Identiv, Inc. - Quarter Report: 2008 September (Form 10-Q)

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008

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

FOR THE TRANSITION PERIOD FROM                     TO                     

SCM MICROSYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE		77-0444317
(STATE OR OTHER JURISDICTION OF		(I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION)		IDENTIFICATION NUMBER)

Oskar-Messter-Str. 13, 85737 Ismaning, Germany
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)

+ 49 89 95 95 5000
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ     No o

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

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o		Smaller reporting company þ
		(Do not check if a smaller reporting company)

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

At November 3, 2008, 15,743,515 shares of common stock were outstanding.

 

 

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements			3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Item 3. Quantitative and Qualitative Disclosures About Market Risk			28
Item 4. Controls and Procedures			28
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			29
Item 1A Risk Factors			29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			42
Item 3. Defaults Upon Senior Securities			42
Item 4. Submission of Matters to a Vote of Security Holders			42
Item 5. Other Information			42
Item 6. Exhibits			42
SIGNATURES			43
EXHIBIT INDEX			44
EX-31.1
EX-31.2
EX-32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net revenue		$	6,393			$	7,617			$	19,377			$	20,721
Cost of revenue			3,483				4,170				10,961				12,201
Gross profit			2,910				3,447				8,416				8,520
Operating expenses:
Research and development			980				815				3,058				2,327
Selling and marketing			2,280				1,625				7,010				4,802
General and administrative			1,697				1,374				4,718				5,653
Amortization of intangible assets			—				—				—				272
Restructuring and other charges			—				(4	)			—				(4	)
Total operating expenses			4,957				3,810				14,786				13,050
Loss from operations			(2,047	)			(363	)			(6,370	)			(4,530	)
Interest and other income (expenses), net			(1,117	)			279				(293	)			999
Loss from continuing operations before income taxes			(3,164	)			(84	)			(6,663	)			(3,531	)
Provision for income taxes			(103	)			(32	)			(151	)			(124	)
Loss from continuing operations			(3,267	)			(116	)			(6,814	)			(3,655	)
Income (loss) from discontinued operations, net of income taxes			424				(83	)			273				(202	)
Gain on sale of discontinued operations, net of income taxes			44				16				553				1,569
Net loss		$	(2,799	)		$	(183	)		$	(5,988	)		$	(2,288	)
Loss per share from continuing operations:
Basic and diluted		$	(0.21	)		$	(0.01	)		$	(0.43	)		$	(0.23	)
Gain (loss) per share from discontinued operations:
Basic and diluted		$	0.03			$	(0.00	)		$	0.05			$	0.08
Net loss per share:
Basic and diluted		$	(0.18	)		$	(0.01	)		$	(0.38	)		$	(0.15	)
Shares used to compute basic and diluted loss per share			15,744				15,736				15,743				15,722
Comprehensive gain (loss):
Net loss		$	(2,799	)		$	(183	)		$	(5,988	)		$	(2,288	)
Unrealized gain (loss) on investments			—				1				28				11
Foreign currency translation adjustment			(24	)			450				(203	)			984
Total comprehensive gain (loss)		$	(2,823	)		$	268			$	(6,163	)		$	(1,293	)

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
(unaudited)

		September 30,				December 31,
		2008				2007
ASSETS
Current assets:
Cash and cash equivalents		$	25,020			$	18,600
Short-term investments			0				13,844
Accounts receivable, net of allowances of $495 and $341 as of September 30, 2008 and December 31, 2007, respectively			6,368				8,638
Inventories			4,321				2,738
Other current assets			1,310				1,455
Total current assets			37,019				45,275
Property and equipment, net			1,313				1,522
Intangible assets, net			321				—
Other assets			1,947				1,767
Total assets		$	40,600			$	48,564
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,484			$	3,063
Accrued compensation and related benefits			1,244				1,213
Accrued restructuring and other charges			1,715				2,960
Accrued professional fees			896				993
Accrued royalties			385				417
Other accrued expenses			2,278				2,325
Income taxes payable			245				277
Total current liabilities			9,247				11,248
Deferred tax liability			74				77
Long-term income taxes payable			142				200
Commitments and contingencies (see Notes 10 and 11)			—				—
Stockholders’ equity:
Common stock, $0.001 par value: 40,000 shares authorized; 16,362 and 16,356 shares issued and 15,744 and 15,737 shares outstanding as of September 30, 2008 and December 31, 2007, respectively			16				16
Additional paid-in capital			229,675				229,414
Treasury stock, 618 shares			(2,777	)			(2,777	)
Accumulated deficit			(198,077	)			(192,089	)
Accumulated other comprehensive income			2,300				2,475
Total stockholders’ equity			31,137				37,039
Total liabilities and stockholders’ equity		$	40,600			$	48,564

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)

		Nine Months
		Ended September 30,
		2008				2007
Cash flows from operating activities:
Net loss		$	(5,988	)		$	(2,288	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Gain from discontinued operations			(826	)			(1,367	)
Depreciation and amortization			216				500
Loss (gain) on disposal of fixed assets			—				(6	)
Stock compensation expense			242				639
Deferred income taxes			(2	)			(2	)
Changes in operating assets and liabilities:
Accounts receivable			2,004				542
Inventories			(1,704	)			(893	)
Other assets			(352	)			1,246
Accounts payable			(381	)			(2,143	)
Accrued expenses			283				(1,619	)
Income taxes payable			(47	)			98
Net cash used in operating activities from continuing operations			(6,555	)			(5,293	)
Net cash provided by (used in) operating activities from discontinued operations			(350	)			697
Net cash used in operating activities			(6,905	)			(4,596	)
Cash flows from investing activities:
Capital expenditures			(534	)			(178	)
Maturities of short-term investments			13,873				12,656
Purchases of short-term investments			—				(16,793	)
Net cash provided by (used in) investing activities			13,339				(4,315	)
Cash flows from financing activities:
Proceeds from issuance of equity securities, net			18				104
Net cash provided by financing activities			18				104
Effect of exchange rates on cash and cash equivalents			(32	)			847
Net increase (decrease) in cash and cash equivalents			6,420				(7,960	)
Cash and cash equivalents at beginning of period			18,600				32,103
Cash and cash equivalents at end of period		$	25,020			$	24,143
Supplemental disclosures of cash flow information:
Income tax refunds received		$	—			$	—
Income taxes paid		$	175			$	108

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008

1. Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of SCM Microsystems, Inc.’s (“SCM” or “the Company”) financial position, results of operations and cash flows have been included. Operating results for the three and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008 or any future period. For further information, refer to the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The preparation of unaudited condensed consolidated financial statements necessarily requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the condensed consolidated balance sheet dates and the reported amounts of revenues and expenses for the periods presented.

Discontinued Operations

     On May 22, 2006, the Company completed the sale of substantially all the assets and some of the liabilities associated with its Digital Television solutions (“DTV solutions”) business to Kudelski S.A. (“Kudelski”) for a total consideration of $10.6 million in cash, of which $9.0 million was paid at the time of sale and $1.6 million was paid in May 2007.

     In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, for the three and nine months ended September 30, 2008 and 2007, this business has been presented as discontinued operations in the condensed consolidated statements of operations and cash flows and all prior periods have been reclassified to conform to this presentation. See Note 3 for further discussion of this transaction.

Recent Accounting Pronouncements and Accounting Changes

     In December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141(R)”). Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period be included in income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of SFAS No. 141(R) will change the Company’s accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.

     In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51. SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity. SFAS No. 160 is effective for us on a prospective basis for business combinations with an acquisition date beginning in the first quarter of fiscal year 2009. As of September 30, 2008, SCM did not have any minority interests.

     On January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115. SFAS No. 159 permits companies to choose to measure certain financial instruments and other items at fair value using an instrument-by-instrument election. The standard requires that unrealized gains and losses are reported in earnings for items measured using the fair value option. The adoption of SFAS No. 159 did not have an impact on SCM’s consolidated financial position, results of operations or cash flows.

