SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO

SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

 

Commission file number 0-29440

 

 

 

 

SCM MICROSYSTEMS, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

Registrant’s telephone number, including area code:

 

+49 89 95 95 5000

 

Securities Registered Pursuant to Section 12(b) of the Act:

None

 

Securities Registered Pursuant to Section 12(g) of the Act:

 

Common Stock, $0.001 par value, and associated Preferred Share Purchase Rights

(Title of Class)

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicated by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

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

 

Based on the closing sale price of the Registrant’s Common Stock on the NASDAQ National Market System on June 30, 2006, the last business day of the Registrant’s most recently completed second fiscal quarter, the aggregate market value of Common Stock held by non-affiliates of the Registrant was $39,279,106. For purposes of this disclosure, shares of Common Stock held by beneficial owners of more than 5% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant, have been excluded in that such persons may be deemed to be affiliates of the Registrant. This determination is not necessarily conclusive.

 

At March 9, 2007, the registrant had outstanding 15,698,278 shares of Common Stock.

 

 

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The Company’s Proxy Statement and Notice of Annual Meeting to be filed within 120 days after the Registrant’s fiscal year end of December 31, 2006 is incorporated by reference into Part II, Item 5 and Part III of this Report.

 

 

SCM Microsystems, Inc.

Form 10-K
For the Fiscal Year Ended December 31, 2006

TABLE OF CONTENTS

 

 

SCM, CHIPDRIVE, EasyTAN and SmartOS are registered trademarks and Opening the Digital World is a trademark of SCM Microsystems. Other product and brand names may be trademarks or registered trademarks of their respective owners.

 

This Annual Report on Form 10-K contains forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. For example, statements, other than statements of historical facts regarding our strategy, future operations, financial position, projected results, estimated revenues or losses, projected costs, prospects, plans, market trends, competition and objectives of management constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “believe,” “could,” “should,” “would,” “may,” “anticipate,” “intend,” “plan,” “estimate,” “expect,” “project” or the negative of these terms or other similar expressions. Although we believe that our expectations reflected in or suggested by the forward-looking statements that we make in this Annual Report on Form 10-K are reasonable, we cannot guarantee future results, performance or achievements. You should not place undue reliance on these forward-looking statements. All forward-looking statements speak only as of the date of this Annual Report on Form 10-K. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our expectations change, whether as a result of new information, future events or otherwise. We also caution you that such forward-looking statements are subject to risks, uncertainties and other factors, not all of which are known to us or within our control, and that actual events or results may differ materially from those indicated by these forward-looking statements. We disclose some of the factors that could cause our actual results to differ materially from our expectations in the “Customers,” “Research and Development,” Competition,” Proprietary Information and Technology” and “Risk Factors” sections and elsewhere in this Annual Report on Form 10-K. These cautionary statements qualify all of the forward-looking statements included in this Annual Report on Form 10-K that are attributable to us or persons acting on our behalf.

 

Description of Business

 

SCM Microsystems, Inc. (“SCM,” the “Company,” “we” and “us”) was incorporated in 1996 under the laws of the state of Delaware. We design, develop and sell hardware, software and silicon solutions that enable people to conveniently and securely access digital content and services. We sell our secure digital access products into two market segments: PC Security and Flash Media Readers.

 

 

We sell our products primarily to original equipment manufacturers, or OEMs, who typically either bundle our products with their own solutions, or repackage our products for resale to their customers. Our OEM customers include: government contractors, systems integrators, large enterprises and computer manufacturers, as well as banks and other financial institutions for our smart card readers; and computer electronics and photographic equipment manufacturers for our digital media readers. We sell and license our products through a direct sales and marketing organization, as well as through distributors, value added resellers and systems integrators worldwide.

 

On May 22, 2006 we completed the sale of our Digital Television solutions (“DTV solutions”) business to Kudelski S.A. As a result, we have accounted for the DTV solutions business as a discontinued operation, and the statements of operations and cash flows for all periods presented reflect the discontinuance of this business. In addition, our operations previously included a retail Digital Media and Video business, which we sold in the third quarter of 2003. As a result of this sale and divestiture, beginning in the second quarter of fiscal 2003, we have accounted for the retail Digital Media and Video business as a discontinued operation, and statements of operations for all periods presented reflect the discontinuance of this business. (See Note 3 to our consolidated financial statements that are attached to this Annual Report on Form 10-K.)

 

Overview of the Market for Secure Digital Access Products

 

Individuals, businesses, governments and educational institutions increasingly rely upon computer networks, the Internet and intranets for information, entertainment and services. The proliferation of and reliance upon electronic data and electronic transactions has created an increasing need to protect the integrity of digital data, as well as to control access to electronic networks and the devices that connect to them. For government entities and large corporate enterprises, there is a need to restrict and manage access to shared networks and intranets to prevent loss of proprietary data. In addition, there is a need to manage and monitor access to information stored on identification cards used in new government-driven programs around the world, such as electronic passports, drivers’ licenses and citizen ID and healthcare cards. In some cases, there may also be a need to expand the capability of electronic networks to protect or restrict access to physical facilities for corporate employees or government personnel. Finally, for consumers and online merchants or banks, there is a need to authenticate credit cardholders or bank clients for Internet transactions without jeopardizing sensitive personal account information. In all of these areas, we believe standards-based devices that easily connect to a PC or network to provide secure, controlled access to digital content or services are an easily deployed and effective solution.

 

PC Security Market

 

The proliferation of personal computers in both the home and office, combined with widespread access to computer networks and the Internet, have created significant opportunities for electronic transactions of all sorts, including business-to-business, e-government, e-commerce and home banking. In government agencies and corporate enterprises, the desire to link disparate divisions or offices, reduce paperwork and streamline operations is also leading to the adoption of more computer- and network-based programs and processes. Network-based programs are also used to track and manage data about large groups of people, for example, citizens of a particular country. While the benefits of computer networks may be significant, network and Internet-based transactions also pose a significant threat of fraud, eavesdropping and data theft for both groups and individuals. To combat this threat, parties at both ends of the transaction must be assured of the integrity of the transaction. Online merchants and consumers need assurance that customers are correctly identified and that the authenticity and confidentiality of information such as credit card numbers is established and maintained. Corporate, government and other networks need security systems that ensure the security of individuals’ data and protect the network from manipulation or abuse both from within and without the enterprise.

 

Increasingly, large organizations such as corporations, government agencies and banks are adopting systems that protect the network, the information in it and the people using it by authenticating each user as the user logs on and off the network. Authentication of a user’s identity is typically accomplished by one of two approaches: passwords, which are codes known only by specific users; and tokens, which are user-specific physical devices that only authorized users possess. Passwords, while easier to use, are also less secure because they tend to be short and static, and are often transmitted without encryption. As a result, passwords are vulnerable to decoding or observation and subsequent use by unauthorized persons. Tokens range from simple credit card-size objects to more complex devices capable of generating time-synchronized or challenge-response access codes. Certain token-based systems require both possession of the token itself and a personal identifier, such as a fingerprint or personal identification number, or PIN, to indicate that the token is being used by an authorized user. Such an approach, referred to as two-factor authentication, provides much greater security than single factor systems such as passwords or the simple possession of a token.

 

One example of a token used in two-factor authentication is the smart card, which contains an embedded microprocessor, memory and a secure operating system. In addition to their security capabilities, smart cards are able to store data such as account information, healthcare records, merchant coupons, still or video images and, in some cases, cash. Smart cards are typically about the size of a credit card and can easily be carried in a wallet or attached to a badge. Smaller cards designed for use with small devices such as mobile phones are also increasingly being utilized. Depending on the application for which they are being used, smart cards can be designed to insert into a reader attached to a PC or other device, or can include wireless capabilities for contactless interface. Worldwide shipments of smart cards topped 2.6 billion in 2005 and are estimated to grow to nearly 3.3 billion in 2006 for applications ranging from mobile communications to corporate security to online banking, according to the European smart card industry organization, Eurosmart. Demand for readers used in conjunction with those cards

is also expected to grow. Research firm Frost & Sullivan predicts that reader shipments will grow from 6.9 million in 2004 to 33 million in 2010. We believe that the combination of smart cards and readers provides a secure solution for network access, personal identification, electronic commerce and other transactions where authentication of the user is critical.

 

To date, the largest and one of the most advanced deployments of smart cards for digital security purposes has been the U.S. Department of Defense’s Common Access Card (“CAC”) program. Beginning in October 2000, the U.S. Department of Defense has distributed smart cards to more than four million military personnel. These cards are being used as the standard identification credential for military personnel, and are also being used for secure authentication and network access. Beginning in 2006, new deployments of the cards have also begun to include capabilities for contactless interface with security terminals at doorways and other entrances to provide secure physical access at government facilities. The U.S. government’s decision to deploy an integrated, agency-wide, common smart card platform will continue to raise the awareness of smart card technology and hence increase the demand for contactless smart card proximity readers in both public and private sectors, according to IMS Research. The firm predicts the Americas’ market for electronic physical access control equipment will reach $766.7 million in 2009, with a forecast compound annual growth rate of 9.1%.

 

Because CAC cards store and protect personnel data, they are also being used wherever a digital signature is required; for example, processing travel orders or expense claims online, electronic voting, contractor verification and in department specific programs. As a result of the CAC program, other government agencies are also employing smart cards as secure ID tokens. The U.S. General Services Administration estimates they will issue smart cards to two million users in various agencies between February 2007 and December 2008.

 

The U.S. government is actively driving the use of smart cards outside the boundaries of the country as well, with the request in 2002 to 27 visa waiver countries to develop electronic passports that will include biometric data to authenticate the holder. Under the auspices of the International Civil Aviation Organization (ICAO), 13 countries have been working together to define and develop standards for e-passports based on contactless smart card technology. The goal of the program is to ensure that these e-passports cannot be copied or altered, and that the biometric facial image stored on the card could be used to positively identify the holder. All of ICAO’s 188 Contracting States must begin issuing only machine readable (i.e., electronic) passports no later than April 1, 2010. 24 of the 27 visa waiver countries met the October 2006 deadline to begin issuing electronic passports and altogether 40 countries worldwide have introduced the new documents, including Australia, Belgium, Canada, China, Denmark, Hong Kong, Japan, Korea, Macao, Malaysia, the Netherlands, Singapore, Sweden, the United Kingdom and the U.S.

 

In many countries, both local and federal governments are beginning to use smart card technology for internal programs, such as new or enhanced national ID cards, storing digital certificates for online transactions, residency permits and visas, and drivers’ licenses. Some examples of programs include national ID rollouts in Thailand and China and deployment of electronic drivers’ licenses in Japan. According to IMS Research Group, more than one billion smart cards will be used in identity programs by governments and other public bodies worldwide by 2010.

