of fiscal 2006, the
Company recorded an income tax expense of $69,000 compared with no provision for
the first nine months of fiscal 2005. The amount of the tax expense recorded for
the first nine months of fiscal 2006 was due to the anticipated alternative
minimum tax on U.S. operations. The Company anticipates that it will record a
tax provision for state taxes if and when profitability occurs at the
approximate rate of 10% of income from U.S. operations. Also, federal
alternative minimum taxes and taxes on profits of the German operations will
result in tax expense.

LIQUIDITY AND CAPITAL RESOURCES

The following table summarizes cash, cash equivalents and investments
(in thousands):

DECEMBER 31, MARCH 31,
2005 2005
---- ----

Cash, cash equivalents and short-term investments $ 21,106 $ 10,115
Cash, cash equivalents, short-term and long-term investments $ 21,106 $ 16,415

The Company's primary sources of liquidity consisted of approximately
$21.1 million in cash, cash equivalents and short-term investments and no
long-term investments as of December 31, 2005 compared to approximately $10.1
million in cash, cash equivalents and short-term investments and approximately
$6.3 million in long-term investments for a total of approximately $16.4 million
as of March 31, 2005. During the nine-month period ended December 31, 2005, the
increase of $11 million in cash, cash equivalents and short-term investments was
primarily related to approximately $5.5 million provided by operations and $6.3
million transferred from long-term investments. The current ratio was 4.2 to 1
as of December 31, 2005.

The following table displays the sources and uses of cash by major
category (in thousands):

NINE MONTHS ENDED
DECEMBER 31,
2005 2004 CHANGE
---- ---- ------

Net cash provided by operating activities $ 5,530 $ 112 $ 5,418
Net cash used in investing activities $ (9,413) $ (1,099) $ (8,314)
Net cash provided by (used in) financing activities $ 617 $ (1,633) $ 2,250

The difference in cash provided by operating activities between the two
periods was largely due to the decrease in net loss between the two periods.

The Company believes that the estimated level of revenues and advance
payments over the next 12 months will be sufficient to generate cash from
operating activities over the same period. However, quarterly fluctuations are
expected. Operating cash flow could be negatively impacted to a significant
degree if GIG does not make the required

payments as scheduled, or if either of the Company's largest U.S. government
programs were to be delayed, reduced, canceled, or not extended, if the Italian
CIE card program does not grow as planned internally, and if these programs are
not replaced by other card orders or other sources of income. Over the next six
to nine months, the amount of equipment purchased for GIG will approximately
equal the amount of cash the Company expects to receive from GIG.

Other than a small short-term working capital line of credit utilized by
a subsidiary in Germany, the Company has not established a line of credit and
has no current plans to do so. The Company may negotiate a line of credit if and
when it becomes appropriate, although no assurance can be made that such
financing would be available on favorable terms or at all, if needed.

As a result of the $1.2 million net income recorded for the fiscal 2006
third quarter, the Company's accumulated deficit decreased to $28.2 million.
Stockholders' equity declined $.7 million during the nine months of fiscal 2006
due primarily to losses of approximately $1.1 million.

The increase in net cash used for investing activities in the fiscal
2006 first nine months as compared to the fiscal 2005 first nine months was due
primarily to $7.9 million of net purchase of liquid investments in the first
nine months of fiscal 2006 versus $1.9 million of net proceeds from maturities
of investments in the first nine months of fiscal 2005 and purchases of property
and equipment of $1.4 million in the first nine months of fiscal 2006 versus
$2.7 million in the first nine months of fiscal 2005.

The Company considers all highly liquid investments, consisting
primarily of commercial paper, discount notes and U.S. government bonds, with
maturities of three months or less at the date of purchase, to be cash
equivalents. Short-term investments also include investments with maturities at
date of purchase of more than three months and up to one year and investments
initially classified as long-term with remaining maturities of less than one
year. All investments with maturities of greater than one year are classified as
long-term investments. Management determines the appropriate classification of
debt securities at the time of purchase and reevaluates the classification of
investments as of each balance sheet date. As of December 31, 2005 the Company
had $20.4 million classified as short-term investment and had no long-term
investment, compared with $6.1 million classified as short-term investments and
$6.3 million classified as long-term investments at March 31, 2005. All auction
rate securities are accounted for as available-for-sale and all other
interest-bearing securities are accounted for as held-to-maturity.

As of December 31, 2005, the Company has non-cancelable purchase orders
of $2.3 million primarily for raw materials. The Company's current card
capacity, assuming optimal card type mix, is estimated at approximately 16
million cards per year. The Company plans to purchase additional production
equipment in a series of steps when deemed appropriate by the Company. The
Company is also increasing production capacity for cards with new structures
used by the programs in Canada, Italy, and a Middle Eastern country. In addition
to investment used for expansion, the Company expects to make additional capital
expenditures for cost savings, quality improvements, and other purposes. The
Company plans to use cash on hand and cash generated from operations to fund
capital expenditures of approximately $8.5 million for equipment and leasehold
improvements over the next nine to twelve months for card production, read/write
drive tooling and assembly, and general support items as customer orders justify
the investment.

The decrease in net cash used for financing activities in the fiscal
2006 first nine months as compared to the fiscal 2005 first nine months was due
primarily to the stock repurchase from open market combined with, repayment in
full of bank loans and long-term debt during fiscal 2005.

Other than the $108,000 repayment on a line of credit for working
capital by a subsidiary in Germany, there were no debt financing activities for
the fiscal 2006 third quarter ended December 31, 2005.