     On January 1, 2008, SCM adopted SFAS No. 157, Fair Value Measurements, for all financial assets and financial liabilities and for all non-financial assets and non-financial liabilities recognized or disclosed at fair value in the financial statements on a recurring basis (i.e., at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and enhances fair value measurement disclosure. SFAS No. 157 does not change the accounting for those instruments that were, under previous GAAP, accounted for at cost or contract value. The adoption of SFAS No. 157 did not have a significant impact on the Company’s consolidated financial statements, and the resulting fair values calculated under SFAS No. 157 after adoption were not significantly different than the fair values that would have been calculated under previous guidance.

     SFAS No. 157 establishes a fair value hierarchy that requires an entity to maximize the use of observable objective inputs and minimize the use of unobservable inputs, which require additional reliance on the Company’s judgment, when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. SFAS No. 157 establishes three levels of inputs that may be used to measure fair value:

	•		Level 1 — Quoted prices for identical instruments in active markets;
	•		Level 2 — Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations, in which all significant inputs are observable in active markets; and
	•		Level 3 — Valuations derived from valuation techniques, in which one or more significant inputs are unobservable.

     The Company uses the following classifications to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified:

     Cash equivalents include highly liquid debt investments (money market fund deposits, commercial paper and treasury bills) with maturities of three months or less at the date of acquisition. These financial instruments are classified in Level 1 of the fair value hierarchy.

     Short-term investments consist of corporate notes and United States government agency instruments and are classified as available-for-sale. These financial instruments are classified in Level 1 of the fair value hierarchy. As of September 30, 2008, the Company has no short-term investments.

     Assets that are measured and recognized at fair value on a recurring basis classified under the appropriate level of the fair value hierarchy as of September 30, 2008 were as follows (in thousands):

		Level 1				Level 2				Level 3				Total
Money market fund deposits		$	11,455			$	—			$	—			$	11,455
Treasury Bills			4,000				—				—				4,000
Commercial papers			1,992				—				—				1,992
Total:		$	17,447			$	—			$	—			$	17,447

     As of September 30, 2008, there are no liabilities that are measured and recognized at fair value on a recurring basis.

     In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements that Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, and FSP 157-2, Effective Date of FASB Statement No. 157. FSP 157-1 amends SFAS No. 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (i.e., at least annually), until the beginning of the first quarter of fiscal 2009. The Company is currently evaluating the impact that SFAS No. 157 will have on its consolidated financial statements when it is applied to non-financial assets and non-financial liabilities that are not measured at fair value on a recurring basis beginning in the first quarter of 2009.

2. Stock Based Compensation

     The Company has a stock-based compensation program that provides its Board of Directors discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options under various plans, the majority of which are stockholder approved. Stock options are generally time-based and expire seven to ten years from the date of grant. Vesting varies, with some options vesting 25% each year over four years; some vesting 1/12^th per month over one year; some vesting 100% after one year; and some vesting 1/12^th per month, commencing four years from the date of grant.

     The Company previously had an Employee Stock Purchase Plan (“ESPP”) that allowed employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. Shares issued as a result of stock option exercises and purchases under the Company’s ESPP were newly issued shares. The Company’s ESPP, Director Option Plan and 1997 Stock Option Plan all expired in March 2007. In November 2007, stockholders approved the 2007 Stock Option Plan, which authorizes the issuance of up to 1.5 million shares of the Company’s common stock pursuant to stock option grants.

     As of September 30, 2008, an aggregate of approximately 3.1 million shares of the Company’s common stock was reserved for future issuance under the Company’s stock option plans, of which 1.9 million shares were subject to outstanding options.

     In calculating stock-based compensation cost, the Company estimates the fair value of each option grant on the date of grant using the Black-Scholes-Merton options pricing model. The Black-Scholes-Merton option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, the Black-Scholes-Merton model requires the input of highly subjective assumptions including the expected stock price volatility.

     The following table illustrates the stock-based compensation expense resulting from stock options and shares issued under the ESPP included in the unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2008 and 2007 (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Cost of revenue		$	6			$	18			$	16			$	51
Research and development			12				21				36				65
Selling and marketing			30				77				92				177
General and administrative			70				117				98				346
Stock-based compensation expense before income taxes		$	118			$	233			$	242			$	639
Income tax benefit			0				0				0				0
Stock-based compensation expense after income taxes		$	118			$	233			$	242			$	639

  Stock Option Plans

     The Company’s Director Option Plan and 1997 Stock Option Plan expired in March 2007, and options can no longer be granted under these plans. However, outstanding options granted under these plans remain exercisable in accordance with the terms of the original grant agreements.

     In November 2007, stockholders approved the 2007 Stock Option Plan, which authorizes the issuance of up to 1.5 million shares of the Company’s common stock pursuant to stock option grants. As of September 30, 2008, a total of 1.1 million shares of the Company’s common stock are reserved for future option grants under the 2000 Stock Option Plan and the 2007 Stock Option Plan, and 1.9 million shares were reserved for future issuance pursuant to outstanding options.

     A summary of the activity under the Company’s stock option plans for the nine months ended September 30, 2008 is as follows:

																		Weighted
										Weighted								Average
		Options				Number of				Average				Aggregate				Remaining
		Available				Options				Exercise Price				Intrinsic				Contractual
		for Grant				Outstanding				per share				Value				Life (in years)
Balance at December 31, 2007			1,493,493				1,862,272			$	10.97			$	191,809				5.77
Options granted			(536,171	)			536,171			$	3.11				—				—
Options cancelled or expired			187,061				(448,023	)		$	15.92				—				—
Options exercised							(6,250	)		$	2.93			$	1,507				—
Balance at September 30, 2008			1,144,383				1,944,170			$	7.69			$	0				5.72
Vested or expected to vest at September 30, 2008							1,772,001			$	8.12			$	0				5.59
Exerciseable at September 30, 2008							1,094,584			$	11.13			$	0				4.69

     The weighted-average grant date fair value per option for options granted during the three and nine months ended September 30, 2008 was $1.38 and $1.39, respectively. The weighted-average grant date fair value per option for options granted during the three and nine months ended September 30, 2007 was $1.38 and $1.90, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2008 was zero and $1,500, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2007 was zero and $8,331, respectively. Cash proceeds from the exercise of stock options were zero and $18,000 for the three and nine months ended September 30, 2008, respectively. Cash proceeds from the exercise of stock options were zero and $33,135 for the three and nine months ended September 30, 2007, respectively. An income tax benefit of less than $1,000 was realized from stock option exercises during both the three and nine months ended September 30, 2008. No income tax benefit was realized from stock option exercises during both the three and nine months ended September 30, 2007. At September 30, 2008, there was $0.9 million of unrecognized stock-based compensation expense, net of estimated forfeitures related to non-vested options, that is expected to be recognized over a weighted-average period of 2.7 years.

     The fair value of option grants was estimated by using the Black-Scholes-Merton model with the following weighted-average assumptions for the three and nine months ended September 30, 2008 and 2007, respectively:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Expected volatility			57	%			54	%			55	%			57	%
Dividend yield			0				0				0				0
Risk-free interest rate			2.87	%			4.13	%			2.72	%			4.53	%
Expected term (in years)			4.00				4.00				4.00				4.00

     Expected Volatility: The Company’s computation of expected volatility for both the three and nine months ended September 30, 2008 is based on the historical volatility of the Company’s stock for a time period equivalent to the expected term.

     Dividend Yield: The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.

     Risk-Free Interest Rate: The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option.

     Expected Term: The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined for both the three and nine months ended September 30, 2008 based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior.

     Forfeitures Rate: Compensation expense recognized in the consolidated statement of operations for both the three and nine months ended September 30, 2008 and 2007 is based on awards ultimately expected to vest and it reflects estimated forfeitures. FASB SFAS No. 123 — revised 2004 (“SFAS 123(R)”) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adoption of SFAS 123(R), the Company accounted for forfeitures as they occurred.

  1997 Employee Stock Purchase Plan

     Until its expiration in March 2007, the Company’s ESPP permitted eligible employees to purchase the Company’s common stock through payroll deductions of up to 10% of their base wages at a purchase price of 85% of the lower of fair market value of the Company’s common stock at the beginning or end of each offering period. The Company had a two-year rolling plan with four purchases every six months within the offering period. If the fair market value per share was lower on the purchase date than the beginning of the offering period, the current offering period terminated and a new two year offering period would have commenced. The Company’s ESPP restricted the maximum amount of shares purchased by an individual to $25,000 worth of the Company’s common stock each year. As of September 30, 2008, no shares were available for future issuance under the Company’s ESPP, due to the plan’s expiration in March 2007.