 

In addition, many governments are also evaluating or making plans to develop electronic healthcare record systems, which would include smart card-based healthcare cards for participants. Puerto Rico, South Africa, Taiwan and several European countries, including Austria, Belgium, France, Germany, Italy and Slovenia, are among the countries and regions that have already deployed or are deploying electronic healthcare cards to millions of healthcare users. These cards identify the user and store insurance and medical information that can be accessed by doctors and hospitals, for example. To date, the largest program actively underway is in Germany, where the government plans to begin distribution of 82 million eHealth cards to citizens in 2007 and have the corresponding network and card reader infrastructure in place for doctors, hospitals, pharmacies and other healthcare providers by 2008.

 

Outside the government sector, many corporate enterprises are adopting smart card technology to protect access to buildings and computer networks. Several smart card-based employee identification programs have already been put in place by companies such as Boeing, Chevron, Hitachi, Microsoft, Nissan, Pfizer, Royal Dutch/Shell Group and Sun Microsystems.

 

In the financial industry, major credit card companies in many parts of the world have embraced smart card technology as a more secure way to safeguard transactions and eliminate fraud, the cost of which can be significant. The majority of credit cards issued worldwide now comply with the Europay Mastercard Visa (EMV) standard for securing financial transactions using a smart card. Canada, most of Europe and Asia/Pacific and some markets in the Middle East, Africa and Latin America are rapidly moving to EMV smart cards to reduce fraud. Smart cards are also expected to have a growing role in online banking. Western Europe, in particular has a high percentage of consumers banking online, and Germany is one of the first countries to coordinate e-government initiatives requiring digital signatures to leverage smart cards issued to bank customers.

 

Our PC Security Products

 

We offer a full range of smart card reader technology solutions to address the need for smart card-based security for a range of applications and environments, including PCs, networks, physical facilities and authentication programs. Our products include smart card readers, application specific integrated circuits, or ASICs, and small office productivity packages based on smart cards. We sell our readers and ASICs primarily to PC original equipment manufacturers, or OEMs, smart card solutions providers and government systems integrators to support specific security programs, such as secure logon for employees, secure home banking or the Common Access Card program; as well as to OEMs that incorporate our products into their devices, such as PCs or keyboards. We sell our small office productivity packages primarily to end users via retail channels and the Internet.

 

Smart Card Readers.  We are one of the world’s largest suppliers of smart card readers for security-oriented applications. Our smart card readers are hardware devices that connect either externally or internally with a computer or other processing platform to verify the identity of, or authenticate, the user, and thus control access. Much like a lock works with a key, our readers work with a smart card to admit or deny access to a computer or network, or to authenticate the card holder for identification and access to facilities, programs or services. Our readers are used to authenticate users in order to support security programs and applications for corporations, financial institutions, governments and individuals. These security programs and applications include secure network logon; personnel identification for programs such as healthcare delivery, drivers’ licenses and electronic passports; secure home banking; digital signatures; and secure e-commerce.

 

Our products employ an open-systems architecture that provides compatibility across a range of hardware platforms and software environments and accommodates remote upgrades so that compatibility can be maintained as the security infrastructure evolves. We have made significant investments in software embedded in our products that enable our smart card readers and components to read the majority of smart cards in the world, regardless of manufacturer or application. Our smart card readers are also available with a variety of interfaces, including biometric (fingerprint), wireless/contactless, keypad, USB, PCMCIA, ExpressCard and serial port, and offer various combinations of interfaces integrated into one device in order to further increase the level of security.

 

To address the varied needs of our customers, we offer an array of smart card readers. These include readers designed for various platforms, such as desktop and notebook computers; as well as readers offering incremental levels of protection against unauthorized use, from simple PC Card reader devices to more complex PIN entry systems, which require both a smart card and a user’s personal identification number to authenticate the user. Our smart card reader product line includes:

 

 

 

Our readers are developed in compliance with relevant industry standards related to the applications for which they will be used. For example, many of our readers, including the SCRx31 Secure Card Reader line, conform to Europay, MasterCard and Visa (EMV) international standards for financial transactions. We typically customize our smart card readers with unique casing designs and configurations to address the specific requirements of each customer.

 

In addition, we also offer ASICs/Chip Sets, which provide smart card interface capabilities for embedded platforms, such as desktop computers or keyboards. We offer two levels of ASICs to provide both basic smart card interface capability and support for multiple interfaces and reader devices. All of our ASICs comply with all relevant security standards for applications in the smart card industry. In addition, our advanced chip allows on-board flash upgrades for future firmware and application enhancements.

 

CHIPDRIVE Productivity Solutions.  We offer several CHIPDRIVE packages, consisting of smart cards, readers and software applications, for small and medium sized businesses. These products support applications such as smart card-enabled logon to Microsoft^® Windows and smart card-based, secure electronic time recording.

 

Flash Media Reader Market

 

Digital cameras have gained rapid popularity over the last few years, resulting in more than half of U.S. households owning a digital camera at the end of 2005, according to research firm InfoTrends. InfoTrends also estimates that U.S. output of digital photo prints exceeded 13.2 billion in 2005 and will increase to 16 billion by 2009. Flash media cards, which store digital images on the majority of digital cameras, are the key driver behind digital print growth. Higher capacity memory cards allow digital camera users to take more pictures before having to download images or swap out the card. As card capacities increase, more time is needed to download images. This uses more of the camera’s battery life, which already may be insufficient for many camera owners. To print without draining the camera battery, the flash media card can be removed and inserted into a card reader — on a PC, printer or kiosk — to download and print images.

 

Retail photo kiosks and minilabs, which give instant, high-quality printouts of digital images, make printing photos more convenient for the consumer and typically provide higher quality prints than home printers. According to an August 2006 survey conducted by InfoTrends, 41% of digital camera owners who print photos had obtained prints at a retail location in 2005, and the number is expected to grow. As flash memory card capacities increase and digital cameras continue to proliferate, we believe consumers will increasingly use photo kiosks and minilabs to download and print their digital pictures. Each photo kiosk or minilab requires a variety of media card readers to download images from the various media cards in use in digital cameras on the market

 

Our Flash Media Reader Products

 

We offer digital media readers that provide an interface to the various formats of digital media cards to download digital images and other content. We sell our digital media readers primarily to photo kiosk manufacturers. Our digital media readers allow photo kiosk makers and others to build flash media interface capabilities into their products. Our product offerings provide interface capabilities for all major memory card formats, including PCMCIA I and II, CompactFlash^® I and II, MultiMediaCard^tm, Secure Digital Card^®, SmartMedia^tm, Sony Memory Stick^® and xD-Picture Card^tm. Our digital media readers leverage our interface chips to enable each reader slot to read multiple types of cards. Our digital media reader product line includes:

 

 

Business Segment Financial Information

 

See Note 11 to our consolidated financial statements that are attached to this Annual Report on Form 10-K for financial information regarding revenue and gross margin for our reported business segments through 2006. See “Management’s Discussion and Analysis of Financial Conditional and Results of Operations” for historical financial information, including revenue and gross margin.

 

Technology

 

Most of the markets in which we participate are in their early stages of development and we expect they will continue to evolve. For example, early markets such as ours typically require complete hardware solutions, but over time requirements shift to critical components such as silicon or software as OEM customers increase their knowledge and sales volumes of the technologies being provided. We are committed to developing products using standards compliant technologies. Our core technologies, listed below, leverage our development efforts to benefit customers across our product lines and markets.

 

Chip-Level Integration.  We have implemented a number of our core interface and processing technologies into silicon chips for each of our two primary product areas.

 

Silicon and Firmware.  For our PC Security products, we have developed interface technology that provides interoperability between PCs and smart cards from many different smart card manufacturers. Our interoperable architecture includes an International Standards Organization, or ISO, compliant layer as well as an additional layer for supporting non-ISO compliant smart cards. Through our proprietary integrated circuits and firmware, our smart card readers can be updated electronically to accommodate new types of smart cards without the need to change the reader’s hardware. For our Flash Media Reader products, we have developed interface technology that provides interoperability and compatibility between various digital appliances, computer platforms and flash memory cards.

 

Complete Hardware Solutions.  We provide complete hardware solutions for a range of secure digital access applications, and we can customize these solutions in terms of physical design and product feature set to accommodate the specific requirements of each customer. For example, we have designed and manufactured smart card readers that incorporate specific features, such as a transparent case and removable USB cable, to address the needs of specific OEM customers.

 

Customers

 

Our products are targeted at government contractors and systems integrators, as well as manufacturers of computers, computer components, consumer electronics and photographic equipment. Sales to a relatively small

number of customers historically have accounted for a significant percentage of our total sales. Sales to our top ten customers accounted for approximately 53% of revenue in 2006, 54% of revenue in 2005 and 54% of revenue in 2004. In each of 2006 and 2004, one customer accounted for more than 10% of revenue. In 2005, two customers accounted for more than 10% of revenue. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security business, could harm our business and operating results.

 

Sales and Marketing

 

We utilize a direct sales and marketing organization, supplemented by distributors, value added resellers, systems integrators and resellers. As of December 31, 2006, we had 26 full-time employees engaged in sales and marketing activities. Our direct sales staff solicits prospective customers, provides technical advice and support with respect to our products and works closely with customers, distributors and OEMs. In support of our sales efforts, we conduct sales training courses, targeted marketing programs and advertising, and ongoing customer and third-party communications programs, and we participate in trade shows.

 

Backlog

 

A significant portion of our sales are made from inventory on a current basis. Sales are made primarily pursuant to purchase orders for current delivery or agreements covering purchases over a period of time. Our customer contracts generally do not require fixed long-term purchase commitments. In view of our order and shipment patterns and because of the possibility of customer changes in delivery schedules or cancellation of orders, we do not believe that such agreements provide meaningful backlog figures or are necessarily indicative of actual sales for any succeeding period.

 

Collaborative Industry Relationships

 

We are party to collaborative arrangements with a number of third parties and are a member of several industry consortia. We evaluate, on an ongoing basis, potential strategic alliances and intend to continue to pursue such relationships. Our future success will depend significantly on the success of our current arrangements and our ability to establish additional arrangements. These arrangements may not result in commercially successful products.

 

PCMCIA.  We are a member of Personal Computer Memory Card International Association, or PCMCIA, an international standards body and trade association with more than 100 member companies. We have been a member of PCMCIA since 1990. PCMCIA was founded in 1989 to establish standards for integrated circuit cards and to promote interchangeability among mobile PCs.

 

PC/SC Workgroup.  We are an associate member of the PC/SC workgroup, a consortium of technology companies that seeks to set the standard for integrating smart cards and smart card readers into the mainstream computing environment.

 

Silicon Trust.  We are a member of Silicon Trust, an industry forum sponsored by Infineon Technologies that focuses on silicon based security solutions, including smart cards, biometrics, and trusted platforms.

 

Smart Card Alliance.  We are a member of the Smart Card Alliance, a U.S.-based, multi-industry association of member firms working to accelerate the widespread acceptance of multiple applications for smart card technology. We are also members of Smart Card Alliance’s Leadership Council and the Physical Access Council, which focuses on issues relating to the implementation of physical access systems. We regularly contribute to Smart

Card Alliance research and education materials including white papers, for example a paper defining key policy, process and technology considerations for a secure smart card-based personal ID system.