Other than the short-term foreign exchange forward contracts, the
Company does not maintain any off-balance sheet transactions, arrangements, or
obligations that have or are reasonable likely to have a material effect on the
condensed consolidated financial statements.

RISK FACTORS AND FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

OUR CURRENT AND FUTURE EXPECTED REVENUES ARE DERIVED FROM A SMALL NUMBER
OF ULTIMATE CUSTOMERS SO THAT THE LOSS OF OR REDUCTIONS IN PURCHASES BY ANY ONE
ULTIMATE CUSTOMER COULD MATERIALLY REDUCE OUR REVENUES AND LEAD TO LOSSES.
During fiscal 2005 and each of the previous two fiscal years, we have derived
more than 84% of our optical memory card and drive-related revenues from four
programs -- two U.S. government programs and two foreign government programs.
Due to the lengthy sales cycles, we believe that these programs, with perhaps
the addition of one or two other foreign programs, will be the basis for a
substantial majority of our revenues in the near-term. The loss of or reductions
in purchases by any one customer due to program cutbacks, competition, or other
reasons would materially reduce our revenue base. Annual or quarterly losses
occur when there are material reductions, gaps or delays in card orders from our
largest U.S. or foreign government programs or if such programs were to be
reduced in scope, delayed, canceled, or not extended and not replaced by other
card orders or other sources of income.

PRIOR TO THE QUARTER ENDED DECEMBER 31, 2005 WE INCURRED NET LOSSES
DURING THE PREVIOUS ELEVEN QUARTERS AND MAY NOT BE ABLE TO GENERATE SUFFICIENT
REVENUE IN THE FUTURE TO SUSTAIN PROFITABILITY. As of December 31, 2005, we had
an accumulated deficit of $28 million and we incurred a loss of $1.1 million for
the first nine months of fiscal 2006, $8.9 million in fiscal 2005 and $12.4
million in fiscal 2004, although we operated profitably in the third quarter of
fiscal 2006. There can be no assurance that we will generate enough card
revenues in the near term to maintain profitability. We are relying upon our
optical memory card technology to generate future product revenues, earnings,
and cash flows. If alternative technologies emerge or if we are otherwise unable
to compete, we may not be able to achieve or sustain profitability on a
quarterly or annual basis. Annual or quarterly losses would also continue if
increases in product revenues or license revenues do not keep pace with
increased selling, general, administrative, research and engineering expenses
and the depreciation and amortization expenses associated with capital
expenditures.

OUR PROGRAM WITH ITALY, WHICH WE BELIEVE WILL BE OUR LARGEST CUSTOMER
FOR THE NEXT FEW YEARS, MAY BE DELAYED OR CANCELLED FOR REASONS OUTSIDE OUR
CONTROL WHICH WOULD CAUSE US TO HAVE LESS REVENUE THAN PLANNED AND WOULD LIKELY
LEAD US TO INCUR OPERATING LOSSES. The Company believes that the Italian CIE
card program will be our largest customer for the next few years, comprising a
significant portion of future revenues. Sales of cards and drives for the
government of Italy for its CIE and PSE card programs represented 19% of total
revenue for the first nine months of fiscal 2006, 26% for fiscal 2005, and 22%
for fiscal 2004, while the current backlog for CIE and PSE cards amounts to
about one-half of total optical memory card backlog. We are increasing capacity
to meet the anticipated demand. However, there can be no assurance that demand
will increase as anticipated by the Company. We would most likely incur losses
if Phase 3 of this program, which is full implementation, was to be delayed,
canceled, not extended, or not implemented at the level foreseen or if the
government were to change its technology decision and no longer use optical
memory cards. While during Phase 2, selected Italian cities have been issuing
cards and testing the card issuing process, full implementation in Phase 3 is
dependent upon card issuance infrastructure developments being successfully
undertaken and the national ID card system functioning as designed, of which
there can be no assurance. Also, if Laser Memory Card SPA of Italy, our VAR
customer for this program, were to discontinue participation in this program or
discontinue operations, interruptions could occur in orders or shipments for
this program until a replacement could be found. Overcoming some of these issues
may be difficult and complex and involve third parties, which could be time
consuming and expensive and lead to delays for implementation of Phase 3.

OUR CONTRACT WITH THE U.S. GOVERNMENT, ONE OF OUR TWO LARGEST ULTIMATE
CUSTOMERS, EXPIRED IN NOVEMBER 2005 AND IF NOT RENEWED COULD RESULT IN ORDER
DELAYS WHICH WOULD LIKELY LEAD US TO INCUR OPERATING LOSSES. EVEN IF A NEW
CONTRACT IS ISSUED, THE U.S. GOVERNMENT HAS THE RIGHT TO DELAY ITS ORDERS OR
COULD CHANGE ITS TECHNOLOGY DECISIONS, WHICH WOULD RESULT IN ORDER DELAYS AND
POSSIBLY IN OPERATING LOSSES. Our fiscal 2005 revenues included sales of
approximately $6 million of Green Cards and Laser Visa BCCs, and we expect
revenues from these programs in fiscal 2006 of $9.7 million, of which $6.9
million has been recognized during the first nine months and comprised 27% of
our revenues and $2.8 million is currently in backlog for shipment in the fourth
quarter. The Company expects these revenues to continue at approximately $9.5
million annually ($7.5 million for Green Cards and $2.0 million for Laser Visa
BCCs) if the government continues to