     Stock-based compensation expense related to the Company’s ESPP recognized under SFAS 123(R) for both the three and nine months ended September 30, 2008 was zero. Stock-based compensation expense related to the Company’s ESPP recognized under SFAS 123(R) for the three and nine months ended September 30, 2007 was zero and a benefit of $40,000, respectively. The benefit in the first nine months of 2007 stemmed from the expiration of the plan before the expected offering periods had terminated. At September 30, 2008, there was no further unrecognized stock-based compensation expense related to outstanding ESPP shares, as the plan expired in March 2007.

3. Discontinued Operations

     On May 22, 2006, the Company completed the sale of substantially all the assets and some of the liabilities associated with its DTV solutions business to Kudelski for a total consideration of $10.6 million in cash, of which $9.0 million was paid at the time of sale and $1.6 million, which was paid in May 2007.

     In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, for both the three and nine months ended September 30, 2008, the DTV solutions business has been presented as discontinued operations in the unaudited consolidated statements of operations and cash flows and all prior periods have been reclassified to conform to this presentation.

     Based on the carrying value of the assets and the liabilities attributed to the DTV solutions business on May 22, 2006, and the estimated costs and expenses incurred in connection with the sale, the Company recorded a net pretax gain of approximately $5.5 million. An additional $1.5 million gain on sale of discontinued operations was realized in May 2007 primarily resulting from the final payment by Kudelski as described above.

     Based on a “Transition Services and Side Agreement” between the Company and Kudelski, revenues relating to the discontinued operations of the DTV solutions business were generated for a limited time after the sale of the DTV solutions business. Under this agreement, a service fee was earned by the Company for its services related to ordering products from a supplier and selling these products to Kudelski. The agreement was terminated at the end of the first quarter of 2007 and related revenues ceased to be generated after that period.

     The operating results for the discontinued operations of the DTV solutions business for the three and nine months ended September 30, 2008 and 2007 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net revenue		$	—			$	—			$	—			$	496
Operating gain (loss)		$	32			$	45			$	26			$	33
Net income (loss) before income taxes		$	32			$	45			$	26			$	56
Income tax benefit (provision)		$	—			$	—			$	—			$	(16	)
Income (loss) from discontinued operations		$	32			$	45			$	26			$	40

     During 2003, the Company completed two transactions to sell its retail Digital Media and Video business. On July 25, 2003, the Company completed the sale of its digital video business to Pinnacle Systems and on August 1, 2003, the Company completed the sale of its retail digital media reader business to Zio Corporation. As a result of these sales, the Company has accounted for the retail Digital Media and Video business as discontinued operations.

     In April 2008, the Company entered into an agreement to terminate its lease agreement for premises leased in the UK, which resulted in the gain on sale of discontinued operations of approximately $0.4 million in the second quarter of 2008.

     The operating results for the discontinued operations of the retail Digital Media and Video business for the three and nine months ended September 30, 2008 and 2007 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net revenue		$	—			$	—			$	—			$	—
Operating loss		$	(58	)		$	(82	)		$	(202	)		$	(236	)
Net gain (loss) before income taxes		$	365			$	(72	)		$	225			$	(186	)
Income tax provision		$	27			$	(56	)		$	22			$	(56	)
Gain (loss) from discontinued operations		$	392			$	(128	)		$	247			$	(242	)

     The net gain from discontinued operations for the three and nine months ended September 30, 2008 mainly resulted from foreign exchange gains in the third quarter of 2008.

4. Short-Term Investments

     At September 30, 2008, the amount of short-term investments was zero. The fair value of short-term investments at December 31, 2007 was as follows (in thousands):

		December 31, 2007
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	13,872			$	—			$	(28	)		$	13,844

     The Company adopted SFAS No. 157 during the quarter ended March 31, 2008, see Note 1 — Basis of Presentation for further discussion and explanation.

5. Inventories

     Inventories consist of (in thousands):

		September 30,				December 31,
		2008				2007
Raw materials		$	1,586			$	1,202
Finished goods			2,735				1,536
Total		$	4,321			$	2,738

6. Property and Equipment

     Property and equipment consists of (in thousands):

		September 30,				December 31,
		2008				2007
Land		$	121			$	142
Building and leasehold improvements			1,746				1,972
Furniture, fixtures and office equipment			2,904				3,223
Automobiles			29				35
Purchased software			3,282				3,526
Total			8,082				8,898
Accumulated depreciation			(6,769	)			(7,376	)
Property and equipment, net		$	1,313			$	1,522

     Depreciation expense was $0.1 million and $0.2 million for the three and nine months ended September 30, 2008, respectively, and $0.1 million and $0.2 million for the three and nine months ended September 30, 2007, respectively.

7. Intangible Assets

     Amortization expense related to intangible assets for continuing operations was zero for the three and nine months ended September 30, 2008, and zero and $0.3 million for the three and nine months ended September 30, 2007, respectively.

     As described in Note 13 to the financial statements, the Company’s investment in TranZfinity, Inc. (“TranZfinity”) follows an exclusive Cooperation Agreement entered into on April 17, 2008 with TranZfinity and on October 1, 2008, the Company and TranZfinity entered into an amendment to the Cooperation Agreement. Under the terms of the Cooperation Agreement, as amended, TranZfinity will work with the Company to develop modular USB devices for the Company’s product portfolio and will supply the Company’s customers with TranZfinity’s application software and services supporting those devices, and the Company will pay TranZfinity a $1.0 million exclusivity fee for the right to be the exclusive provider of those products (the “Exclusive Products”). The exclusivity fee is comprised of $500,000 cash (of which the remaining balance to be paid was $179,298 as of September 30, 2008), and a $4 payment from the Company to TranZfinity for each Exclusive Product sold by the Company (up to a maximum aggregate amount of $500,000, of which the remaining balance is the full $500,000 as of September 30, 2008). The $320,702 already paid in relation to the exclusivity fee has been capitalized in September 2008 as an intangible asset, which will be subject to amortization starting in the fourth quarter 2008.

     Continuing Operations

     During the three and nine months ended September 30, 2008, the Company incurred no restructuring and other charges related to continuing operations. During the three and nine months ended September 30, 2007, the Company realized income from the release of a severance accrual related to continuing operations of $4,000.

     Accrued liabilities related to restructuring actions and other activities during the nine months ended September 30, 2008 and during the year ended December 31, 2007 consist of the following (in thousands):

		Lease/Contract								Other
		Commitments				Severance				Costs				Total
Balances as of January 1, 2007		$	15			$	106			$	9			$	130
Provision for 2007			—				—				—				—
Changes in estimates			—				(4	)			—				(4	)
			—				(4	)			—				(4	)
Payments and other changes in 2007			(3	)			(102	)			1				(104	)
Balances as of December 31, 2007			12				—				10				22
Provision for Q1 2008			—				—				—				—
Changes in estimates			—				—				—				—
			—				—				—				—
Payments and other changes in Q1 2008			—				—								—
Balances as of March 31, 2008			12				—				10				22
Provision for Q2 2008			—				—				—				—
Changes in estimates			—				—				—				—
			—				—				—				—
Payments and other changes in Q2 2008			(1	)			—				—				(1	)
Balances as of June 30, 2008			11				—				10				21
Provision for Q3 2008			—				—				—				—
Changes in estimates			—				—				—				—
			—				—				—				—
Payments and other changes in Q3 2008			(2	)			—				(1	)			(3	)
Balances as of September 30, 2008		$	9			$	—			$	9			$	18

     Discontinued Operations

     During the three and nine months ended September 30, 2008, income from restructuring and other items related to discontinued operations was approximately $46,000 and 0.6 million, respectively. In the second quarter 2008, a termination payment and related transaction costs of approximately $0.5 million were incurred and the related restructuring accruals of approximately $0.9 million were released related primarily to an agreement to terminate our lease agreement for the premises leased in the UK. The transaction resulted in a net gain of approximately $0.4 million from discontinued operations in the second quarter 2008.