 

Teletrust.  We are a member of Teletrust, a German organization whose goal is to provide a legally accepted means to adopt digital signatures. Digital signatures are encrypted personal identifiers, typically stored on a secure smart card, which allow for a high level of security through internationally accepted authentication methods. We are a member of the smart card terminal committee, which defines the standards for connecting smart cards to computers for applications such as secure electronic commerce over the Internet.

 

We are also members of several flash media card organizations, including CompactFlash Association, Memory Stick Developers Forum, MultiMediaCard Association, SD Card Association, SSFDC SmartMedia Forum, xD-Picture Card Forum, Photo Marketing Association International and USB Implementers Forum.

 

Research and Development

 

To date, we have made substantial investments in research and development, particularly in the areas of smart card-based physical and network access devices and digital connectivity and interface devices. Our engineering design teams work cross-functionally with marketing managers, applications engineers and customers to develop products and product enhancements to meet customer and market requirements. We also strive to develop and maintain close relationships with key suppliers of components and technologies in order to be able to quickly introduce new products that incorporate the latest technological advances. Our future success will depend upon our ability to develop and to introduce new products that keep pace with technological developments and emerging industry standards while addressing the increasingly sophisticated needs of our customers.

 

Our research and development expenses were approximately $3.8 million, $4.1 million and $4.8 million for the years ended December 31, 2006, 2005 and 2004, respectively. As of December 31, 2006, we had 83 full-time employees engaged in research and development activities, including software and hardware engineering, testing and quality assurance and technical documentation. The majority of our research and development activities occur in India. We fund a small portion of our research and development activities with technology development revenues received from OEM customers in connection with design and development of specific products.

 

Manufacturing and Sources of Supply

 

Through September 2005, we manufactured our products primarily using internal resources in Singapore, supplemented by contract manufacturers in Asia. Since October 2005, we have ceased to manufacture any of our own components or products internally and have shifted these activities to contract manufacturers in Singapore and China. We have implemented a global sourcing strategy that we believe enables us to achieve greater economies of scale, better gross margins and more uniform quality standards for our products. In the event any of our contract manufacturers are unable or unwilling to continue to manufacture our products, we may have to rely on other current manufacturing sources or identify and qualify new contract manufacturers. Any significant delay in our ability to obtain adequate supplies of our products from current or alternative sources would harm our business and operating results.

 

We believe that our success will depend in large part on our ability to provide quality products and services while ensuring the highest level of security for our products during the manufacturing process. We have a formal quality control program to satisfy our customers’ requirements for high quality and reliable products. To ensure that products manufactured by others are consistent with our standards, we manage all key aspects of the production process, including establishing product specifications, selecting the components to be used to produce our products, selecting the suppliers of these components and negotiating the prices for these components. In addition, we work with our suppliers to improve process control and product design. As of December 31, 2006, we had 11 full-time employees engaged in manufacturing and logistics activities, focused on coordinating product management and supply chain activities between SCM and our contract manufacturers.

 

We rely upon a limited number of suppliers of several key components of our products. For example, we currently utilize the foundry services of Atmel and Samsung to produce our ASICs for smart cards readers; we use chips and antenna components from Philips in our contactless smart card readers; and we use various mechanical

components in our smart card readers from TaiSol Electronics. Wherever possible, we have added a second source of supply for mechanical components such as printed circuit boards or casing. However, risk remains that we may be adversely impacted by an inadequate supply of components, price increases, late deliveries or poor component quality. In addition, some of the basic components we use in our products, such as flash media, may at any time be in great demand. This can result in the components not being available to us timely or at all, particularly if larger companies have ordered more significant volumes of the components; or in higher prices being charged for the components. Disruption or termination of the supply of components or software used in our products could delay shipments of our products, which could have a material adverse effect on our business and operating results. These delays could also damage relationships with current and prospective customers.

 

Competition

 

The PC Security and Flash Media Reader markets are competitive and characterized by rapidly changing technology. We believe that competition in these markets is likely to intensify as a result of anticipated increased demand for digital access products. We currently experience competition from a number of sources, including:

 

 

We also experience indirect competition from certain of our customers who currently offer alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these and other parties that develop digital data security products based upon approaches similar to or different from those employed by us. In addition, the market for digital data security and access control products may ultimately be dominated by approaches other than the approach marketed by us.

 

We believe that the principal competitive factors affecting the market for our products include:

 

 

While we believe that we compete favorably with respect to these factors, we may not be able to continue to successfully compete due to these or other factors and competitive pressures we face could materially and adversely affect our business and operating results.

 

Proprietary Technology and Intellectual Property

 

Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights, which afford only limited protection. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable, and that any issued patent will fail to provide us with any competitive advantages.

 

There has been a great deal of litigation in the technology industry regarding intellectual property rights and from time to time we may be required to use litigation to protect our proprietary technology. This may result in our incurring substantial costs and there is no assurance that we would be successful in any such litigation. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software without authorization. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to the same extent as do the laws of the United States. Because many of our products are sold and a substantial portion of our business is conducted outside the United States, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology, duplicate our products or design around patents or other intellectual property rights. If we are unsuccessful in protecting our intellectual property or our products or technologies are duplicated by others, our business could be harmed.

 

In addition, we have from time to time received claims that we are infringing upon third parties’ intellectual property rights. Future disputes with third parties may arise and these disputes may not be resolved on terms acceptable to us. As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, divert management resources, cause product shipment delays, or require us to redesign our products, accept product returns or to write off inventory. Any of these events could have a material adverse effect on our business and operating results.

 

Employees

 

As of December 31, 2006, we had 156 full-time employees, of which 83 were engaged in engineering, research and development; 26 were engaged in sales and marketing; 11 were engaged in manufacturing and logistics; and 36 were engaged in general management and administration. We are not subject to any collective bargaining agreements and, to our knowledge, none of our employees are currently represented by a labor union. To date, we have experienced no work stoppages and believe that our employee relations are generally good.

 

Foreign Operations

 

Our corporate headquarters are in Ismaning, Germany and we lease small sales and marketing facilities in California and in Japan. We conduct our research and development activities from our facility in Chennai, India.

 

Please see Note 11 to our consolidated financial statements attached to this Annual Report on Form 10-K which are included in response to Item 8 for financial information about geographic areas in which we have operations.

 

Availability of SEC Filings

 

We make available through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports free of charge as soon as reasonably practicable after we electronically file such material with the Securities and Exchange Commission. Our Internet address is www.scmmicro.com. The content on our website is not incorporated by reference into this filing.

 

Our business and results of operations are subject to numerous risks, uncertainties and other factors that you should be aware of, some of which are described below. The risks, uncertainties and other factors described below are not the only ones facing our company. Additional risks, uncertainties and other factors not presently known to us or that we currently deem immaterial may also impair our business operations.

 

Any of the risk, uncertainties and other factors could have a materially adverse effect on our business, financial condition, results of operations, cash flows or product market share and could cause the trading price of our common stock to decline substantially.

 

We have incurred operating losses and may not achieve profitability.

 

We have a history of losses with an accumulated deficit of $191.7 million as of December 31, 2006. We may continue to incur losses in the future and may be unable to achieve or maintain profitability.

 

Our quarterly and annual operating results will likely fluctuate.

 

Our quarterly and annual operating results have varied greatly in the past and will likely vary greatly in the future depending upon a number of factors. Many of these factors are beyond our control. Our revenues, gross profit and operating results may fluctuate significantly from quarter to quarter due to, among other things:

 

 

Due to these and other factors, our revenues may not increase or even remain at their current levels. In particular, although we have indicated that we believe we will be profitable for fiscal 2007 as a whole, we may not be able to reach profitability in any quarterly period of 2007 or for the year as a whole, because of the risks outlined above. Because a majority of our operating expenses are fixed, a small variation in our revenues can cause significant variations in our operational results from quarter to quarter and our operating results may vary significantly in future periods. Therefore, our historical results may not be a reliable indicator of our future performance.

 

It is difficult to estimate operating results prior to the end of a quarter.

 

We do not typically maintain a significant level of backlog. As a result, revenue in any quarter depends on contracts entered into or orders booked and shipped in that quarter. Historically, many of our customers have tended to make a significant portion of their purchases towards the end of the quarter, in part because they believe they are able to negotiate lower prices and more favorable terms. This trend makes predicting revenues difficult. The timing of closing larger orders increases the risk of quarter-to-quarter fluctuation in revenues. If orders forecasted for a specific group of customers for a particular quarter are not realized or revenues are not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected. In addition, from time to time, we may experience unexpected increases in demand for our products resulting from fluctuations in our customers’ deployment schedules as they implement smart card-based programs. These occurrences are not always predictable and can have a significant impact on our results in the period in which they occur.

 

Our listing on both the NASDAQ Stock Market and the Prime Standard of the Frankfurt Stock Exchange exposes our stock price to additional risks of fluctuation.

 

Our common stock is listed both on the NASDAQ Stock Market and the Prime Standard of the Frankfurt Stock Exchange and we typically experience a significant volume of our trading on the Prime Standard. Because of this, factors that would not otherwise affect a stock traded solely on the NASDAQ Stock Market may cause our stock price to fluctuate. For example, European investors may react differently and more positively or negatively than investors in the United States to events such as acquisitions, dispositions, one-time charges and higher or lower than expected revenue or earnings announcements. A positive or negative reaction by investors in Europe to such events could cause our stock price to increase or decrease significantly. The European economy and market conditions in general, or downturns on the Prime Standard specifically, regardless of the NASDAQ Stock Market conditions, also could negatively impact our stock price.

 

Our stock price has been and is likely to remain volatile.

 

Over the past few years, the NASDAQ Stock Market and the Prime Standard of the Frankfurt Exchange have experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. Volatility in our stock price on either or both exchanges may result from a number of factors, including, among others:

 

 

 

In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

 

A significant portion of our sales typically comes from a small number of customers and the loss of one or more of these customers or variability in the timing of orders could negatively impact our operating results.

 

Our products are generally targeted at OEM customers in the consumer electronics, digital photography and computer industries, as well as the government sector and corporate enterprises. Sales to a relatively small number of customers historically have accounted for a significant percentage of our revenues. For example, sales to our top ten customers accounted for approximately 53% of revenue in 2006, 54% of revenue in 2005 and 54% of revenue in 2004. We expect that sales of our products to a relatively small number of customers will continue to account for a high percentage of our total sales for the foreseeable future, particularly in our Flash Media Reader business. The loss of a customer or reduction of orders from a significant customer, including those due to product performance issues, changes in customer buying patterns, or market, economic or competitive conditions in our market segments, would increase our dependence on a smaller group of our remaining customers. Likewise, variations in the timing or patterns of customer orders could also increase our dependence on other customers in any particular period. Dependence on a small number of customers and variations in order levels period to period could result in decreased revenues, decreased margins, and/or inventory or receivables write-offs and otherwise harm our business and operating results.

 

Sales of our products depend on the development of emerging applications in our target markets.