personalize cards at that rate and continues to maintain an inventory level
equal to six-months of usage. However, our U.S. government subcontract expired
in November 2005. While we have backlog as of December 31, 2005, for $6.5
million in optical memory cards deliverable through August 2006, further orders
will require a new contract or a purchase order. Based on events to date, the
Company believes that a follow-on contract or purchase order will be issued
prior to the completion of deliveries under the existing contract; however,
there is no assurance that a follow-on contract or purchase order will be issued
by the U.S. government. Under U.S. government procurement regulations, even with
a contract or purchase order in place, the government reserves certain rights,
such as the right to withhold releases, to reduce the quantities released,
extend delivery dates, reduce the rate at which cards are issued, and cancel all
or part of its unfulfilled purchase orders. We would most likely incur losses if
both of our largest U.S. government programs were to be delayed, canceled, or
not extended or if the government were to change its technology decision and no
longer use optical memory cards. The U.S. government acting through its prime
contractor delayed orders for Green Cards during fiscal 2004 due to a design
change and again in the first part of fiscal 2005 because of excess inventory,
which resulted in a gap in production of several months, and which in turn
significantly and adversely affected our operating results for the first half of
fiscal 2005. Any future excess inventory held by the U.S. government, delayed
funding, slower than anticipated program volume, or any future changes to the
design of the cards may result in future gaps in orders or production which may
negatively impact our operating results. Our U.S. government card deliveries
depend upon the issuance of corresponding order releases by the government to
its prime contractor and then to us. If Anteon International Corporation, our
VAR customer and the U.S. government prime contractor for this program, were to
discontinue participation in this program or discontinue operations,
interruptions could occur in orders or shipments for this program until a
replacement could be found.

OUR PRODUCT REVENUES WILL NOT GROW IF WE DO NOT WIN NEW BUSINESS IN THE
U.S. AND ABROAD. We do not expect future growth from the U.S. Green Card and
Laser Visa BCC programs as we expect our fiscal 2006 revenues from these
programs to approximate what we expect will be their steady state revenue of
approximately $9.5 million. We expect our revenues from Italian CIE and PSE
cards to be between $20 million and $30 million for fiscal 2007, and about $11
million during the second half of fiscal 2006. During full implementation, we
expect our revenues from these programs to grow to reach the $40 million per
year. In order for us to achieve our overall revenue growth goal, we will need
not only for these programs to continue and reach their anticipated levels, of
which there can be no assurance, but we will also need to win new business in
the U.S. and abroad. Other optical memory card programs that are emerging
programs or prospective applications in various countries include motor vehicle
registration cards in India and identification cards for Costa Rica and also for
a Middle Eastern country; where we shipped $0.6 million of cards during fiscal
2005 and $1.5 million in the first nine months of fiscal 2006 during the
experimental phase of the program. There can be no assurance that sizable orders
will follow or even if ordered we will be successful in shipping products for
any of these programs. Nor can there be any assurance that we will be able to
win any other new business in the U.S. or abroad which is necessary to grow our
business to the level we desire.

SINCE THE SALES CYCLE FOR OUR PRODUCTS IS TYPICALLY LONG AND
UNPREDICTABLE, WE HAVE DIFFICULTY PREDICTING FUTURE REVENUE GROWTH. Obtaining
substantial orders usually involves a lengthy sales cycle, requiring marketing
and technical time and expense with no guarantee that substantial orders will
result. This long sales cycle results in uncertainties in predicting operating
results, particularly on a quarterly basis. In addition, since our major
marketing programs involve the U.S. government and various foreign governments
and quasi-governmental organizations, additional uncertainties and extended
sales cycles can result. Factors which increase the length of the sales cycle
include government regulations, bidding procedures, budget cycles, and other
government procurement procedures, as well as changes in governmental
policy-making.

THE TIMING OF OUR U.S. GOVERNMENT REVENUES IS NOT UNDER OUR CONTROL AND
CANNOT BE PREDICTED BECAUSE WE REQUIRE A FIXED SHIPMENT SCHEDULE IN ORDER TO
RECORD REVENUE WHEN WE DELIVER CARDS TO A VAULT, OTHERWISE WE RECOGNIZE REVENUE
WHEN THE CARDS ARE SHIPPED OUT OF A VAULT OR WE RECEIVE A FIXED SHIPMENT
SCHEDULE FROM THE GOVERNMENT. We recognize revenue from product sales when the
following criteria are met: (a) persuasive evidence of an arrangement exists;
(b) delivery has occurred; (c) the fee is fixed or determinable; and (d)
collectibility is reasonably assured.

Our U.S. government subcontract requires delivery of cards to a secure
vault built on our premises. Deliveries are made into the vault on a production
schedule specified by the government or one of its specified agents. When the

cards are delivered to the vault, all title and risk of ownership are
transferred to the government. At the time of delivery, the prime contractor is
invoiced, with payment due within thirty days. The contract does not provide for
any return provisions other than for warranty. We recognize revenue when the
cards are delivered into the vault because we have fulfilled our contractual
obligations and the earnings process is complete. However, if we do not receive
a shipment schedule for shipment from the vault, revenue is not recognized until
the cards are shipped from the vault. In addition, revenue recognition for
future deliveries into the vault would be affected if the U.S. government
cancels the shipment schedule. As a result, our revenues may fluctuate from
period to period if we do not continue to obtain shipment schedules under this
subcontract or if the shipment schedules are cancelled. In this case, we would
no longer recognize revenue when cards are delivered to the vault, but instead
such revenue recognition would be delayed until the cards are shipped from the
vault to the U.S. government.