     During the three and nine months ended September 30, 2007, income from restructuring and other items related to discontinued operations was approximately $16,000 and $92,000, respectively.

     Accrued liabilities related to the Digital Media and Video restructuring actions and other activities during the nine months ended September 30, 2008 and during the year ended December 31, 2007 consist of the following (in thousands):

		Lease/Contract
		Commitments				Other Costs				Total
Balances as of January 1, 2007		$	2,949			$	352			$	3,301
Provision for 2007			—				—				—
Changes in estimates			(70	)			(40	)			(110	)
			(70	)			(40	)			(110	)
Payments and other changes in 2007			(290	)			37				(253	)
Balances as of December 31, 2007			2,589				349				2,938
Provision for Q1 2008			—				—				—
Changes in estimates			(19	)			—				(19	)
			(19	)			—				(19	)
Payments and other changes in Q1 2008			(54	)			26				(28	)
Balances as of March 31, 2008			2,516				375				2,891
Provision for Q2 2008			—				—				—
Changes in estimates			(494	)			—				(494	)
			(494	)			—				(494	)
Payments and other changes in Q2 2008			(539	)			(2	)			(541	)
Balances as of June 30, 2008			1,483				373				1,856
Provision for Q3 2008			—				—				—
Changes in estimates			(46	)			—				(46	)
			(46	)			—				(46	)
Payments and other changes in Q3 2008			(74	)			(39	)			(113	)
Balances as of September 30, 2008		$	1,363			$	334			$	1,697

9. Segment Reporting, Geographic Information and Major Customers

     SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The method for determining what information to report is based on the way that management organizes the operating segments within the Company for making operating decisions and assessing financial performance. The Company’s chief operating decision maker is considered to be its executive staff, consisting of the Chief Executive Officer; Chief Financial Officer; Executive Vice President, Strategic Sales and Business Development and Executive Vice President, Strategy, Marketing and Engineering.

     The Company’s continuing operations provide secure digital access solutions primarily to original equipment manufacturers, or OEMs, in two markets segments: PC Security and Digital Media Readers. The executive staff reviews financial information and business performance along these two business segments. The Company evaluates the performance of its segments at the revenue and gross margin level. The Company’s reporting systems do not track or allocate operating expenses or assets by segment. The Company does not include intercompany transfers between segments for management purposes.

     Summary information by segment for the three and nine months ended September 30, 2008 and 2007 is as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
PC Security:
Net revenue		$	5,873			$	6,140			$	15,758			$	17,100
Gross profit			2,748				2,846				7,172				7,345
Gross profit %			47	%			46	%			46	%			43	%
Digital Media Readers:
Net revenue		$	520			$	1,477			$	3,619			$	3,621
Gross profit			162				601				1,244				1,175
Gross profit %			31	%			41	%			34	%			32	%
Total:
Net revenue		$	6,393			$	7,617			$	19,377			$	20,721
Gross profit			2,910				3,447				8,416				8,520
Gross profit %			46	%			45	%			43	%			41	%

     Geographic net revenue is based on selling location. Information regarding net revenue by geographic region is as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net revenue
United States		$	2,655			$	3,635			$	7,214			$	9,574
Europe			2,064				2,603				7,151				6,716
Asia-Pacific			1,674				1,379				5,012				4,431
Total		$	6,393			$	7,617			$	19,377			$	20,721
% of net revenue
United States			42	%			48	%			37	%			47	%
Europe			32	%			34	%			37	%			32	%
Asia-Pacific			26	%			18	%			26	%			21	%

     Long-lived assets by geographic location as of September 30, 2008 and December 31, 2007, are as follows (in thousands):

		September 30,				December 31,
		2008				2007
Property and equipment, net:
United States		$	7			$	14
Europe			201				171
Asia-Pacific			1,105				1,337
Total		$	1,313			$	1,522

     All of the long-lived assets as of September 30, 2008, and December 31, 2007, disclosed for Asia-Pacific, relate to the Company’s facilities in India.

     The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. Those lease agreements existing as of September 30, 2008, expire at various dates during the next five years.

     Purchases for inventories are highly dependent upon forecasts of customer demand. Due to the uncertainty in demand from its customers, the Company may have to change, reschedule, or cancel purchases or purchase orders from its suppliers. These changes may lead to vendor cancellation charges on these purchases or contractual commitments. The Company enters into a number of agreements for the sourcing of supplies and materials including some arrangements with minimum purchase commitments. As of September 30, 2008, total purchase and contractual commitments due within one year were approximately $10.1 million, and additional purchase and contractual commitments due within two years were approximately $2.6 million.

     The Company provides warranties on certain product sales, which range from twelve to twenty-four months, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. The Company currently establishes warranty reserves based on historical warranty costs for each product line combined with liability estimates based on the prior twelve months’ sales activities. If actual return rates and/or repair and replacement costs differ significantly from the Company’s estimates, adjustments to recognize additional cost of sales may be required in future periods.

     Components of the reserve for warranty costs for the nine months ended September 30, 2008 and 2007 were as follows (in thousands):

		2008				2007
Balances at January 1		$	36			$	34
Additions related to sales during the period			32				46
Warranty costs incurred during the period			(19	)			(49	)
Adjustments to accruals related to prior period sales			(28	)			(2	)
Balances at September 30		$	21			$	29

11. Net Income (Loss) per Common Share

     The following table sets forth the computation of basic and diluted net income (loss) per common share (in thousands, except per share amounts):

		For the Three Months Ended								For the Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net loss from continuing operations		$	(3,267	)		$	(116	)		$	(6,814	)		$	(3,655	)
Income (loss) from discontinued operations			468				(67	)			826				1,367
Net loss		$	(2,799	)		$	(183	)		$	(5,988	)		$	(2,288	)
Shares used in income (loss) per common share — basic			15,744				15,736				15,743				15,722
Net income (loss) per common share — basic and diluted
Continuing operations		$	(0.21	)		$	(0.01	)		$	(0.43	)		$	(0.23	)
Discontinued operations		$	0.03			$	(0.00	)		$	0.05			$	0.08
Net loss per common share — basic and diluted		$	(0.18	)		$	(0.01	)		$	(0.38	)		$	(0.15	)

     The computation of diluted net loss per common share for the three and nine months ended September 30, 2008 excludes the effect of the potential exercise of options to purchase approximately zero and 3,000 shares, respectively, because the effect would be anti-dilutive in periods when there is a net loss. The computation of diluted net loss per common share for the three and nine months ended September 30, 2008 also excludes the effect of the potential exercise of options to purchase approximately 2.0 million and 1.9 million shares, respectively, because the option exercise price was greater than the average market price of the common shares and the effect would have been anti-dilutive.

     The computation of diluted net income (loss) per common share for the three and nine months ended September 30, 2007 excludes the effect of the potential exercise of options to purchase approximately 7,000 and 33,000 shares, respectively, because the effect would be anti-dilutive in periods when there is a net loss. The computation of diluted net income (loss) per common share for the three and nine months ended September 30, 2007 also excludes the effect of the potential exercise of options to purchase approximately 1.7 million and 1.7 million shares, respectively, because the option exercise price was greater than the average market price of the common shares and the effect would have been anti-dilutive.

12. Legal Proceedings

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

13. Subsequent Events

     Investment in TranZfinity

     On October 1, 2008, the Company entered into a Stock Purchase Agreement with TranZfinity, pursuant to which the Company purchased 10 million shares of TranZfinity common stock, or 33.7% of TranZfinity’s outstanding shares (16.67% on a fully diluted basis), for an aggregate purchase price of $2.5 million. The transaction closed on October 2, 2008. The Company also entered into a Stockholders Agreement with TranZfinity and certain other stockholders of TranZfinity, which sets forth certain rights and privileges of the Company and the other stockholders of TranZfinity, including rights and privileges with respect to the composition of TranZfinity’s Board of Directors.