 

We sell our products primarily to address emerging applications that have not yet reached a stage of mass adoption or deployment. For example, we sell our smart card readers for use in e-passport programs in Europe and for authentication of personnel within various U.S. government agencies, both of which are new applications that are not yet widely implemented. If demand for products for applications such as these does not develop further and grow sufficiently, our revenue and gross profit margins could decline or fail to grow. We cannot predict the future growth rate, if any, or size or composition of the market for any of our products. Our target markets have not consistently grown or developed as quickly as we had expected, and we have experienced delays in the development of new products designed to take advantage of new market opportunities. Since new target markets are still evolving, it is difficult to assess the competitive environment or the size of the market that may develop. The demand and market acceptance for our products, as is common for new technologies, is subject to high levels of uncertainty and risk and may be influenced by various factors, including, but not limited to, the following:

 

 

 

Our products may have defects, which could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in costly litigation or liability.

 

Products such as our smart card readers and digital media readers may contain defects for many reasons, including defective design or manufacture, defective material or software interoperability issues. Often, these defects are not detected until after the products have been shipped. If any of our products contain defects or perceived defects or have reliability, quality or compatibility problems or perceived problems, our reputation might be damaged significantly, we could lose or experience a delay in market acceptance of the affected product or products and we might be unable to retain existing customers or attract new customers. In addition, these defects could interrupt or delay sales or our ability to recognize revenue for products shipped. In the event of an actual or perceived defect or other problem, we may need to invest significant capital, technical, managerial and other resources to investigate and correct the potential defect or problem and potentially divert these resources from other development efforts. If we are unable to provide a solution to the potential defect or problem that is acceptable to our customers, we may be required to incur substantial product recall, repair and replacement and even litigation costs. These costs could have a material adverse effect on our business and operating results.

 

In addition, because our customers rely on our PC Security products to prevent unauthorized access to PCs, networks or facilities, a malfunction of or design defect in our products (or even a perceived defect) could result in legal or warranty claims against us for damages resulting from security breaches. If such claims are adversely decided against us, the potential liability could be substantial and have a material adverse effect on our business and operating results. Furthermore, the publicity associated with any such claim, whether or not decided against us, could adversely affect our reputation. In addition, a well-publicized security breach involving smart card-based and other security systems could adversely affect the market’s perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. Any of the foregoing events could cause demand for our products to decline, which would cause our business and operating results to suffer.

 

If we do not accurately anticipate the correct mix of products that will be sold, we may be required to record charges related to excess inventories.

 

Due to the unpredictable nature of the demand for our products, we are required to place orders with our suppliers for components, finished products and services in advance of actual customer commitments to purchase these products. Significant unanticipated fluctuations in demand could result in costly excess production or inventories. In order to minimize the negative financial impact of excess production, we may be required to significantly reduce the sales price of the product to increase demand, which in turn could result in a reduction in the value of the original inventory purchase. If we were to determine that we could not utilize or sell this inventory, we may be required to write down its value, which we have done in the past. Writing down inventory or reducing product prices could adversely impact our cost of revenues and financial condition.

 

Our business could suffer if our third-party manufacturers cannot meet production requirements.

 

Our products are manufactured outside the United States by contract manufacturers. Our reliance on foreign manufacturing poses a number of risks, including, but not limited to:

 

 

 

In the second half of 2005 we shifted all product and component manufacturing previously performed by our employees to contract manufacturers, while continuing to manage demand planning, procurement and other related activities within SCM. The exclusive use of contract manufacturing reduces the flexibility we have in our operations and requires us to exercise strong planning and management in order to ensure that our products are manufactured on schedule, to correct specifications and to a high standard of quality. If any of our contract manufacturers cannot meet our production requirements, we may be required to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. We may be unable to identify or qualify new contract manufacturers in a timely manner or at all or with reasonable terms and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative manufacturers would materially and adversely affect our business and operating results. In addition, if we are not successful at managing the contract manufacturing process, the quality of our products could be jeopardized or inventories could be too low or too high, which could result in damage to our reputation with our customers and in the marketplace, as well as possible write-offs of excess inventory.

 

We have a limited number of suppliers of key components, and may experience difficulties in obtaining components for which there is significant demand.

 

We rely upon a limited number of suppliers of several key components of our products. For example, we currently utilize the foundry services of Atmel and Samsung to produce our ASICs for smart cards readers; we use chips and antenna components from Philips in our contactless smart card readers; and we use various mechanical components in our smart card readers from TaiSol Electronics. Our reliance on a limited number of suppliers may expose us to various risks including, without limitation, an inadequate supply of components, price increases, late deliveries and poor component quality. This could result in components not being available to us in a timely manner or at all, particularly if larger companies have ordered more significant volumes of those components, or in higher prices being charged for components. Disruption or termination of the supply of components or software used in our products could delay shipments of these products. These delays could have a material adverse effect on our business and operating results and could also damage relationships with current and prospective customers.

 

Our future success will depend on our ability to keep pace with technological change and meet the needs of our target markets and customers.

 

The markets for our products are characterized by rapidly changing technology and the need to meet market requirements and to differentiate our products through technological enhancements, and in some cases, price. Our customers’ needs change, new technologies are introduced into the market, and industry standards are still evolving. As a result, product life cycles are often short and difficult to predict, and frequently we must develop new products quickly in order to remain competitive in light of new market requirements. Rapid changes in technology, or the adoption of new industry standards, could render our existing products obsolete and unmarketable. If a product is deemed to be obsolete or unmarketable, then we might have to reduce revenue expectations or write down inventories for that product.

 

Our future success will depend upon our ability to enhance our current products and to develop and introduce new products with clearly differentiated benefits that address the increasingly sophisticated needs of our customers and that keep pace with technological developments, new competitive product offerings and emerging industry standards. We must be able to demonstrate that our products have features or functions that are clearly differentiated from existing or anticipated competitive offerings, or we may be unsuccessful in selling these products. In addition, in cases where we are selected to supply products based on features or capabilities that are still under development, we must be able to complete our product design and delivery process on a timely basis, or risk losing current and any future revenue from those products. In developing our products, we must collaborate closely with our customers, suppliers and other strategic partners to ensure that critical development, marketing and distribution projects proceed in a coordinated manner. Also, this collaboration is important because these relationships increase our exposure to information necessary to anticipate trends and plan product development. If any of our current relationships terminate or otherwise deteriorate, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, our product development and marketing efforts may be adversely affected, and we could lose sales. We expect that our product development efforts will continue to require substantial investments and we may not have sufficient resources to make the necessary investments.

 

In some cases, we depend upon partners who provide one or more components of the overall solution for a customer in conjunction with our products. If our partners do not adapt their products and technologies to new market or distribution requirements, or if their products do not work well, then we may not be able to sell our products into certain markets.

 

Because we operate in markets for which industry-wide standards have not yet been fully set, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines. If any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected.

 

Our markets are highly competitive.

 

The markets for our products are competitive and characterized by rapidly changing technology. We believe that the principal competitive factors affecting the markets for our products include:

 

 

We currently experience competition from a number of companies in each of our target market segments and we believe that competition in our markets is likely to intensify as a result of anticipated increased demand for secure digital access products. We may not be successful in competing against offerings from other companies and could lose business as a result.

 

We also experience indirect competition from certain of our customers who currently offer alternative products or are expected to introduce competitive products in the future. For example, we sell our products to many OEMs who incorporate our products into their offerings or who resell our products in order to provide a more complete solution to their customers. If our OEM customers develop their own products to replace ours, this would result in a loss of sales to those customers, as well as increased competition for our products in the marketplace. In addition, these OEM customers could cancel outstanding orders for our products, which could cause us to write down inventory already designated for those customers. We may in the future face competition from these and other parties that develop digital data security products based upon approaches similar to or different from those employed by us. In addition, the market for digital information security and access control products may ultimately be dominated by approaches other than the approach marketed by us.

 

Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products and may be able to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, new competitors, or alliances among competitors, may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share.

 

Sales of our smart card readers to the U.S. government are impacted by uncertainty of timelines and budgetary allocations, as well as by the delay of standards for information technology (IT) projects.

 

Historically, we have sold a significant proportion of our smart card reader products to the U.S. government and we anticipate that some portion of our future revenues will also come from this sector. The timing of U.S. government smart card projects is not always certain. For example, while the U.S. government has announced plans for several new smart card-based security projects, few have yet reached a stage of sustained high volume card or reader deployment, in part due to delays in reaching agreement on specifications for a new federally mandated set of identity credentials. In addition, government expenditures on IT projects have varied in the past and we expect them to vary in the future. As a result of shifting priorities in the federal budget and in the Department of Homeland Security, U.S. government spending may be reallocated away from IT projects, such as smart card deployments. The slowing or delay of government projects for any reason could negatively impact our sales.

 

We may have to take back unsold inventory from our customers.

 

If demand is less than anticipated, customers may ask that we accept returned products that they do not believe they can sell. We may determine that it is in our best interest to accept returns in order to maintain good relations with our customers. Returns may increase beyond present levels in the future. Once these products have been returned, we may be required to take additional inventory reserves to reflect the decreased market value of slow-selling returned inventory, even if the products are in good working order.

 

Large stock holdings outside the U.S. make it difficult for us to achieve quorum at stockholder meetings and this could restrict, delay or prevent our ability to implement future corporate actions, as well as have other effects, such as the delisting of our stock from the NASDAQ Stock Market.

 

To achieve a quorum at a regular or special stockholder meeting, at least one-third of all shares of our stock entitled to vote must be present at such a meeting in person or by proxy. As of August 7, 2006, the record date for our 2006 Annual Meeting of Stockholders, more than two-thirds of our shares outstanding were held by retail stockholders in Germany, through German banks and brokers. Securities regulations and customs in Germany result in very few German banks and brokers providing our proxy materials to our stockholders in Germany and in very few German stockholders voting their shares even when they do receive such materials. In addition, the absence of a routine “broker non-vote” in Germany typically requires the stockholder to return the proxy card to us before the votes it represents can be counted for purposes of establishing a quorum.

 

We expect that a significant percentage of our shares will continue to be held by retail stockholders in Germany through German banks and brokers. As a result, it is difficult and costly for us, and requires considerable management resources, to achieve a quorum at annual and special meetings of our stockholders, if we are able to do so at all. For example, because of the large pool of shares in Germany that were not voted, we had to adjourn our 2006 Annual Meeting of Stockholders from its original date of October 6, 2006, until November 3, 2006, in order to solicit enough votes to achieve quorum. This resulted in additional cost and diversion of management resources from our operations. We may not be successful in obtaining proxies from a sufficient number of our stockholders to constitute a quorum in the future. If we are unable to achieve a quorum at a future annual or special meeting of our stockholders, corporate actions requiring stockholder approval could be restricted, delayed or even prevented. These include, but are not limited to, actions and transactions that may be of benefit to our stockholders, part of our strategic plan or necessary for our corporate governance, such as corporate mergers, acquisitions, dispositions, sales

or reorganizations, financings, stock incentive plans or the election of directors. Even if we are able to achieve a quorum for a particular meeting, some of these actions or transactions require the approval of a majority of the total number of our shares then outstanding, and we may not be successful in obtaining such approval.