WE COULD EXPERIENCE EQUIPMENT, RAW MATERIAL, QUALITY CONTROL, OR OTHER
PRODUCTION PROBLEMS ESPECIALLY IN PERIODS OF INCREASING VOLUME. There can be no
assurance that we will be able to meet our projected card manufacturing capacity
if and when customer orders reach higher levels. We have made and intend to
continue to make significant capital expenditures to expand our card
manufacturing capacity. For example, we plan $8.5 million of capital
expenditures during the next nine to twelve months. However, since customer
demand is difficult to predict, we may be unable to ramp up our production
quickly enough to timely fill new customer orders. This could cause us to lose
new business and possibly existing business. In addition, if we overestimate
customer demand, we could incur significant costs from creating excess capacity
which was the case during fiscal 2005. We may experience manufacturing
complications associated with increasing our manufacturing capacity of cards and
drives, including the adequate production capacity for sheet-lamination process
cards to meet order requirements and delivery schedules. We may also experience
difficulties implementing new manufacturing processes or outsourcing some of our
manufacturing. The addition of fixed overhead costs increases our breakeven
point and results in lower profit margins unless compensated for by increased
product sales. When purchasing raw materials for our anticipated optical card
demand, we take into consideration the order-to-delivery lead times of vendors
and the economic purchase order quantity for such raw materials. If we
over-estimate customer demand, excess raw material inventory can result.

IF WE ARE UNABLE TO BUY RAW MATERIALS IN SUFFICIENT QUANTITIES AND ON A
TIMELY BASIS, WE WILL NOT BE ABLE TO DELIVER PRODUCTS TO CUSTOMERS ON TIME WHICH
COULD CAUSE US TO LOSE CUSTOMERS, AND OUR REVENUES COULD DECLINE. We depend on
sole source and limited source suppliers for optical card raw materials. Such
materials include plastic films used in optical memory card production, which
are available from one supplier in the U.S. and from multiple foreign suppliers.
Processing chemicals, inks, and bonding adhesives are obtained from various U.S.
and foreign suppliers. Certain photographic films are commercially available
solely from Eastman Kodak Company, of the United States. No assurance can be
given that Kodak will continue to supply such photographic films on a
satisfactory basis and in sufficient quantities. If Kodak were to discontinue
manufacturing the film from which our optical media is made, we would endeavor
to establish an alternate supplier for such film, although the purchase price
could increase and reliability and quality could decrease from a new supplier.
No assurance can be given that there will be adequate demand to attract a second
source. In addition, an alternate supplier could encounter technical issues in
producing the film as there may be know-how and manufacturing expertise which
Kodak has developed over the years which an alternate supplier may have
difficulty to replicate. We have pre-purchased a long-term supply of the film
used to produce mastering loops for prerecording cards. With regard to the film
from which our optical media is made, we currently have an order which Kodak has
accepted with deliveries scheduled through June 2006. If Kodak announced that it
was no longer going to sell film, we would request that Kodak provide us with a
last-buy opportunity which we would plan to take maximum advantage of, although
no assurance can be given that Kodak would provide us with such an opportunity.
We have film on hand plus on order that we believe would provide us with an
adequate supply to meet anticipated demand until we could locate and begin
volume purchases from a second source.

AN INTERRUPTION IN THE SUPPLY OF READ/WRITE DRIVE PARTS OR DIFFICULTIES
ENCOUNTERED IN READ/WRITE DRIVE ASSEMBLY COULD CAUSE A DELAY IN DELIVERIES OF
DRIVES AND OPTICAL MEMORY CARDS AND A POSSIBLE LOSS OF SALES, WHICH WOULD
ADVERSELY AFFECT OUR OPERATING RESULTS. Several major components of our
read/write drives are designed specifically for our read/write drive. For
example, the optical recording head for the current drive is a part obtained
from one supplier; and at current production volumes, it is not economical to
have more than one supplier for

this custom component. The ability to produce read/write drives in high-volume
production, if required, will be dependent upon maintaining or developing
sources of supply of components that meet our requirements for high volume,
quality, and cost. In addition, we could encounter quality control or other
production problems at high-volume production of read/write drives. We are also
investing in research and engineering in an effort to develop new drive
products.

IF WE ARE UNABLE TO DEVELOP UPGRADED READ/WRITE DRIVES THAT COST LESS TO
MANUFACTURE AND ALSO A READ-ONLY DRIVE, WE COULD LOSE POTENTIAL NEW BUSINESS.
The price of our standard read/write drive ranges from $1,800 to just under
$2,000 depending on quantity purchased. We believe the price of our drives is
competitive in applications requiring a large number of cards per each drive,
because the relatively low cost for our cards offsets the high cost per drive
when compared with our major competition, IC card systems. In addition, we have
undertaken a product development program for a portable read-only drive now
available in prototype, which we believe would increase our prospects for
winning future business. However, there can be no assurance that our development
program will be successful, that production of any new design will occur in the
near term, or that significantly lower manufacturing costs or increased sales
will result.

WE MAY NOT BE ABLE TO ADAPT OUR TECHNOLOGY AND PRODUCTS TO COMMERCIAL
APPLICATIONS WHICH GENERATE MATERIAL AMOUNTS OF REVENUE AND PROFIT. THIS WOULD
LIMIT THE FUTURE GROWTH OF OUR BUSINESS TO THE GOVERNMENT SECTOR AND THE LACK OF
DIVERSIFICATION EXPOSES US TO ENHANCED RISK OF COMPETITION. We are seeking
commercial applications for our optical memory products in order to lessen our
dependence upon the government sector. Our efforts to develop OpticalProximity
access cards with HID Corporation are but one example. We may be unsuccessful in
these efforts in which case we would not obtain the diversity of revenues we are
seeking for the future. If the use of our technology remains limited to secure
ID card applications for government use, then we are more susceptible to other
technologies and products making in-roads or to political pressures or changing
laws.