     The Company’s investment in TranZfinity follows an exclusive Cooperation Agreement entered into on April 17, 2008 with TranZfinity. On October 1, 2008, the Company and TranZfinity entered into an amendment to the Cooperation Agreement pursuant to which TranZfinity consented to the assignment by SCM Microsystems GmbH and the assumption by

SCM Microsystems, Inc. of all of SCM Microsystems GmbH’s rights and obligations under the Cooperation Agreement. Under the terms of the Cooperation Agreement, as amended, TranZfinity will work with the Company to develop modular USB devices for the Company’s product portfolio and will supply the Company’s customers with TranZfinity’s application software and services supporting those devices, and the Company will pay TranZfinity a $1.0 million exclusivity fee for the right to be the exclusive provider of those products (the “Exclusive Products”). The exclusivity fee is comprised of $500,000 cash (of which the remaining balance to be paid was $179,298 as of September 30, 2008), and a $4 payment from the Company to TranZfinity for each Exclusive Product sold by the Company (up to a maximum aggregate amount of $500,000, of which the remaining balance is the full $500,000 as of September 30, 2008). In addition to the exclusivity fee, the Company will pay TranZfinity a five percent (5%) royalty on the Company’s net selling price for each Exclusive Product sold by the Company.

     Sale of Patents

     On October 30, 2008, the Company sold at auction certain non-core patents that are unrelated to the Company’s current business. The Company will receive net proceeds of $1.4 million from the sale of these patents.

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

     This Quarterly Report on Form 10-Q contains forward-looking statements for purposes of the safe harbor provisions under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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, forward-looking statements can be identified by terms such as “will,” “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 Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q. 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 important factors that could cause our actual results to differ materially from our expectations under “Part II — Item 1A, Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. These cautionary statements qualify all of the forward-looking statements included in this Quarterly Report on Form 10-Q that are attributable to us or persons acting on our behalf.

     The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto set forth in Part I — Item 1 of this Quarterly Report on Form 10-Q. We also urge readers to review and consider our disclosures describing various factors that could affect our business, including the disclosures under the headings “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” and the audited financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2007.

Overview

     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 in two market segments: PC Security and Digital Media Readers.

•

For the PC Security market, we offer smart card reader technology that enables authentication of individuals for applications such as electronic passports and drivers’ licenses, electronic healthcare cards, secure logical access to PCs and networks, and physical access to facilities. Within the PC Security segment, we also offer a line of smart card solutions under the CHIPDRIVE® brand that include productivity applications such as time recording and attendance, physical access and password management for small and medium sized enterprises.

•

For the Digital Media Reader market, we offer digital media readers that are used to transfer digital content to and from various flash media. These readers are primarily used in digital photo kiosks.

     We sell our PC Security 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 typically sell our smart card readers to government contractors, systems integrators, large enterprises and computer manufacturers, as well as banks and other financial institutions. We sell our digital media readers primarily to computer and photo processing equipment manufacturers. 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 Condensed Consolidated Financial Statements of this Form 10-Q.)

Growth Strategies

     We have put in place a number of strategies to grow revenues over the long-term, as discussed below.

     Throughout most of 2007, our revenue growth strategy was primarily based on investing in new PC Security products to address emerging smart card-based security programs in Europe, including e-passport, national ID and e-health. Additionally, we implemented programs to expand sales of our CHIPDRIVE business productivity solutions for small and medium-sized businesses to markets outside Germany. We also continued our traditional focus on the U.S. government market, providing smart card readers for authentication programs within various federal agencies; as well as providing digital media readers for the photo kiosk market in the U.S.

     In late 2007, we began to implement a new growth strategy that aims to expand sales of existing product lines into new geographic markets and to diversify and expand our customer base. As part of this strategy, we added sales resources in Europe, Asia and the Americas to increase our ability to address current and future business opportunities. For example, we added sales resources to target authentication programs in the government and enterprise sectors in Latin America and Asia and we began targeting the photo kiosk markets in Europe and Asia. As sales cycles for government projects and design cycles for photo kiosks may take several quarters, we believe we will begin to realize revenue from these investments in the first half of 2009.

     In early 2008, we implemented an additional growth strategy aimed at further diversifying and expanding our customer base by targeting the emerging contactless reader market. We have begun investing to develop new PC Security products based on contactless technologies such as Near Field Communication and FeliCa^® and have initiated business development activities aimed at penetrating the worldwide financial services and enterprise markets with our contactless reader products. For example, in October 2008, we introduced the first in a family of new products called @MAXX™ that are aimed at the market for contactless applications.

     To better leverage our own capabilities, we have also adopted a more active approach to partnering with other companies that can provide complementary resources and strengths. For example, in recent months we have worked together with XIRING, a French security solutions company, to develop a mobile eHealth terminal for the German electronic health card system. We have also taken an equity position in TranZfinity, a company with which we developed our @MAXX family of contactless readers and which has agreed to provide application services for those readers. Additionally, we have signed a distribution agreement with Hirsch Electronics, a supplier of physical access control systems, to sell our physical access control terminals into their customer base in the U.S. government.

     To ensure that we have the expertise and executive leadership to manage the Company, we have reorganized and strengthened our management team with key executive hires and promotions. Felix Marx joined as Chief Executive Officer in October 2007; Sour Chhor joined as Executive Vice President, Strategy, Marketing and Engineering in February 2008; and Manfred Mueller was promoted to Executive Vice President, Strategic Sales and Business Development in March 2008. In the first nine months of 2008, we have also added expertise in contactless technologies and the contactless market with the addition of new sales, marketing and engineering professionals from the contactless industry. We believe our new executives and the expanded expertise of our management team strengthen our ability to anticipate and respond to market trends both in the traditional smart card industry and in the emerging market for contactless solutions.

     We have invested in new products, resources and programs to support the growth strategies described above and this has resulted in increased operating expenses year over year. We believe these investments are critical to the success of our growth strategies and we expect to continue to invest in these strategies in the future.

Trends in our Business

     In our continuing operations, we may experience significant variations in demand for our products quarter to quarter. This is particularly true for our PC Security products, a significant proportion of which are currently sold for 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.

     Historically, we have sold a significant proportion of our PC Security products to the U.S. government for PC and network access by military and federal employees, and these sales have been an important component of our overall revenue. However, during the first six months of 2008, we experienced significantly weaker demand for our smart card readers from the U.S. government sector due to project and budget delays. Sales to the U.S. government market increased in the third quarter of 2008, returning to levels similar to those we experienced in 2007, as some projects moved forward. During the past several quarters, we have also experienced an ongoing shift in the U.S. government market away from external reader devices and towards interface chips that provide embedded reader technology in laptops and keyboards. We have also sold high volumes of smart card interface chips for embedded readers to laptop and keyboard manufacturers in Asia that have partially offset the decrease in sales of our external readers; however these chips have a lower average selling price than our external reader devices. Our sales to Asia increased 21% in the third quarter of 2008 and 17% in the first nine months of 2008 compared with the prior year. We continue to believe that we remain a leading supplier of smart card reader technology to the U.S. government market and that we are not losing share to competitors. However, the shift in demand from external reader devices towards embedded readers in the U.S. government market has resulted and is likely to continue to result in reduced revenue opportunity for us.

     In the third quarter of 2008, European sales decreased approximately 20% compared with the prior year quarter due to variability in the timing of orders for regional programs requiring smart card readers. We continue to expect that the rollout of the new electronic health card in Germany will provide significant additional opportunity for SCM. Currently we are one of a limited number of suppliers certified to provide eHealth card terminals approved for this program. However, the timing of the program’s launch is still uncertain, and it may not begin before the end of 2008.

     Sales of our Digital Media Reader products are less subject to variability based on market or project demands; 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. During the third quarter of 2008, digital media reader sales were well below recent quarterly levels due to unexpectedly light orders from a major customer.

     Both our PC Security and Digital Media Reader businesses are subject to ongoing pricing pressure. To counter this trend, we have implemented ongoing cost reduction programs that have resulted in ongoing improvements to our product margins. We believe we should be able to offset pricing pressure and material cost increases with ongoing improvements in our supply chain systems.

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 (U.S. GAAP). 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.