 

The future failure to hold an annual meeting of stockholders may result in our being out of compliance with Delaware law and the qualitative listing requirements of the NASDAQ Stock Market, each of which requires us to hold an annual meeting of our stockholders. Our inability to obtain a quorum at any such meeting may not be an adequate excuse for such failure. In accordance with Section 211 of the Delaware General Corporation Law, if there has been a failure to hold an annual meeting, the Court of Chancery may order a meeting to be held upon the application of any stockholder or director. Lack of compliance with the qualitative listing requirements of the NASDAQ Stock Market could result in the delisting of our common stock on the NASDAQ Stock Market. Either of these events would divert management’s attention from our operations and would likely be costly and could also have an adverse effect on the trading price of our common stock.

 

We have global operations, which require significant financial, managerial and administrative resources.

 

Our business model includes the management of separate product lines that address disparate market opportunities that are geographically dispersed. While there is some shared technology across our products, each product line requires significant research and development effort to address the evolving needs of our customers and markets. To support our development and sales efforts, we maintain company offices and business operations in several locations around the world, including Germany, India, Japan and the United States. We also must manage contract manufacturers in Singapore and China. Managing our various development, sales, administrative and manufacturing operations places a significant burden on our financial systems and has resulted in a level of operational spending that is disproportionately high compared to our current revenue levels.

 

Operating in diverse geographic locations also imposes significant burdens on our managerial resources. In particular, our management must:

 

 

Any failure to effectively manage our operations globally could have a material adverse effect on our business and operating results.

 

We conduct a significant portion of our operations outside the United States. Economic, political, regulatory and other risks associated with international sales and operations could have an adverse effect on our results of operation.

 

In addition to our corporate headquarters being located in Germany, we conduct a substantial portion of our business in Europe and Asia. Approximately 57% of our revenue for the year ended December 31, 2006 and approximately 58% of our revenue for the year ended December 31, 2005 were derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to risks associated with foreign operations, any of which could impact our sales and/or our operational performance. These risks include, but are not limited to:

 

 

 

Fluctuations in the valuation of foreign currencies could result in currency exchange losses.

 

A significant portion of our business is conducted in foreign currencies, principally the euro. Fluctuations in the value of foreign currencies relative to the U.S. dollar will continue to cause currency exchange gains and losses. We cannot predict the effect of exchange rate fluctuations upon future quarterly and annual operating results. We may experience currency losses in the future. To date, we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations.

 

Our key personnel are critical to our business, and such key personnel may not remain with us in the future.

 

We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel were to leave and not be replaced with sufficiently qualified and experienced personnel, our business could be adversely affected.

 

We also believe that our future success will depend in large part on our ability to attract and retain highly qualified technical and management personnel. However, competition for such personnel is intense. We may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future.

 

Likewise, as a small, dual-traded company, we are challenged to identify, attract and retain experienced professionals with diverse skills and backgrounds who are qualified and willing to serve on our Board of Directors. The increased burden of regulatory compliance under the Sarbanes-Oxley Act of 2002 creates additional liability and exposure for directors and financial losses in our business and lack of growth in our stock price make it difficult for us to offer attractive director compensation packages. If we are not able to attract and retain qualified board members, our ability to practice a high a level of corporate governance could be impaired.

 

We are subject to a lengthy sales cycle and additional delays could result in significant fluctuations in our quarterly operating results.

 

Our initial sales cycle for a new customer usually takes a minimum of six to nine months. During this sales cycle, we may expend substantial financial and managerial resources with no assurance that a sale will ultimately result. The length of a new customer’s sales cycle depends on a number of factors, many of which we may not be able to control. These factors include the customer’s product and technical requirements and the level of competition we face for that customer’s business. Any delays in the sales cycle for new customers could delay or reduce our receipt of new revenue and could cause us to expend more resources to obtain new customer wins. If we are unsuccessful in managing sales cycles, our business could be adversely affected.

 

We face risks associated with strategic transactions.

 

A component of our ongoing business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. We have in the past acquired or made, and from time to time in the future may acquire or make, investments in companies, products and technologies that we believe are complementary to our existing businesses, products and technologies. Any future acquisition could expose us to significant risks, including, without limitation, the use of our limited cash balances or potentially

dilutive stock offerings to fund such acquisitions; costs of any necessary financing, which may not be available on reasonable terms or at all; accounting charges we might incur in connection with such acquisitions; the difficulty and expense of integrating personnel, technologies, customer, supplier and distributor relationships, marketing efforts and facilities acquired through acquisitions; diversion of our management resources; failure to realize anticipated benefits; costly fees for legal and transaction-related services and the unanticipated assumption of liabilities. Any of the foregoing could have a material adverse effect on our financial condition and results of operations. We may not be successful with any such acquisition.

 

Our business strategy also contemplates divesting portions of our business from time to time, if and when we believe we would be able to realize greater value for our stockholders in so doing. We have in the past sold, and may from time to time in the future sell, all or one or more portions of our business. For example, in the second quarter of 2006, we completed the sale of our DTV solutions business to Kudelski. Any divestiture or disposition could expose us to significant risks, including, without limitation, costly fees for legal and transaction-related services; diversion of management resources; loss of key personnel; and reduction in revenue. Further, we may be required to retain or indemnify the buyer against certain liabilities and obligations in connection with any such divestiture or disposition and we may also become subject to third party claims arising out of divestiture or disposition. In addition, any such divestiture or disposition could result in our recognition of an operating loss to the extent that the proceeds received by us in the divestiture or disposition are less than the book value of the assets sold. Regarding the sale of our DTV solutions business in particular, risks include our ability to collect the remaining $2 million in disputed payments for the business, and our ability to improve operational efficiencies or reduce operating costs through the transfer of our DTV solutions business. Failure to overcome these risks could have a material adverse effect on our financial condition and results of operations.

 

We may be exposed to risks of intellectual property infringement by third parties.

 

Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights, which afford only limited protection. We may not be successful in protecting our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable or that any issued patent will fail to provide us with any competitive advantages.

 

There has been a great deal of litigation in the technology industry regarding intellectual property rights, and from time to time we may be required to use litigation to protect our proprietary technology. This may result in our incurring substantial costs and we may not be successful in any such litigation.

 

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software without authorization. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to the same extent as do the laws of the United States. Because many of our products are sold and a significant portion of our business is conducted outside the United States, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate. There is a risk that our competitors will independently develop similar technology or duplicate our products or design around patents or other intellectual property rights. If we are unsuccessful in protecting our intellectual property or our products or technologies are duplicated by others, our business could be harmed.

 

Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

 

We prepare our financial statements to conform with generally accepted accounting principles, or GAAP, in the United States. These accounting principles are subject to interpretation by the Financial Standards Accounting Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various other bodies formed to interpret and create appropriate accounting rules and policies. A change in those rules or policies could have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. For example, under the recently issued Financial Accounting Standard Board Statement No. 123(R), as of January 1, 2006 we were required to apply certain expense recognition

provisions to share-based payments to employees using the fair value method. Adoption of SFAS 123R resulted in our recording stock option compensation expense of $0.6 million in fiscal year 2006. Any other changes in accounting policies in the future may also result in significant accounting charges. See Note 2 to our consolidated financial statements attached to the Annual Report on Form 10-K for the expense disclosures under SFAS No. 123R.

 

We face costs and risks associated with maintaining effective internal controls over financial reporting.

 

Under Section 302 of the Sarbanes-Oxley Act of 2002, on a quarterly basis our management is required to make certain certifications regarding our disclosure controls and internal controls over financial reporting. The process of maintaining and evaluating the effectiveness of these controls is expensive, time-consuming and requires significant attention from our management and staff. We have found a material weakness in our internal controls in the past and we cannot be certain in the future that we will be able to report that our controls are without material weakness or to complete our evaluation of those controls in a timely fashion.

 

If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, we may discover material weaknesses that we would then be required to disclose. We may not be able to accurately or timely report on our financial results, and we might be subject to investigation by regulatory authorities. As a result, the financial position of our business could be harmed; current and potential future shareholders could lose confidence in us and/or our reported financial results, which may cause a negative effect on the trading price of our common stock; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

 

In addition, all internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to the preparation and presentation of financial statements. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

 

We face risks from litigation.

 

From time to time, we may be subject to litigation, which could include claims regarding infringement of the intellectual property rights of third parties, product defects, employment-related claims, and claims related to acquisitions, dispositions or restructurings. For example, in December 2005, a complaint was filed in France against SCM Microsystems GmbH, one of our wholly-owned subsidiaries, by Aston France S.A. alleging participation by SCM Microsystems GmbH in the counterfeiting of Aston’s conditional access modules and claiming damages in the amount of approximately $69 million. While this claim was subsequently withdrawn, any such claims or litigation may be time-consuming and costly, divert management resources, cause product shipment delays, require us to redesign our products, require us to accept returns of products and to write off inventory, or have other adverse effects on our business. Any of the foregoing could have a material adverse effect on our results of operations and could require us to pay significant monetary damages.

 

We expect the likelihood of intellectual property infringement and misappropriation claims may increase as the number of products and competitors in our markets grows and as we increasingly incorporate third-party technology into our products. As a result of infringement claims, we could be required to license intellectual property from a third party or redesign our products. Licenses may not be offered when we need them or on acceptable terms. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments or we may be required to license some of our intellectual property to others in return for such licenses. If we are unable to obtain a license that is necessary for us or our third party manufacturers to manufacture our allegedly infringing products, we could be required to suspend the manufacture of products or stop our suppliers from using processes that may infringe the rights of third parties. We may also be unsuccessful in redesigning our products. Our suppliers and customers may be subject to infringement claims based on intellectual property included in our products. We have historically agreed to indemnify our suppliers and customers for patent infringement claims relating to our products. The scope of this indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney’s fees. We may periodically engage in litigation as a

result of these indemnification obligations. Our insurance policies exclude coverage for third-party claims for patent infringement.

 

We are exposed to credit risk on our accounts receivable. This risk is heightened in times of economic weakness.

 

We distribute our products both through third-party resellers and directly to certain customers. A substantial majority of our outstanding trade receivables are not covered by collateral or credit insurance. We may not be able to monitor and limit our exposure to credit risk on our trade and non-trade receivables, we may not be effective in limiting credit risk and avoiding losses. Additionally, if the global economy and regional economies deteriorate, one or more of our customers could experience a weakened financial condition and we could incur a material loss or losses as a result.

 

Provisions in our agreements, charter documents, Delaware law and our rights plan may delay or prevent our acquisition by another company, which could decrease the value of your shares.

 

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us or enter into a material transaction with us without the consent of our Board of Directors. These provisions include a classified Board of Directors and limitations on actions by our stockholders by written consent. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, our Board of Directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.

 

We have adopted a stockholder rights plan. The triggering and exercise of the rights would cause substantial dilution to a person or group that attempts to acquire us on terms or in a manner not approved by our Board of Directors, except pursuant to an offer conditioned upon redemption of the rights. While the rights are not intended to prevent a takeover of our company, they may have the effect of rendering more difficult or discouraging an acquisition of us that was deemed to be undesirable by our Board of Directors.