IF WE ARE UNABLE TO ADAPT TO TECHNOLOGICAL CHANGES IN THE DATA CARD
INDUSTRY AND IN THE INFORMATION TECHNOLOGY INDUSTRY GENERALLY, WE MAY NOT BE
ABLE TO EFFECTIVELY COMPETE FOR FUTURE BUSINESS. The information technology
industry is characterized by rapidly changing technology and continuing product
evolution. The future success and growth of our business will require the
ability to maintain and enhance the technological capabilities of the LaserCard
product line. There can be no assurance that the Company's products currently
sold or under development will remain competitive or provide sustained revenue
growth.

SEVERAL OF OUR FOREIGN PROGRAMS INVOLVE OUR CARDS AS PART OF A SOLUTION
WHICH INCLUDES TECHNOLOGIES OF THIRD PARTIES THAT ARE INTEGRATED BY OUR SYSTEMS
INTEGRATOR CUSTOMER OR SUBCONTRACTOR. WE THEREFORE DO NOT HAVE CONTROL OVER THE
OVERALL SYSTEM WHICH COULD LEAD TO TECHNICAL AND COMPATIBILITY ISSUES WHICH ARE
DIFFICULT, EXPENSIVE, AND TIME CONSUMING TO SOLVE. THIS COULD CAUSE OUR ULTIMATE
CUSTOMERS, GENERALLY GOVERNMENTS, TO FIND FAULT IN OPTICAL CARDS AND SWITCH TO
OTHER SOLUTIONS EVEN THOUGH OUR OPTICAL TECHNOLOGY IS NOT THE ROOT CAUSE. In
certain of our current foreign programs such as Italy, India, and a Middle
Eastern country, and possibly in future other programs, various third party
technologies such as contact or contactless chips will be added to our cards.
The embedding or addition of other technologies to the LaserCard optical memory
card, especially when contracted to independent third parties, could potentially
lead to technical, compatibility and other issues. In such circumstances, it may
be difficult to determine whether a fault originated with the Company's
technology or that of a co-supplier. If such faults occur, they could be
difficult, expensive, and time-consuming to resolve. Such difficulties could
lead to our ultimate customers, the foreign governments, switching to other
technologies even though optical technology is not the root cause. The resulting
loss of customers would adversely affect our revenues.

IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY
BE ABLE TO USE OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR COMPETITIVE POSITION,
REDUCE REVENUES, OR INCREASE COSTS. We use a combination of patent, trademark,
and trade secret laws, confidentiality procedures, and licensing arrangements to
establish and protect our proprietary rights. Our existing and future patents
may not be sufficiently broad to protect our proprietary technologies. Despite
our efforts to protect

proprietary rights, we cannot be certain that the steps we have taken will
prevent the misappropriation or unauthorized use of our technologies,
particularly in foreign countries where the laws may not protect proprietary
rights as fully as U.S. law. Any patents we may obtain may not be adequate to
protect our proprietary rights. Our competitors may independently develop
similar technology, duplicate our products, or design around any of our issued
patents or other intellectual property rights. Litigation may be necessary to
enforce our intellectual property rights or to determine the validity or scope
of the proprietary rights of others. This litigation could result in substantial
costs and diversion of resources and may not ultimately be successful. We cannot
predict whether the expiration or invalidation of our patents would result in
the introduction of competitive products that would affect our future revenues
adversely. However, since our technology is now in the commercial stage, our
know-how and experience in volume card production, system development and
software capabilities, brand-name recognition within our card markets, and
dominant-supplier status for optical memory cards are of far greater importance
than our patents. At this time, we believe that our existing patent portfolio is
helpful but is no longer essential for maintaining the LaserCard's market
position.

THE MARKETS FOR OUR PRODUCTS ARE COMPETITIVE, AND IF WE ARE UNABLE TO
COMPETE SUCCESSFULLY, REVENUES COULD DECLINE OR FAIL TO GROW. Our optical memory
cards may compete with optical memory cards that can be manufactured and sold by
three of our licensees (although none is currently doing so) and with other
types of portable data storage cards and technologies used for the storage and
transfer of digital information. These may include integrated circuit/chip
cards; 2-dimensional bar code cards and symbology cards; magnetic-stripe cards;
thick, rigid CD-read only cards or recordable cards; radio frequency, or RF,
chip cards; and small, digital devices such as data-storage keys, tokens, finger
rings, and small cards and tags. The financial and marketing resources of some
of the competing companies are greater than our resources. Competitive product
factors include system/card portability, interoperability, price-performance
ratio of cards and associated equipment, durability, environmental tolerance,
and card security. Although we believe our cards offer key technological and
security advantages for certain applications, the current price of optical card
read/write drives is a competitive disadvantage in some of our targeted markets.
However, we believe the price of our drives is competitive in applications
requiring a large number of cards per each drive, because the relatively low
cost for our cards offsets the high cost per drive when compared with our major
competition, IC card systems. In countries where the telecommunications
infrastructure is extensive and low cost, centralized databases and wide-area
networks may limit the penetration of optical memory cards. These trends toward
Internet, intranet, and remote wireless networks will in some cases preclude
potential applications for our cards.