	•		We recognize product revenue upon shipment provided that risk and title have transferred, a purchase order has been received, collection is determined to be reasonably assured and no significant obligations remain. Maintenance revenue is deferred and amortized over the period of the maintenance contract. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required, which could have a material impact on our results of operations.
	•		We typically plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. We regularly review inventory quantities on hand and record an estimated provision for excess inventory, technical obsolescence and no sale-ability based primarily on our historical sales and expectations for future use. Actual demand and market conditions may be different from those projected by our management. This could have a material effect on our operating results and financial position. If we were to make different judgments or utilize different estimates, the amount and timing of our write-down of inventories could be materially different. Excess inventory frequently remains saleable. When excess inventory is sold, it yields a gross profit margin of up to 100%. Sales of excess inventory have the effect of increasing the gross profit margin beyond that which would otherwise occur, because of previous write-downs. Once we have written down inventory below cost, we do not subsequently write it up.
	•		We adopted the Financial Accounting Standards Board’s (“FASB”) Interpretation No. 48, Accounting For Uncertain Tax Positions (“FIN 48”) in the first quarter of 2007. We are required to make certain judgments and estimates in determining income tax expense for financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period. The calculation of our tax liabilities requires dealing with uncertainties in the application of complex tax regulations. FIN 48 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. It is inherently difficult and subjective to estimate such amounts. We reevaluate such uncertain tax positions on a quarterly basis based on factors such as, but not limited to, changes in tax laws, issues settled under audit and changes in facts or circumstances. Such changes in recognition or measurement might result in the recognition of a tax benefit or an additional charge to the tax provision in the period.
	•		The carrying value of our net deferred tax assets reflects that we have been unable to generate sufficient taxable income in certain tax jurisdictions. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefit, or that future deductibility is uncertain. Management evaluates the realizability of the deferred tax assets quarterly. At September 30, 2008, we have recorded valuation allowances against all of our deferred tax assets. The deferred tax assets are still available for us to use in the future to offset taxable income, which would result in the recognition of a tax benefit and a reduction in our effective tax rate. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of the realizability of deferred tax assets inaccurate, which could have a material impact on our financial position or results of operations.
	•		We accrue the estimated cost of product warranties during the period of sale. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by actual warranty costs, including material usage or service delivery costs incurred in correcting a product failure. If actual material usage or service delivery costs differ from our estimates, revisions to our estimated warranty liability would be required, which could have a material impact on our results of operations.
	•		During previous years, we have recorded restructuring charges as we rationalized operations in light of strategic decisions to align our business focus on certain markets. These measures, which included major changes in senior management, workforce reduction, facilities consolidation and the transfer of our production to contract manufacturers, were largely intended to align our capacity and infrastructure to anticipate customer demand and to transition our operations to better cost efficiencies. In connection with plans we have adopted, we recorded estimated expenses for severance and outplacement costs, lease cancellations, asset write-offs and other restructuring costs. Statement of Financial Accounting Standard (“SFAS”) No. 146, Accounting for Costs

			Associated with Exit or Disposal Activities, requires that a liability for a cost associated with an exit or disposal activity initiated after December 31, 2002 be recognized when the liability is incurred and that the liability be measured at fair value. Given the significance of, and the timing of the execution of such activities, this process is complex and involves periodic reassessments of original estimates. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring and other plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.
	•		With the Stock Purchase Agreement with TranZfinity (see Note 13 to Condensed Consolidated Financial Statements) we have entered into a non-marketable equity investment. Non-marketable equity investments are inherently risky, and a number of these companies are likely to fail. Their success is dependent on product development, market acceptance, operational efficiency, and other factors. In addition, depending on their future prospects and on market conditions, they may not be able to raise additional funds when needed or they may receive lower valuations, with less favorable investment terms than in previous financings, and our investment might become impaired. We will review our investment quarterly for indicators of impairment. Nevertheless, the impairment analysis for non-marketable equity investments requires significant judgment to identify events or circumstances that would significantly harm the value of the investment. The indicators that we will use to identify those circumstances can include, but are not limited to the investee’s revenue and earnings trends; the technological feasibility of the investee’s products and technologies; factors related to the investee’s ability to remain in business, such as the investee’s liquidity, debt ratios, and the rate at which the investee is using its cash; and the investee’s receipt of additional funding at a lower valuation.

Recent Accounting Pronouncements

     In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141(R)”). Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period be included in income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of SFAS No. 141(R) will change our accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.

     In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51. SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity. SFAS No. 160 is effective for us on a prospective basis for business combinations with an acquisition date beginning in the first quarter of fiscal year 2009. As of September 30, 2008, we did not have any minority interests.

     On January 1, 2008, we adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115. SFAS No. 159 permits companies to choose to measure certain financial instruments and other items at fair value using an instrument-by-instrument election. The standard requires that unrealized gains and losses are reported in earnings for items measured using the fair value option. The adoption of SFAS No. 159 did not have an impact on our consolidated financial position, results of operations or cash flows.

     On January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, for all financial assets and financial liabilities and for all non-financial assets and non-financial liabilities recognized or disclosed at fair value in the financial statements on a recurring basis (i.e., at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and enhances fair value measurement disclosure. SFAS No. 157 does not change the accounting for those instruments that were, under previous GAAP, accounted for at cost or contract value. The adoption of SFAS No. 157 did not have a significant impact on our consolidated financial statements, and the resulting fair values calculated under SFAS No. 157 after adoption were not significantly different than the fair values that would have been calculated under previous guidance.

     SFAS No. 157 establishes a fair value hierarchy that requires an entity to maximize the use of observable objective inputs and minimize the use of unobservable inputs, which require additional reliance on our judgment, when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. SFAS No. 157 establishes three levels of inputs that may be used to measure fair value:

	•		Level 1 — Quoted prices for identical instruments in active markets;
	•		Level 2 — Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations, in which all significant inputs are observable in active markets; and
	•		Level 3 — Valuations derived from valuation techniques, in which one or more significant inputs are unobservable.

     We use the following classifications to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified:

     Cash equivalents include highly liquid debt investments (money market fund deposits, commercial paper and treasury bills) with maturities of three months or less at the date of acquisition. These financial instruments are classified in Level 1 of the fair value hierarchy.

     Short-term investments consist of corporate notes and United States government agency instruments and are classified as available-for-sale. These financial instruments are classified in Level 1 of the fair value hierarchy. As of September 30, 2008, we had no short-term investments.

     Assets that are measured and recognized at fair value on a recurring basis classified under the appropriate level of the fair value hierarchy as of September 30, 2008 were as follows (in thousands):

		Level 1				Level 2				Level 3				Total
Money market fund deposits		$	11,455			$	—			$	—			$	11,455
Treasury Bills			4,000				—				—				4,000
Commercial papers			1,992				—				—				1,992
Total:		$	17,447			$	—			$	—			$	17,447

     As of September 30, 2008, there are no liabilities that are measured and recognized at fair value on a recurring basis.

     In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements that Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, and FSP 157-2, Effective Date of FASB Statement No. 157. FSP 157-1 amends SFAS No. 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. We are currently evaluating the impact that SFAS No. 157 will have on our consolidated financial statements when it is applied to non-financial assets and non-financial liabilities that are not measured at fair value on a recurring basis beginning in the first quarter of 2009.

Results of Operations

     Net Revenue. Summary information by product segment for the three and nine months ended September 30, 2008 and 2007 is as follows (in thousands):

		Three months ended								% change				Nine months ended								% change
		September 30,								period to				September 30,								period to
		2008				2007				period				2008				2007				period
PC Security
Revenue		$	5,873			$	6,140				(4	)%		$	15,758			$	17,100				(8	)%
Gross profit			2,748				2,846								7,172				7,345
Gross profit %			47	%			46	%							46	%			43	%
Digital Media Readers
Revenue		$	520			$	1,477				(65	)%		$	3,619			$	3,621				(0	)%
Gross profit			162				601								1,244				1,175
Gross profit %			31	%			41	%							34	%			32	%
Total:
Revenue		$	6,393			$	7,617				(16	)%		$	19,377			$	20,721				(6	)%
Gross profit			2,910				3,447								8,416				8,520
Gross profit %			46	%			45	%							43	%			41	%

     Net revenue for the third quarter of 2008 was $6.4 million, down 16% from $7.6 million for the same period of 2007. The decrease in third quarter revenue year over year was primarily driven by lower sales of our Digital Media Reader products. For the first nine months of 2008, net revenue was $19.4 million, down 6% from revenue of $20.7 million for the first nine months of 2007. The decrease in revenue for the nine months of 2008 compared with the prior-year period resulted primarily from lower sales of our PC Security products in the first and third quarters of 2008.