 

These provisions will apply even if the offer were to be considered adequate by some of our stockholders. Also, because these provisions may be deemed to discourage a change of control, they could decrease the value of our common stock.

 

SCM has no unresolved comments from the Securities and Exchange Commission.

 

Our corporate headquarters are in Ismaning, Germany, where we lease approximately 36,000 square feet pursuant to a lease agreement that expires November 15, 2008. We also lease small sales and marketing facilities in California and in Japan. We own a research and development facility of approximately 17,600 square feet in Chennai, India. We consider these properties as adequate for our business needs.

 

We also lease approximately 69,000 square feet at a facility in Guilford, Connecticut, where the lease term expires February 2011. During 2003, we discontinued operations at the Guilford facility and we are currently attempting to sublease the unused space. We lease premises of approximately 11,200 square feet in the U.K. where the lease term expires September 2016. During 2003, we discontinued operations in the U.K. Currently, we have subleased the premises for a part of the remaining leasing period to an unrelated business.

 

From time to time, we could be subject to claims arising in the ordinary course of business or could be a defendant in lawsuits. While the outcome of such claims or other proceedings cannot be predicted with certainty, our management currently expects that any such liabilities, to the extent not provided for by insurance or otherwise, would not have a material adverse effect on our financial condition, results of operations or cash flows.

 

In December 2005, a complaint was filed in France against SCM Microsystems GmbH (“SCM GmbH”), one of our wholly-owned subsidiaries, by Aston France S.A.S., alleging participation by SCM GmbH in the counterfeiting of Aston’s conditional access modules. Aston was one of SCM GmbH’s Digital Television customers until November 2002, when SCM GmbH entered into a settlement agreement (the “2002 Settlement”) with Aston that included SCM GmbH’s agreement to cancel binding orders made by Aston and the return by Aston of unsold inventory to SCM GmbH. In April 2005, SCM GmbH entered into an agreement with Aston whereby Aston agreed to (i) seek a refund from the French government for approximately $4.7 million in value added taxes that SCM GmbH had paid to the French government with respect to products that Aston purchased from SCM GmbH prior to November 2002 and (ii) remit the refunded amount to SCM GmbH. On October 13, 2005 the French government refunded approximately $4.7 million (the “VAT Refund”) to Aston, but Aston did not remit such amount to SCM GmbH.

 

In its complaint, Aston claimed damages in the amount of EUR 57 million. Further, in November 2005 Aston obtained a preliminary injunction in France to block a payment obligation by Aston to SCM GmbH of the VAT Refund. On February 2, 2006, SCM GmbH filed a counterclaim against Aston in Germany alleging damages in the amount of approximately EUR 11.5 million resulting from Aston’s fraudulent misrepresentation and breach of contract in connection with the 2002 Settlement.

 

On June 6, 2006, following a court decision in favor of SCM GmbH, Aston paid to SCM GmbH the full amount of the VAT Refund, including currency gains, in the amount of US$5 million.

 

Effective January 22, 2007, all disputes between and among the parties were settled and withdrawn, with no further payment between the parties, apart from reimbursement in a nominal amount from SCM GmbH to Aston of court awarded legal fees previously paid by Aston to SCM GmbH.

 

For information related to matters submitted to a vote of our security holders at our annual meeting held on November 3, 2006, please see Part II, Item 4 of our quarterly report on Form 10-Q for the quarter ended September 30, 2006, filed with the Securities and Exchange Commission on November 14, 2006.

 

Price Range of Common Stock; Number of Holders; Dividends

 

Our common stock is quoted on the Nasdaq Stock Market’s National Market under the symbol “SCMM” and on the Prime Standard of the Frankfurt Stock Exchange under the symbol “SMY.” According to data available at March 13, 2007, we estimate we had approximately 12,211 stockholders of record and beneficial stockholders. The following table sets forth the high and low closing prices of our common stock for the periods indicated.

 

 

We have never declared or paid cash dividends on our common stock or other securities. We currently anticipate that we will retain all of our future earnings for use in the expansion and operation of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

The disclosure required by Item 201(d) of Regulation S-K is included in Item 12 and incorporated by reference to our 2007 Proxy Statement.

 

Recent Sales of Unregistered Securities

 

None.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

None.

 

The table below has been restated to account for the sale of our DTV solutions business in fiscal 2006 and the sale of our retail Digital Media and Video business in fiscal 2003, with both businesses treated as discontinued operations.

 

SCM MICROSYSTEMS, INC.

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

 

 

 

The following information should be read in conjunction with the audited consolidated financial statements and notes thereto attached to this Annual Report on Form 10-K. We also urge readers to review and consider our disclosures describing various factors that could affect our business, including the disclosures under the headings “Risk Factors” in this Annual Report on Form 10-K.

 

Overview

 

SCM Microsystems designs, develops and sells hardware, software and silicon solutions that enable people to conveniently and securely access digital content and services. We sell our secure digital access products into two market segments: PC Security and Flash Media Readers. Our products are sold primarily to original equipment providers, or OEMs, who typically either bundle our products with their own solutions, or repackage our products for resale to their customers. Our OEM customers include: government contractors, systems integrators, large enterprises, computer manufacturers, as well as banks and other financial institutions for our smart card readers; and computer and photographic equipment manufacturers for our digital media readers. We sell and license our products through a direct sales and marketing organization, as well as through distributors, value added resellers and systems integrators worldwide.

 

On May 22, 2006 we completed the sale of our DTV solutions business to Kudelski S.A. As a result, we have accounted for the DTV solutions business as discontinued operations, and the statements of operations and cash flows for all periods presented reflect the discontinuance of this business. Previously, our operations also included a retail Digital Media and Video business that we sold in the third quarter of 2003. As a result of this sale and divestiture, beginning in the second quarter of fiscal 2003, we have accounted for the retail Digital Media and Video business as a discontinued operation, and statements of operations for all periods presented have been reclassified to reflect the discontinuance of this business. For comparability, certain 2002 figures have been reclassified, where appropriate, to conform to the financial statement presentation used in 2003, 2004, 2005 and 2006. (See Note 3 to our consolidated financial statements attached to this Annual Report on Form 10-K.)

 

In our continuing operations, revenues have grown over the past few quarters, but the rate and sustainability of this progress is unpredictable due to significant variations in demand for our products quarter to quarter. This is particularly true for our PC Security products, many of which are targeted at new smart card-based ID programs run by various U.S., European and Asian governments. Sales of our smart card readers and chips for government programs are impacted by testing and compliance schedules of government bodies as well as roll-out schedules for application deployments, both of which contribute to variability in demand from quarter to quarter. Sales of our Flash Media Reader products are less subject to this variability; however, we are dependent on a small number of customers in both of our primary product segments, which can result in fluctuations in sales levels from one period to another.

 

We have adopted a strategy to grow revenue that is based on introducing new PC Security and Flash Media Reader products to address new market opportunities. During 2006, we experienced increased demand for our smart card readers, primarily from the government sector, where we began to provide readers for new and emerging programs such as e-passports and e-healthcare. While we believe that e-Passport and other government authentication programs will continue to grow in the future and that we will continue to play an active role in providing smart card readers to these programs, it is very difficult to estimate the level or timing of demand in any given period.

 

In both our PC Security and Flash Media Reader businesses, pricing pressure has increased over the last several quarters, resulting in lower gross profits. To address an increasingly competitive environment, we have put in place cost reduction programs that resulted in margin improvement in the fourth quarter of 2006 and that we believe should result in stable margin levels going forward.

 

We have taken measures to reduce operating expenses over the last several quarters, the bulk of which have been centered around the outsourcing of our manufacturing operations and the consolidation of facilities and functions. Beginning in October 2005, we began the closure of our Singapore manufacturing facility and shifted the manufacturing of our products and components to external contract manufacturers in Singapore and China. During fiscal 2006, we completed the closure of our Singapore office and moved all corporate finance and compliance

functions from California to Germany. In addition, during 2006 we reduced headcount and the use of outside contract personnel, and further curtailed marketing expenses such as tradeshow participation. The full effect of these cost cutting actions was not experienced until the fourth quarter of 2006, when our GAAP operating expenses decreased from an average of $5.7 million for the first three quarters of fiscal 2006 to $3.5 million in the fourth quarter.

 

Critical Accounting Policies and Estimates

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, bad debts, inventories, asset impairment, deferred tax assets, accrued warranty reserves, restructuring costs, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Management believes the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

 

 

Recent Accounting Pronouncements

 

In April 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FASB Interpretation No. 46(R)-6 (“FSP FIN 46(R)-6”), which addresses how a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as amended (“FIN 46(R)”). The variability that is considered in applying FIN 46(R) affects the determination of (a) whether the entity is a variable interest entity, (b) which interests are variable interests in the entity and (c) which party, if any, is the primary beneficiary of the variable interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN 46(R)-6 provides additional guidance to consider for determining variability. FSP FIN 46(R)-6 is effective beginning the first day of the first reporting period beginning after June 15, 2006. After evaluating FSP FIN 46(R)-6, we determined that there is no impact to our consolidated financial position, results of operations or cash flows from its adoption.

 

In June 2006, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation) (“Issue No. 06-03”). Under Issue No. 06-03, a company must disclose its accounting policy regarding the gross or net presentation of certain taxes. If taxes included in gross revenues are significant, a company must disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of this Issue are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity’s activities over a period of time, such as gross receipts taxes, are not within the scope of the issue. Issue No. 06-03 is effective for the first annual or interim reporting period beginning after December 15, 2006. After evaluating Issue No. 06-03, we determined that there is no impact to our consolidated financial position, results of operations or cash flows from its adoption.

 

In July 2006, the FASB issued FASB Interpretation No. 48 Accounting For Uncertain Tax Positions (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption are to be accounted for as an adjustment to the beginning balance of retained earnings.

 

We have completed our initial evaluation of the impact of the January 1, 2007, adoption of FIN 48 and determined, that such adoption will most likely result in a reduction of our disclosed income taxes payable of $1.9 million as of December 31, 2006. The expected reduction of income taxes payable will be accounted for as an increase to the January 1, 2007 beginning balance of retained earnings. Our expectation of the impact from the adoption of FIN 48 is subject to revision as management completes its analysis.

 

In September 2006, the Securities and Exchange Commission (“SEC”) published Staff Accounting Bulletin (SAB) No 108. SAB 108 expresses the staff views regarding the process of quantifying financial statement misstatements. The bulletin prescribes the use of “rollover” and “iron curtain” approaches in quantifying misstatements. “Rollover” approach quantifies a misstatement based on the amount of the error originating in the current year income statement. “Iron curtain” approach quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the year, irrespective of the misstatement’s year(s) of origination. The statement is effective immediately. We did not have any misstatements that were determined to be material on the basis of either of the approaches mentioned above.

 

In September 2006, FASB issued SFAS No. 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for the fiscal year beginning January 1, 2008. We are currently evaluating the impact of the provisions of SFAS 157 on our financial position, results of operations and cash flows and do not believe the impact of the adoption will be material.