THE PRICE OF OUR COMMON STOCK IS SUBJECT TO SIGNIFICANT VOLATILITY. The
price of our common stock is subject to significant volatility, which may be due
to fluctuations in revenues, earnings, liquidity, press coverage, financial
market interest, low trading volume, and stock market conditions, as well as
changes in technology and customer demand and preferences. As a result, our
stock price might be low at the time a stockholder wants to sell the stock.
Also, since we have a relatively low number of shares outstanding (approximately
11 million shares) there will be more volatility in our stock if one or two
major holders, for example, large institutional holders, attempt to sell a large
number of shares in the open market. There also is a large short position in our
stock, which can create volatility when borrowed shares are sold short and later
if shares are purchased to cover the short position. Furthermore, our trading
volume is often small, meaning that a few trades may have disproportionate
influence on our stock price. In addition, someone seeking to liquidate a
sizeable position in our stock may have difficulty doing so except over an
extended period or privately at a discount. Thus, if one or more stockholders
were to sell or attempt to sell a large number of its shares within a short
period of time, such sale or attempt could cause our stock price to decline.
There can be no guarantee that stockholders will be able to sell the shares that
they acquired at a price per share equal to the price they paid for the stock.

WE ARE SUBJECT TO RISKS ASSOCIATED WITH CHANGES IN FOREIGN CURRENCY
EXCHANGE RATES. Part of the manufacturing process of the LaserCard products that
we sell in Italy takes place in our operations in Germany. Also, some of the raw
materials we use to manufacture optical memory cards are sourced in Europe.
These costs are denominated in euros, the currency used in much of Europe.
However, when we sell our finished products the prices that we charge are
denominated in United States dollars. Accordingly, we are subject to exposure if
the exchange rate for euros increases in relation to the United States dollar.
During fiscal 2005, we experienced a $0.2 million loss on foreign currency
exchange. As of December 31, 2005, we had not entered into a forward exchange
contract to hedge against or potentially minimize the foreign currency exchange
risk related to transactions other than those related to intercompany and
external payables and receivables.

WE SOLD A SECOND-SOURCE CARD MANUFACTURING LICENSE TO GLOBAL INVESTMENTS
GROUP (GIG), UNDER WHICH WE WILL PROVIDE CERTAIN FACTORY SET-UP AND TRAINING
SERVICES. IF WE ARE NOT SUCCESSFUL OR IF GIG IS UNABLE TO FINANCE THIS
OPERATION, THE SECOND-SOURCE SUPPLY OF OPTICAL CARDS WILL NOT MATERIALIZE. IF WE
AND GIG ARE SUCCESSFUL, THE SECOND-SOURCE WILL COMPETE WITH US FOR BUSINESS. If
GIG is not successful, but current and potential customers require a second
source of optical memory cards (which is a common business practice) they could
decide to use alternate technology cards, such as chip cards, that have
multiple-source suppliers. We are obligated to deliver approximately $12 million
worth of the required manufacturing equipment and installation support to GIG
for its to-be-built new card manufacturing facility in Slovenia, to provide a
targeted initial manufacturing capacity of 10 million optical cards annually. If
GIG is successful, this will supply a second source for optical memory cards. We
will also be assigning personnel to be on site during the license term to assist
with quality, security, and operational procedures, with a mutual goal that the
facility and the cards made in Slovenia conform to our standards. If cards are
not produced in conformance with our quality standards, the reputation and
marketability of optical memory card technology could be damaged. If the factory
does not become operational and produce quality cards in high volume, or if GIG
is unable to raise sufficient capital to build, equip and operate this facility,
we would not obtain the hoped-for benefits--including ongoing royalties, sales
of raw materials to GIG, expansion of the European market, and a bona fide
second source for optical memory cards. On the other hand, if and when the
factory is successfully manufacturing the cards in high volume, it will compete
against us for business in certain territories, which could reduce our potential
card revenues if the market does not expand. Revenue will be recognized over the
remaining term of the agreement beginning when operation of the factory
commences. The Company could incur greater expenses than it anticipates for the
purchase and installation of the required manufacturing equipment thereby
reducing cash and anticipated profits. While GIG currently anticipates its plant
becoming operational during the second half of 2006, GIG has a history of prior
delays.

WE MAY NOT BE ABLE TO ATTRACT, RETAIN OR INTEGRATE KEY PERSONNEL, WHICH
MAY PREVENT US FROM SUCCEEDING. We may not be able to retain our key personnel
or attract other qualified personnel in the future. Our success will depend upon
the continued service of key management personnel. The loss of services of any
of the key members of our management team, including our chief executive
officer, chief operating officer, the managing directors of our German
operations, vice president of business development or our vice president of
finance and treasurer, or our failure to attract and retain other key personnel
could disrupt operations and have a negative effect on employee productivity and
morale, thus decreasing production and harming our financial results. In
addition, the competition to attract, retain and motivate qualified personnel is
intense.

OUR CALIFORNIA FACILITIES ARE LOCATED IN AN EARTHQUAKE ZONE AND THESE
OPERATIONS COULD BE INTERRUPTED IN THE EVENT OF AN EARTHQUAKE, FIRE, OR OTHER
DISASTER. Our card manufacturing, corporate headquarters, and drive assembly
operations, administrative, and product development activities are located near
major earthquake fault lines. In the event of a major earthquake, we could
experience business interruptions, destruction of facilities and/or loss of
life, all of which could materially adversely affect us. Likewise, fires,
floods, or other events could similarly disrupt our operations and interrupt our
business.