     Our PC Security product line principally consists of smart card readers and related chip technology that are primarily used in large security programs where smart cards are employed to authenticate the identity of people in order to control access to computers or computer networks; borders; buildings and other facilities; and services, such as health care. Also included in this business segment are our CHIPDRIVE software and reader solutions, which provide electronic timecard and other productivity applications for small and medium enterprises and are primarily sold in Europe. The majority of revenue in our PC Security business segment is government, financial or enterprise programs and is subject to significant variability based on the size and timing of customer orders.

     Sales of our PC Security products were $5.9 million in the third quarter of 2008, down 4% from sales of $6.1 million in the third quarter of 2007. Sales levels in the third quarter of 2008 were relatively unchanged in the U.S., up approximately 20% in Asia and down approximately 20% in Europe, compared with the third quarter of the prior year. U.S. sales in the third quarter of 2008 increased against U.S. sales in the prior two quarters due to stronger demand for smart card readers for U.S. government programs. Lower sales in Europe were the result of variability in the timing of orders and regional programs requiring smart card readers. Higher sales in Asia were the result of increased sales of smart card interface chips compared with the 2007 period.

     For the first nine months of 2008, sales of PC Security products were $15.8 million, down 8% from sales of $17.1 million for the first nine months of 2007. The decrease in sales in the first nine months of 2008 compared with the prior year was primarily due to a significant reduction in sales of our smart card reader products for U.S. government authentication programs in the first two quarters of 2008, mainly due to project and budget delays. During the first nine months of 2008, we have also experienced an ongoing shift in the U.S. government market away from external reader devices and towards interface chips that provide embedded reader technology in laptops and keyboards. We have sold high volumes of smart card interface chips for embedded readers to laptop and keyboard manufacturers in Asia that have somewhat offset the decrease in sales of our external reader devices in the U.S.; however, these chips have a lower average selling price than our external reader devices.

     Our Digital Media Reader product line consists of digital media readers and related ASIC technology used to provide an interface for flash memory cards, primarily embedded in digital photography kiosks, where the readers are used to download and print digital photos. Two to three customers, historically, have accounted for approximately two-thirds of sales in this business segment. As a result, revenue in our Digital Media Reader product line can fluctuate significantly quarter to quarter due to variability in the size and timing of customer orders.

     Sales of our Digital Media Reader products were $0.5 million in the third quarter of 2008, down 65% from sales of $1.5 million in the same period of 2007. For the first nine months of 2008, sales of Digital Media Reader products were $3.6 million, unchanged from sales of $3.6 million for the first nine months of 2007. During the third quarter of 2008, digital media reader sales were well below recent quarterly levels due to unexpectedly light orders from a major customer.

     Gross Profit Margin. Gross profit margin for the third quarter of 2008 was $2.9 million, or 46% of revenue, compared with $3.4 million, or 45% of revenue in the third quarter of 2007.

     Gross profit margin for our PC Security products was $2.7 million, or 47% of revenue for the third quarter of 2008, compared with $2.8 million, or 46% for the third quarter of 2007. Gross profit margin in the third quarter of 2008 reflects a more favorable mix of products sold compared with the same period of 2007 as well as ongoing product cost reductions.

     Gross profit margin for our Digital Media Reader products was $0.2 million, or 31% for the third quarter of 2008, down from $0.6 million, or 41% for the third quarter of 2007. The decrease in gross profit margin in the third quarter of 2008 compared with the same period of 2007 was primarily due to lower revenue levels in the 2008 period.

     For the first nine months of 2008, gross profit margin was $8.4 million, or 43% of revenue, compared with $8.5 million, or 41% of revenue for the first nine months of 2007. The improvement in gross profit margin in the first nine months of 2008 compared with the prior year primarily is due to a more favorable mix of higher margin products overall and product cost reductions in our PC Security business.

     We expect there will be some variation in our gross profit from period to period, as our gross profit has been and will continue to be affected by a variety of factors, including, without limitation, 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.

     Research and Development.

		Three months ended								% change				Nine months ended								% change
		September 30,								period to				September 30,								period to
(In thousands)		2008				2007				period				2008				2007				period
Expenses		$	980			$	815				20	%		$	3,058			$	2,327				31	%
Percentage of total revenues			15	%			11	%							16	%			11	%

     Research and development expenses consist primarily of employee compensation and fees for the development of hardware and firmware products. We focus the bulk of our research and development activities on the development of products for new and emerging market opportunities.

     Research and development expenses were $1.0 million, or 15% of revenue in the third quarter of 2008, up 20% from $0.8 million, which represented 11% of revenue in the third quarter of 2007. For the first nine months of 2008, research and development expenses were $3.1 million, up 31% from $2.3 million for the first nine months of 2007. Higher research and development expenses in the third quarter and first nine months of 2008 compared with the prior year are primarily due to the development of new contactless PC Security products and increased development activity related to readers for the German e-health program.

     We expect our research and development expenses to vary based on future project demands and on the markets we target.

     Selling and Marketing.

		Three months ended								% change				Nine months ended								% change
		September 30,								period to				September 30,								period to
(In thousands)		2008				2007				period				2008				2007				period
Expenses		$	2,280			$	1,625				40	%		$	7,010			$	4,802				46	%
Percentage of total revenues			36	%			21	%							36	%			23	%

     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, including e-health, contactless applications and the market business productivity solutions for small and medium-sized businesses.

     Selling and marketing expenses were $2.3 million, or 36% of revenue in the third quarter of 2008, up 40% from $1.6 million, which represented 21% of revenue in the third quarter of 2007. For the first nine months of 2008, sales and marketing expenses were $7.0 million, up 46% from $4.8 million in the first nine months of 2007. Higher sales and marketing expenses in the third quarter and first nine months of 2008 compared with the prior year are primarily due to the hiring of new sales resources over the past several quarters in Asia, Europe and the Americas to enhance our ability to address current and future business opportunities, as well as an increased level of travel expenses related to new business development activities. Also included in the first nine months of 2008 are approximately $0.2 million in severance costs recorded in the second quarter of 2008.

     General and Administrative.

		Three months ended								% change				Nine months ended								% change
		September 30,								period to				September 30,								period to
(In thousands)		2008				2007				period				2008				2007				period
Expenses		$	1,697			$	1,374				24	%		$	4,718			$	5,653				(17	)%
Percentage of total revenues			27	%			18	%							24	%			27	%

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

     General and administrative expenses were $1.7 million, or 27% of revenue in the third quarter of 2008, up 24% from $1.4 million, which represented 18% of revenue in the third quarter of 2007. Higher general and administrative expenses in the third quarter of 2008 primarily resulted from increased business development activities related to our strategy to expand and diversify our customer base and market opportunities. For the first nine months of 2008, general and administrative expenses were $4.7 million, down 17% from $5.7 million in the first nine months of 2007. General and administrative expense in the first nine months of 2007 included $1.4 million in severance and other costs associated with the resignation of our former chief executive officer. General and administrative expenses in the first nine months of 2008 were also impacted by the devaluation of the dollar against foreign currencies, namely the euro, as we pay the majority of these expenses in local currency but account for those expenses in dollars. If the trend in recent weeks continues and the dollar continues to strengthen in relation to foreign currencies, we expect this impact to be less pronounced in the fourth quarter of 2008.

     Amortization of Intangibles. Amortization of intangibles was zero during the third quarter of 2008 and 2007. For the first nine months of 2008, amortization of intangibles was zero, compared with $0.3 million during the first nine months of 2007.

     Interest and Other Income (Expenses), net. Interest and other income (expenses), net consists of interest earned on invested cash and foreign currency gains or losses.

     In the third quarter of 2008, interest income resulting from invested cash balances was $0.2 million, compared with interest income of $0.4 million for the third quarter of 2007. In the first nine months of 2008, interest income was $0.6 million, compared with interest income of $1.2 million in the first nine months of 2007. The reduction in interest income reflects our reduced cash balance and the reduction in interest rates in 2008 compared to 2007.

     Foreign currency losses were $1.3 million in the third quarter of 2008 compared with $0.1 million in the third quarter of 2007. Foreign currency losses were $0.9 million in the first nine months of 2008 compared with $0.2 million for the first nine months of 2007. Our foreign currency losses primarily result from the valuation of current assets and liabilities denominated in a currency other than the functional currency of the respective entity in the local financial statements. Accordingly, these foreign currency losses are predominantly non-cash items. Higher foreign exchange losses in the third quarter of 2008 are primarily the result of the weakening of the euro versus the U.S. dollar, as measured at the end of the quarter. If the euro remains weak relative to the U.S. dollar for the next several weeks, we expect that we will record further losses on foreign currency exchange in the fourth quarter of 2008.

     Income Taxes. In the three and nine months ended September 30, 2008, we recorded a provision for income taxes of $0.1 million and $0.2 million, respectively, primarily for minimum taxation, which could not be offset with operating loss carryforwards and tax expenses in a foreign subsidiary with no loss carryforwards.

     In the three and nine months ended September 30, 2007, we recorded a provision for income taxes of $32,000 and $0.1 million, respectively, primarily for minimum taxation, which could not be offset with operating loss carryforwards and tax expenses in a foreign subsidiary with no loss carryforwards.

     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. Net revenue for the DTV solutions business in both the three and nine months ended September 30, 2008 was zero. Net revenue for the DTV solutions business in the three and nine months ended September 30, 2007 was zero and $0.5 million, respectively. Operating gain for the DTV solutions business in the three and nine months ended September 30, 2008 was $32,000 and $26,000, respectively. Operating loss for the DTV solutions business for the three and nine months ended September 30, 2007 was $45,000 and $33,000, respectively.

     In May 2007, we received a final payment of $1.6 million from Kudelski related to the sale of our DTV solutions business that resulted in a $1.5 million gain on sale of discontinued operations in the first quarter of 2007 (See Note 3 to Condensed Consolidated Financial Statements). During the three and nine months ended September 30, 2007, net gain on the disposal of discontinued operations was approximately $16,000 and $1.6 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. Net revenue for the retail Digital Media and Video business was zero in each of the three and nine months ended September 30, 2008 and 2007. Operating loss for the retail Digital Media and Video business in the three and nine months ended September 30, 2008 was $0.1 million and $0.2 million, respectively. Operating loss for the retail Digital Media and Video business was $0.1 million and $0.2 million in the three and nine months ended September 30, 2007, respectively.

     In April 2008, we entered into an agreement to terminate our lease agreement for premises leased in the UK, which resulted in approximately $0.4 million in gain on sale of discontinued operations. During the three and nine months ended September 30, 2008, the total net gain on the disposal of discontinued operations was approximately $44,000 and $0.6 million, respectively.

Liquidity and Capital Resources

     As of September 30, 2008, our working capital, which we have defined as current assets less current liabilities, was $27.8 million, compared to $34.0 million as of December 31, 2007, a decrease of approximately $6.2 million. The reduction in working capital for the first nine months of 2008 primarily reflects a reduction of cash and cash equivalents and short-term investments of $7.4 million and a combined decrease in accounts receivable, inventories and other current assets of $0.8 million. The reduction in other current assets was partly offset by a $2.0 million decrease in current liabilities.

     Cash and cash equivalents and short-term investments were $25.0 million as of September 30, 2008, a decrease of approximately $7.4 million compared to $32.4 million as of December 31, 2007. Short-term investments were zero at September 30, 2008, compared to $13.8 million at December 31, 2007. The reduction in short-term investments is the result of our decision in late 2007 to move liquidity resources into more highly liquid debt investments (money market fund deposits, commercial paper and treasury bills) with maturities of three months or less at the date of acquisition.

     The following summarizes our cash flows for the nine months ended September 30, 2008 (in thousands):

		Nine Months Ended
		September 30,
		2008
Operating cash used in continuing operations		$	(6,555	)
Operating cash used in discontinued operations			(350	)
Investing cash provided			13,339
Financing cash flow			18
Effect of exchange rate changes on cash and cash equivalents			(32	)
Increase in cash and cash equivalents			6,420
Cash and cash equivalents at beginning of period			18,600
Cash and cash equivalents at end of period		$	25,020

     During the first nine months of 2008, cash used in operating activities was $6.9 million. This use of cash consisted of a net loss of approximately $6.0 million, the use of approximately $0.2 million from net changes in operating assets and liabilities and the use of approximately $1.2 million from the net changes in the assets and liabilities from discontinued operations. This effect was partially offset by positive cash flow adjustments for depreciation, amortization and stock compensation totaling $0.5 million.

     Significant commitments that will require the use of cash in future periods include obligations under operating leases, inventory purchase commitments and other contractual agreements. Gross committed lease obligations were approximately $4.6 million at September 30, 2008. As of September 30, 2008, inventory and other purchase commitments due within one year were approximately $10.1 million and additional inventory and other purchase commitments due within two years were approximately $2.6 million.

     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 2009. 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.

     Cash provided from investing activities of $13.3 million for the nine months ended September 30, 2008 was primarily from the maturity of short-term investments, which was partly offset by capital expenditures of $0.5 million.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     There has been no significant change in our exposure to market risk during the three months ended September 30, 2008. For discussion of SCM’s exposure to market risk, refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risk, contained in the Company’s Annual Report incorporated by reference in Form 10-K for the year ended December 31, 2007.

Item 4. Controls and Procedures

     Attached as exhibits to this Form 10-Q are certifications of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This “Controls and Procedures” section includes information concerning the controls and controls evaluation referred to in the certifications.

     (a) Evaluation of Disclosure Controls and Procedures

     As of September 30, 2008, SCM carried out an evaluation, as required in Rule 13a-15(b) under the Exchange Act, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Exchange Act. Based on this evaluation, our CEO and CFO concluded that, as of September 30, 2008, our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed in our Securities and Exchange Commission (“SEC”) reports that we file or furnish under the Exchange Act (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 CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. In the course of this evaluation, we sought to identify any significant deficiencies or material weaknesses in our disclosure controls and procedures, to determine whether we had identified any acts of fraud involving personnel who have a significant role in our disclosure controls and procedures, and to confirm that any necessary corrective action, including process improvements, was taken. The overall goals of these evaluation activities are to monitor our disclosure controls and procedures and to make modifications as necessary. We intend to maintain these disclosure controls and procedures, modifying them as circumstances warrant.

     (b) Changes in Internal Controls over Financial Reporting

     In connection with our continued monitoring and maintenance of our controls procedures as part of the implementation of section 404 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 third quarter of 2008 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

     (c) Inherent Limitations on Effectiveness of Controls

     A control system, no matter how well designed and operated, can only provide reasonable assurances that the objectives of the control system are met. Because there are inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within SCM have been or will be detected.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

     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 in the following risk factors 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 risks, 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 $198.1 million as of September 30, 2008. We may not be able to achieve expected results, including any guidance or outlook we may provide from time to time; we may continue to incur losses; and we may be unable to achieve or maintain profitability.

Our quarterly and annual operating results 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:

	•		business and economic conditions overall and in our markets;
	•		the timing and amount of orders we receive from our customers that may be tied to budgetary cycles, seasonal demand, product plans or program roll-out schedules;
	•		cancellations or delays of customer product orders, or the loss of a significant customer;
	•		our ability to obtain an adequate supply of components on a timely basis;
	•		poor quality in the supply of our components;
	•		delays in the manufacture of our products;
	•		the absence of significant backlog in our business;
	•		our inventory levels;
	•		our customer and distributor inventory levels and product returns;

	•		competition;
	•		new product announcements or introductions;
	•		our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all;
	•		our ability to successfully market and sell products into new geographic or market segments;
	•		the sales volume, product configuration and mix of products that we sell;
	•		technological changes in the markets for our products;
	•		the rate of adoption of industry-wide standards;
	•		reductions in the average selling prices that we are able to charge due to competition or other factors;
	•		strategic acquisitions, sales and dispositions;
	•		fluctuations in the value of foreign currencies against the U.S. dollar;
	•		the timing and amount of marketing and research and development expenditures;
	•		loss of key personnel; and
	•		costs related to events such as dispositions, organizational restructuring, headcount reductions, litigation or write-off of investments.