 

Results of Operations

 

The following table sets forth our statements of operations as a percentage of net revenue for the periods indicated:

 

We sell our secure digital access products into two market segments: PC Security and Flash Media Readers.

 

 

Revenue

 

The following table sets forth our annual revenues and year-to-year change in revenues by product segment for the fiscal years ended December 31, 2006, 2005 and 2004:

 

 

Fiscal 2006 Revenue Compared with Fiscal 2005 Revenue

 

Revenue for the year ended December 31, 2006 was $33.6 million, an increase of 20% from $27.9 million in 2005. This increase was driven by higher demand for our PC Security products, offset by a slight decrease in sales of Flash Media Reader products. Sales of our PC Security products accounted for 71% and sales of our Flash Media Reader products accounted for 29% of total revenue in 2006.

 

Sales of our PC Security products increased 36% to $23.7 million in 2006, compared with $17.4 million in 2005. This product line consists of smart card readers and related chip technology that are utilized principally in security programs where smart cards are used to identify and authenticate people in order to control access to computers and computer networks, buildings or other facilities, and border entry points. Revenue in this product line is subject to significant variability based on the size and timing of product orders. The majority of product orders are tied to government or corporate security projects that typically deploy our smart card readers in one or more stages, resulting in order volumes that can range from small to very large over a series of months or years. In 2006, higher revenue levels were primarily the result of higher sales of smart card readers in the United States for U.S. government security projects as well as growth in demand for our products in Europe primarily related to e-passport projects. We believe that potential growth in sales of our PC Security products has been curtailed by the slow pace at which new smart card programs reach a stage requiring high volumes, which directly drives demand for our readers.

 

Revenue from our Flash Media Reader product line decreased 6% from $10.5 million in 2005 to $9.9 million in 2006. Flash Media Reader revenue consists of sales of digital media readers and related ASIC technology used to provide an interface for flash memory cards in computer printers and digital photography kiosks, which are used to download and print digital photos, and in consumer electronics products such as televisions to download and view digital photos. The revenue decrease in 2006 was primarily due to a reduction in the price we were able to charge the primary customer for one of our digital media reader products, as the customer had decided they did not need the advanced functionality provided by components we previously had used in the readers. We therefore began to use simpler and less expensive components and thus the price of the product was lowered.

 

Fiscal 2005 Revenue Compared with Fiscal 2004 Revenue

 

Revenue for the year ended December 31, 2005 was $27.9 million, down 7% from $30.0 million in 2004. Sales of our Security products accounted for 62% and sales of our Flash Media Reader products accounted for 38% of total revenue in 2005.

 

Sales of our PC Security products decreased 13% to $17.4 million in 2005, compared with $20.0 million in 2004. Revenue in this product line is subject to significant variability based on the size and timing primarily of product orders. In 2005, lower revenue levels were primarily the result of fluctuations in order levels, as well as some impact from continued competition for business in Europe, based on price. In particular, we experienced significantly lower sales in the U.S. compared with the prior year period due to the timing of orders for smart card readers for U.S. government security projects.

 

Revenue from our Flash Media Reader product line increased 5% from $10.0 million in 2004 to $10.5 million in 2005. During the first half of 2005, we ceased to sell certain products within this business, which reduced our revenue base significantly. Beginning in the third quarter, we introduced a new category of digital media reader products designed to be embedded in televisions, which helped us to partially offset this revenue loss and stabilize revenue levels.

 

Gross Profit

 

The following table sets forth our gross profit and year-to-year change in gross profit by product segment for the fiscal years ended December 31, 2006, 2005 and 2004:

 

 

Gross profit for 2006 was $11.9 million, or 35% of revenue. During 2006 gross profit for our PC Security products was impacted by increased pricing pressure, offset by the effect of a more favorable product mix as we increased the number of contactless readers sold, particularly for e-passport applications During the fourth quarter of 2006, we experienced an increase in gross profit in our PC Security business primarily due to better inventory management and cost reduction programs established earlier in the year. In our Flash Media Reader business, gross profit was impacted by pricing pressure, as well as by an increasing proportion of lower margin products sold.

 

Gross profit for 2005 was $10.8 million, or 39% of revenue. Our 2005 gross profit was negatively impacted by inventory write-downs of approximately $1.3 million in our PC security segment, severance costs for manufacturing personnel in our Singapore facility of $0.5 million, as well as by pricing pressure, mix of products sold and tooling costs.

 

Gross profit for 2004 was $12.3 million, or 41% of total revenue. Our 2004 gross profit was adversely impacted by inventory write-downs of $0.7 million related to PC Security product inventory and $0.7 million related to Flash Media Reader product inventory.

 

Our gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, inventory write-downs and the cost and availability of components. Accordingly, gross profit percentages are expected to continue to fluctuate from period to period.

 

Operating Expenses

 

Research and Development

 

 

Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. Research and development costs are primarily related to hardware and chip development.

 

We focus the bulk of our research and development activities on the development of products for new and emerging market opportunities. In 2006, we focused primarily on the development of smart card reader technology for the global e-passport market, electronic ID applications and the German e-healthcard program. Research and development expenses were $3.8 million in 2006, or 11% of revenue, compared with $4.1 million in 2005, or 15% of revenue, a decrease of 8%. This decrease was primarily due to a lower level of external resources used, as well as the offsetting effects of approximately $0.2 million of contributions from customer funded development.

 

In 2005, research and development expenses decreased 15% from 2004 levels of $4.8 million, which represented 16% of revenue. This decrease was primarily due to lower headcount and contract service costs and to the offsetting effect of customer funded development contributions of $0.4 million.

 

We expect our research and development expenses to vary based on future project demands.

 

Selling and Marketing

 

 

Selling and marketing expenses consist primarily of employee compensation as well as tradeshow participation and other marketing costs. We focus a significant proportion of our sales and marketing activities on new and emerging market opportunities. In 2006, these opportunities included e-passport, electronic ID applications and the early stages of the e-healthcard program in Germany. Selling and marketing expenses were $7.5 million in 2006, or 22% of revenue, compared with $7.0 million, or 25% of revenue in 2005, an increase of 7%. The increase primarily consisted of $0.3 million in severance costs related to the consolidation and closure of facilities in the third quarter of 2006, as part of the Company’s efforts to lower expenses. We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

 

In 2005, sales and marketing expenses decreased 18% from $8.6 million in 2004, which represented 29% of revenue. This decrease was primarily the result of planned reductions in headcount and tradeshow expenditures as part of the Company’s efforts to lower expenses.

 

During 2004, selling and marketing expenses decreased in the second half of the year as we completed the launch of several new products. While there was an overall decrease in spending, this decrease was offset in part by increased costs associated with the effect of foreign currency exchange related to the payment of European employees in euros.

 

We expect our sales and marketing costs will vary as we continue to align our resources to address existing and new market opportunities.

 

General and Administrative

 

 

General and administrative expenses consist primarily of compensation expenses for employees performing our administrative functions, professional fees arising from legal, auditing and other consulting services.

 

In 2006, general and administrative expenses were $7.5 million, or 22% of revenue, compared with $9.2 million, or 33% of revenue in 2005, a decrease of 18%. The reduction in general and administrative expenses in 2006 primarily related to the consolidation and transfer of our corporate finance and compliance functions from the U.S. to Germany and the transfer of local finance functions from Singapore and the U.S. to Germany. These actions have resulted in a more streamlined and efficient audit process and a decrease in the number of personnel required to prepare our financial statements. The streamlining of general and administrative functions was accompanied by a further reduction in expenditures for third-party professional fees. The majority of the decrease occurred in the fourth quarter of 2006, which also resulted in a more favorable comparison for the year as a whole.

 

General and administrative expenses in 2005 were relatively unchanged from 2004 levels. While the Company initiated cost reduction measures in the second half of 2004, including a small reduction in headcount and a reduction in expenditures for third-party professional fees, these measures were partially offset by increased costs associated with the effect of foreign currency exchange related to the payment of European employees in euros and increased spending related to Sarbanes-Oxley compliance.

 

Amortization of Intangibles

 

Amortization of intangible assets was $0.7 million in 2006, $0.7 million in 2005 and $1.1 million in 2004. Lower amortization amounts in 2005 and 2006 reflect a lower level of intangible assets on our balance sheet.

 

Impairment of Goodwill and Intangibles

 

As required under SFAS No. 142, we evaluate the carrying value of goodwill and indefinite-lived intangible assets on our balance sheet from time to time and we will record a charge for impairment whenever events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable.

 

In 2006 and 2005, no charge for impairment was recorded.

 

In 2004 we concluded that the carrying value of customer relations and core technology relating to a past acquisition was not supportable because the estimate of future cash flows related to these intangible assets was not sufficient to recover the carrying value of such intangibles. Accordingly, we took a charge of $0.4 million under SFAS No. 144 for intangible asset impairment.

 

Restructuring and Other Charges (Credits)

 

During 2006, we recorded restructuring and other charges of $1.4 million, primarily related to severance costs for general and administrative personnel that were affected by our decision to relocate corporate finance and compliance functions from the U.S. to Germany and local finance functions from the U.S. and Singapore to Germany, as well as the outsourcing of our manufacturing operations from our Singapore facility to contract manufacturers. Severance costs for manufacturing personnel of approximately $0.3 million have been recorded in cost of revenue (See Note 8 to our consolidated financial statements attached to this Annual Report on Form 10-K).

 

During 2005, we incurred restructuring and other charges of $0.8 million, which included $0.2 million of severance costs related to a reduction in force of non-manufacturing personnel at our Singapore facility, resulting

from our decision to outsource manufacturing operations to contract manufacturers. Severance costs for manufacturing personnel of $0.5 million were recorded in cost of revenue. (See Note 8 to our consolidated financial statements attached to this Annual Report on Form 10-K.) Restructuring and other charges in 2005 also included $0.1 million primarily related to changes in estimates for European tax related matters.

 

During 2004, we incurred restructuring and other credits related to continuing operations of $0.6 million, which resulted primarily from restructuring costs related to cost reduction actions taken by management during the second half of the year that included employee severance charges of $0.6 million.

 

Loss from Investments

 

From time to time, we may make strategic investments in both private and public companies. During each quarter, we evaluate our investments for possible asset impairment. We examine a number of factors, including the current economic conditions and markets for each investment, as well as its cash position and anticipated cash needs for the short and long term.

 

We had no strategic investments in 2006, 2005 or 2004 and therefore did not record a loss or gain related to investments during these periods.

 

Interest Income, Net

 

Interest income, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt.

 

Interest income resulting from cash balances was $1.4 million in 2006, $0.7 million in 2005 and $0.8 million in 2004. Higher interest income in 2006 resulted from higher interest rates and a greater amount of cash invested. The 2005 period includes a cumulative adjustment to interest income taken in the second quarter for the correction of an error in accounting for the amortization of premiums and discounts on investments. The correction of the error resulted in a reduction of interest income in the second quarter and the year of 2005 of approximately $0.3 million.

 

Reductions in invested cash balances in 2005 compared with 2004 were offset by higher rates of return on invested funds.