ACTS OF TERRORISM OR WAR MAY ADVERSELY AFFECT OUR BUSINESS. Acts of
terrorism, acts of war, and other events may cause damage or disruption to our
properties, business, employees, suppliers, distributors, resellers, and
customers, which could have an adverse effect on our business, financial
condition, and operating results. Such events may also result in an economic
slowdown in the United States or elsewhere, which could adversely affect our
business, financial condition, and operating results.

WE ARE PLANNING TO IMPLEMENT ENTERPRISE RESOURCE PLANNING ("ERP")
SOFTWARE DURING CALENDAR 2006 TO PROVIDE US THE INFORMATION WE NEED TO BETTER
MANAGE AND PLAN OUR BUSINESS AND ENHANCE OUR FINANCIAL REPORTING. IF THIS
IMPLEMENTATION IS UNSUCCESSFUL OR DELAYED, IT COULD ADVERSELY IMPACT RATHER THAN
ENHANCE OUR ABILITY TO MANAGE AND GROW OUR BUSINESS. Our ability to successfully
implement our business plan and comply with regulations requires an effective
planning and management process. We expect that we will need to continue to
improve existing, and implement new, operational and financial systems,
procedures and controls to

manage our business effectively in the future, especially as we integrate our
German subsidiary's management and accounting information system. We are
planning to implement ERP software during calendar 2006 to provide us the
information we need to better manage and plan our business and enhance our
financial reporting. Such implementations are costly and require personnel time
and attention in order to succeed and can be delayed and problematic. Any delay
in the implementation of, or disruption in the transition to, new or enhanced
systems, procedures or controls, could harm our ability to accurately forecast
sales demand, manage our supply chain and record and report financial and
management information on a timely and accurate basis.

AS A RESULT OF OUR REQUIRED ANNUAL EVALUATION OF OUR INTERNAL CONTROLS
OVER FINANCIAL REPORTING, WE MAY IDENTIFY INTERNAL CONTROL WEAKNESSES NEEDING
REMEDIATION, WHICH COULD HARM OUR REPUTATION. In March 31, 2005, we completed
the first annual evaluation of our internal controls over financial reporting as
required by Section 404 of the Sarbanes-Oxley Act of 2002 for the fiscal year
ended March 31, 2005. Although our assessment, testing and evaluation resulted
in our conclusion that as of March 31, 2005, our internal controls over
financial reporting were effective, we cannot predict the outcome of our testing
in future periods. If our internal controls are found to be ineffective in
future periods, our reputation could be harmed. We may incur additional expenses
and commitment of management's time in connection with further evaluations,
either of which could materially increase our operating expenses and accordingly
reduce our net income.

BEGINNING APRIL 1, 2006, WE WILL BE REQUIRED TO RECORD COMPENSATION
EXPENSE FOR STOCK OPTIONS. AS A RESULT OF THE RESULTING SIGNIFICANT EXPENSES, IT
WILL BE MORE DIFFICULT FOR US TO CONTINUE TO BE PROFITABLE AND ANY PROFITABILITY
WE ACHIEVE WILL BE REDUCED SIGNIFICANTLY. In December 2004, FASB issued an
accounting standard that requires the fair value of all equity-based awards
granted to employees be recognized in the statement of operations as
compensation expense, for fiscal years beginning after December 15, 2005, rather
than just showing such expense in a footnote as we have been doing. Given our
outstanding options and our current intention to continue to grant options in
the future as an incentive and retention tool for our service providers, the
adoption of this accounting standard will reduce our profitability as measured
by generally accepted accounting principles (GAAP) which may adversely affect
our stock price. Such adoption could lead us to supplement our GAAP reports with
non-GAAP measures in order to provide analysts with the same metrics we use to
measure our business. Such adoption could also lead us to reduce or otherwise
alter our use of stock options which we believe help align our service providers
long-term interests with increasing our enterprise value. This could, in turn,
hurt our ability to recruit employees and retain existing employees and
directors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RATE RISKS

INTEREST RATE RISK. The Company invests its cash, beyond that needed for
daily operations, in high quality debt securities. In doing so, the Company
seeks primarily to preserve the value and liquidity of its capital and,
secondarily, to safely earn income from these investments. To accomplish these
goals, the Company invests only in debt securities issued by (a) the U.S.
Treasury and U.S. government agencies, state agencies and corporations and (b)
debt instruments that meet the following criteria:

o Commercial paper rated A1/P1 or debt instruments rated AAA, as
rated by the major rating services
o Can readily be sold for cash

Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. Fixed rate securities may have
their fair market value adversely impacted because of a rise in interest rates,
while floating rate securities may produce less income than expected if interest
rates fall. Due in part to these factors, the Company's future investment income
may fall short of expectations because of changes in interest rates or we may
suffer losses in principal if forced to sell securities that have seen a decline
in market value because of changes in interest rates.

There were no material changes during the third quarter of fiscal 2006
in the Company's exposure to market risk for changes in interest rates.

The following summarizes short-term and long-term investments at fair
value, weighted average yields and expected maturity dates as of December 31,
2005 (in thousands, except for percentages):

FISCAL YEARS

2006 2007 TOTAL
---- ---- -----

Auction Rate Securities $ 14,050 $ -- $ 14,050
Weighted Average Yield 4.37% -- 4.37%
U.S. Government and Agency Obligations 6,241 -- 6,241
Weighted Average Yield 2.67% -- 2.67%
-------- -------- --------

Total Investments $ 20,291 $ -- $ 20,291
======== ========= ========

FOREIGN CURRENCY EXCHANGE RATE RISK. The Company's U.S. operations sell
products in various international markets. To date an immaterial amount of sales
have been denominated in euros. In addition, some raw material purchases and
purchased services are denominated in euros. As of December 31, 2005, the
outstanding balance of a debt relating to the acquisition of Challenge Card
Design Plastikkarten GmbH and cards & more GmbH, of Germany was immaterial.
Accordingly, the exchange rate risk related to this debt is minimal.

Since September 2005, the Company has entered into short-term forward
exchange contracts to hedge intercompany loans receivable which denominated in
euro to minimize the foreign currency exchange risk. As of December 31, 2005,
the short-term forward exchange contract was outstanding with a notional amount
of 1.7 million euros and the Company is required to close the position on
January 27, 2006. This contract primarily hedges intercompany loans receivable
with the respective gains and losses being reported in SG&A. Accordingly, these
gains and losses were not material for the three and nine-month periods ended
December 31, 2005.

The income statements of the Company's non-U.S. operations are
translated into U.S. dollars at the average exchange rate in each applicable
period. To the extent the U.S. dollar weakens against euro, the translation of
euro denominated transactions results in increased revenues, operating expenses
and net income for the non-U.S. operations. Similarly, the Company's revenues,
operating expenses and net income will decrease for the non-U.S. operations if
the U.S. dollar strengthens against euro. For the nine-month period ended
December 31, 2005, the fluctuation of the average exchange rate as compared to
the average exchange rate from fiscal year 2005 was immaterial. Additionally,
the assets and liabilities of the non-U.S. operations are translated into U.S.
dollars at exchange rates in effect as of the applicable balance sheet dates,
and revenue and expense accounts of these operations are translated at average
exchange rates during the applicable period the transactions occur. Translation
gains and

losses are included as an adjustment to stockholders' equity.

ITEM 4. CONTROLS AND PROCEDURES

(A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. The Company's
principal executive officer and principal financial officer have
evaluated the Company's disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) as of the
end of the period covered by this Form 10-Q and have determined
that they are reasonable taking into account the totality of the
circumstances.

(B) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. There were
no significant changes in the Company's internal control over
financial reporting that occurred during the third quarter of
fiscal 2006 that have materially affected, or are reasonably
likely to materially affect, such control.

PART II. OTHER INFORMATION

ITEM 1. - LEGAL PROCEEDINGS

None

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

None

ITEM 3. - DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the
period for which this report is filed.

ITEM 5. - OTHER INFORMATION

None

ITEM 6. - EXHIBITS

EXHIBIT NO. EXHIBIT DESCRIPTION

3(I) Certificate of Incorporation: Exhibit 3.1 of the
registrant's annual report on Form 10-K for the
fiscal year ended March 31, 2005, filed with the SEC
on June 15, 2005, is hereby incorporated by
reference.

3(II) Bylaws: Exhibit 3.2 of the registrant's annual
report on Form 10-K for the fiscal year ended March
31, 2005, filed with the SEC on June 15, 2005, is
hereby incorporated by reference.

10.1-10.8 Material Contracts: Exhibits 10.1 through 10.8
listed in registrant's annual report on Form 10-K
for the fiscal year ended March 31, 2005, filed with
the SEC on June 15, 2005, are hereby incorporated by
reference.

31.1 Rule 13a-14(a) Certification of Richard M. Haddock,
chief executive officer is filed herewith.

31.2 Rule 13a-14(a) Certification of Steven G. Larson,
chief financial officer is filed herewith.

32.1 Section 1350 Certification of Richard M. Haddock,
chief executive officer is filed herewith.

32.2 Section 1350 Certification of Steven G. Larson,
chief financial officer is filed herewith.

Exhibits 31.1, 31.2, 32.1, and 32.2 are filed herewith while the other
exhibits are incorporated by reference. No other exhibits are included in this
report as the contents of the required exhibits are either not applicable to
Registrant, to be provided only if Registrant desires, or contained elsewhere in
this report.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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:

LASERCARD CORPORATION
(Registrant)

Signature Title Date
--------- ----- ----

/s/ Richard M. Haddock Chief Executive Officer February 3, 2006
- --------------------------------
Richard M. Haddock

/s/ Steven G. Larson Chief Financial Officer February 3, 2006
- --------------------------------
Steven G. Larson

INDEX TO EXHIBITS

[ITEM 14(c)]
Exhibit
Number Description
- ------ -----------

3(I) Certificate of Incorporation: Exhibit 3.1 of the registrant's
annual report on Form 10-K for the fiscal year ended March 31,
2005, filed with the SEC on June 15, 2005, is hereby incorporated
by reference.

3(II) Bylaws: Exhibit 3.2 of the registrant's annual report on Form 10-K
for the fiscal year ended March 31, 2005, filed with the SEC on
June 15, 2005, is hereby incorporated by reference.

10.1-10.8 Material Contracts: Exhibits 10.1 through 10.8 listed in
registrant's annual report on Form 10-K for the fiscal year ended
March 31, 2005, filed with the SEC on June 15, 2005, are hereby
incorporated by reference.

31.1 Rule 13a-14(a) Certification of Richard M. Haddock, chief
executive officer is filed herewith.

31.2 Rule 13a-14(a) Certification of Steven G. Larson, chief financial
officer is filed herewith.

32.1 Section 1350 Certification of Richard M. Haddock, chief executive
officer is filed herewith.

32.2 Section 1350 Certification of Steven G. Larson, chief financial
officer is filed herewith.