 

Foreign Currency Gains and Losses and Other Income and Expense

 

We recorded foreign currency exchange losses and other expense of $0.2 million in 2006, foreign currency exchange gains and other income of $1.7 million in 2005, and foreign currency losses and other expenses of $1.7 million in 2004. Changes in currency valuation in all periods presented were primarily a result of exchange rate movements between the U.S. dollar and the euro.

 

During 2006, foreign currency losses were $0.3 million, due primarily to the devaluation of the U.S. dollar. Other income was $0.1 million.

 

During 2005, foreign currency gains were $1.6 million, due primarily to the revaluation of dollar holdings in an entity where the euro is the functional currency. Other income was $0.1 million, primarily attributable to the settlement of transactional tax issues in Europe.

 

During 2004, net foreign currency losses resulted from foreign currency losses of $1.6 million, due primarily to the decrease in the value of the U.S. dollar as compared with the euro.

 

Income Taxes

 

In 2006 and 2005, we recorded provisions for income taxes of $0.1 million and $0.2 million, respectively, primarily resulting from taxes payable in foreign jurisdictions that are not offset by operating loss carryforwards.

 

In 2004, we recorded a net benefit for income taxes of $0.2 million, primarily due to changes in estimates for taxes related to foreign tax jurisdictions.

 

Discontinued Operations

 

On May 22, 2006, we completed the sale of substantially all the assets and some of the liabilities associated with our DTV solutions business to Kudelski S.A. Revenue for the DTV solutions business was $13.5 million, $20.8 million and $19.1 million in 2006, 2005 and 2004, respectively. Operating loss for the DTV solutions business was $1.3 million, $1.9 million and $6.6 million in 2006, 2005 and 2004, respectively. Net gain (loss) for the DTV solutions business in 2006, 2005 and 2004 was $3.0 million, $(1.6) million and $(6.1) million, respectively.

 

During 2003, we completed two transactions to sell our retail Digital Media and Video business. On July 25, 2003, we completed the sale of our digital video business to Pinnacle Systems and on August 1, 2003, we completed the sale of our retail digital media reader business to Zio Corporation.

 

Revenue for the retail Digital Media and Video business in 2006, 2005 and 2004 was $0, $0 and $16,000, respectively. Operating loss for the retail Digital Media and Video business for the same periods was $0.2 million, $0.3 million and $0.3 million, respectively. Net gain (loss) for the retail Digital Media and Video business for 2006, 2005 and 2004 was $0.5 million, $(0.5) million and $(0.2) million, respectively.

 

During 2006, we recorded a net gain on disposal of discontinued operations of $5.2 million, primarily related to the sale of the assets of the DTV solutions business.

 

During 2005, our net loss on disposal of discontinued operations was $2.2 million, of which the majority related to the settlement of litigation with DVD Cre8, Inc. and related legal costs.

 

During 2004, our net gain on disposal of discontinued operations was $0.4 million and included $1.6 million of inventory and asset recoveries, offset in part by changes in estimate of lease commitments of $0.4 million and legal costs of $0.8 million.

 

Liquidity and Capital Resources

 

As of December 31, 2006, our working capital, which we have defined as current assets less current liabilities, was $32.0 million, compared to $27.3 million as of December 31, 2005. Working capital increased in 2006 by approximately $4.7 million. While current assets increased by $0.5 million resulting from an increase in cash, cash equivalents and short-term investments of $4.5 million which was mainly offset in part by a reduction in inventories of $4.1 million, current liabilities decreased by $4.1 million resulting primarily from lower accounts payable by $1.1 million, reduced accruals by $2.6 million and a decrease in income taxes payable by $0.4 million.

 

In 2006, cash and cash equivalents increased by $18.4 million, primarily due to the maturity of short-term investments which have been invested short-term in cash. Operating activities provided $0.2 million, investing activities provided $17.5 million, financing activities resulted in a positive cash flow of $0.3 million and the effect of exchange rates on cash and cash equivalents was $0.5 million.

 

Cash used in continuing operations of $10.3 million was primarily due to a net loss before discontinued operations and depreciation and amortization of $6.7 million. The remaining $3.6 million cash used in continuing operations resulted mainly from the net effect of changes in working capital. Cash provided in operating activities from discontinued operations was $10.5 million and consisted primarily of the $9.0 million received in the sale of the DTV solutions business offset in part by the value of the sold working capital positions as well as the $5.0 million received from Aston for a VAT refund.

 

Cash provided by investing activities from continuing operations of $14.0 million resulted primarily from the maturity of short-term investments of $16.9 million, partially offset by purchases of $2.9 million.

 

Cash provided by investing activities from discontinued operations resulted from the sale of the DTV solutions business. The $3.5 million represented the net book value of sold assets and liabilities in the transaction.

 

Cash provided by financing activities was from the issuance of common stock of $0.3 million related to the Company’s employee stock purchase and stock option programs. At December 31, 2006, our outstanding stock options as a percentage of outstanding shares were 11%, compared to 18% at December 31, 2005.

 

During 2006, we used $10.3 million in cash to fund continuing operations. We currently expect that our current capital resources and available borrowings should be sufficient to meet our operating and capital requirements through at least the end of 2007. We may, however, seek additional debt or equity financing prior to that time. There can be no assurance that additional capital will be available to us on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

 

Off-Balance Sheet Arrangements

 

We have not entered into off-balance sheet arrangements, or issued guarantees to third parties.

 

Contractual Obligations

 

The following summarizes expected cash requirements for contractual obligations as of December 31, 2006 (in thousands):

 

 

Approximately $1.8 million of the purchase commitments relate to the sold DTV solutions business.

 

Foreign Currencies

 

We transact business in various foreign currencies and accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated sales and operating expenses in Europe, Singapore, India and Japan, where we conduct business in both local currencies and U.S. dollars. We assess the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis.

 

Our foreign currency exchange gains and losses are primarily the result of the revaluation of intercompany receivables/payables (denominated in U.S. dollars) and trade receivables (denominated in a currency other than the functional currency) to the functional currency of the subsidiary. We have performed a sensitivity analysis as of December 31, 2006 and 2005 using a modeling technique which evaluated the hypothetical impact of a 10% movement in the value of the U.S. dollar compared to the functional currency of the subsidiary, with all other variables held constant, to determine the incremental transaction gains or losses that would have been incurred. The foreign exchange rates used were based on market rates in effect at December 31, 2006 and 2005. The results of this hypothetical sensitivity analysis indicated that a hypothetical 10% movement in foreign currency exchange rates would result in increased foreign currency gains or losses of $1.1 million and $1.0 million for 2006 and 2005, respectively.

 

Fixed Income Investments

 

We do not use derivative financial instruments in our investment portfolio. We do, however, limit our exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. At the present time, the maximum duration of any investment in our portfolio is limited to less than one year. The guidelines also establish credit quality standards, limits on exposure to one issue or issuer, as well as to the type of instrument. Due to the limited duration and credit risk criteria we have established, our exposure to market and credit risk is not expected to be material.

 

At December 31, 2006, we had $32.1 million in cash and cash equivalents and $4.8 million in short-term investments. Based on our cash and cash equivalents and short term investments as of December 31, 2006, a hypothetical 10% change in interest rates along the entire interest rate yield curve would not be expected to materially affect the fair value of our financial instruments that are exposed to changes in interest rates.

 

At December 31, 2005, we had $13.7 million in cash and cash equivalents and $18.8 million in short-term investments. Based on our cash and cash equivalents and short term investments as of December 31, 2005, a hypothetical 10% change in interest rates along the entire interest rate yield curve would not materially affect the fair value of our financial instruments that are exposed to changes in interest rates.

 

The information required by this Item is incorporated by reference to pages F-1 through F-28 of this Form 10-K.

 

None.

 

Evaluation of Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of December 31, 2006. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective, such that the information relating to our business and operations, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

Report on Internal Control over Financial Reporting

 

As a result of the SEC’s extension of the deadline for non-accelerated filers’ compliance with the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002, as a non-accelerated filer we are not subject to these requirements in our annual report on Form 10-K for the fiscal year ending December 31, 2006. We will be required to provide management’s report on internal control over financial reporting beginning with our annual report for the fiscal year ending on December 31, 2007. Further, we will be required to file the auditor’s attestation report on internal control over financial reporting beginning with our annual report for the fiscal year ending on December 31, 2008.

 

Changes in Internal Control Over Financial Reporting

 

In connection with our continued monitoring and maintenance of our controls procedures in relation to the provisions of the Sarbanes-Oxley Act of 2002, we continue to review, revise and improve the effectiveness of our internal controls. We made no changes to our internal control over financial reporting during the fourth quarter of 2006 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

 

Not applicable.

 

The information required by Item 10 concerning our directors and officers will be set forth under the captions “Election of Directors” and “Matters Relating to the Board of Directors” in our Proxy Statement relating to our 2007 Annual Meeting of Stockholders, referred to in the Annual Report on Form 10-K as the “Proxy Statement,” which we expect will be filed within 120 days of the end of our fiscal year pursuant to General Instruction G(3) of Form 10-K. Such information is incorporated herein by reference. The information required by this item concerning compliance with Section 16(a) of the Exchange Act is incorporated by reference to the section captioned “Section 16(a) Beneficial Ownership Compliance” that will be set forth in the Proxy Statement. The information required by this item concerning our code of ethics is incorporated by reference to the section captioned “Code of Conduct and Ethics” that will be set forth in the Proxy Statement. The information required by this item concerning the Audit Committee of our Board of Directors is incorporated by reference to the section captioned “Board Committees” in our Proxy Statement.

 

The information required by Item 11 will be set forth under the section captioned “Executive Compensation” contained in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 12 will be set forth under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 13 will be set forth under the caption “Certain Relationships and Related Transactions” in the Proxy Statement, which information is incorporated herein by reference.

 

The information required by Item 14 will be set forth under the caption “Principal Accountant Fees and Services” in the Proxy Statement, which information is incorporated herein by reference.

 

(a) Documents Filed with Report

 

1. Financial Statements

 

The following Consolidated Financial Statements and Independent Auditors’ Reports are incorporated by reference to pages F-1 through F-28 of this Form 10-K.

 

a. The consolidated balance sheets as of December 31, 2006 and 2005, and the consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2006, together with the notes thereto.

 

b. The report of our Independent Registered Public Accounting Firm.

 

2. Financial Statement Schedule

 

The following financial statement schedule should be read in conjunction with the consolidated financial statements and the notes thereto.

 

Schedule II — Valuation and Qualifying Accounts

 

 

3. Exhibits

 

 

 

 

 

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.

 

Registrant

 

SCM MICROSYSTEMS, INC.

 

Robert Schneider

Chief Executive Officer and Director

 

March 19, 2007

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

 

Index to Consolidated Financial Statements

 

 

To the Board of Directors and Stockholders

of SCM Microsystems, Inc.:

 

We have audited the accompanying consolidated balance sheets of SCM Microsystems, Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of SCM Microsystems, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

WIRTSCHAFTSPRÜFUNGSGESELLSCHAFT

 

Munich, Germany

March 20, 2007

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

(In thousands)

 

 

See notes to consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS