UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10 – Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

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 or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). 

Yes o          No þ

At October 31, 2007, 15,735,615 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			20
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			28
		Item 4.		Controls and Procedures			28
PART II. OTHER INFORMATION
		Item 1.		Legal Proceedings			28
		Item 1A		Risk Factors			28
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			39
		Item 3.		Defaults Upon Senior Securities			39
		Item 4.		Submission of Matters to a Vote of Security Holders			40
		Item 5.		Other Information			40
		Item 6.		Exhibits			40
SIGNATURES							41
EXHIBIT INDEX							42
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

PART 1. 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,
		2007				2006				2007				2006
Net revenue		$	7,617			$	7,396			$	20,721			$	24,185
Cost of revenue			4,170				5,271				12,201				16,251
Gross profit			3,447				2,125				8,520				7,934
Operating expenses:
Research and development			815				1,085				2,327				3,115
Selling and marketing			1,625				2,292				4,802				6,053
General and administrative			1,374				2,208				5,653				6,340
Amortization of intangible assets			—				170				272				495
Restructuring and other charges			(4	)			400				(4	)			1,066
Total operating expenses			3,810				6,155				13,050				17,069
Loss from operations			(363	)			(4,030	)			(4,530	)			(9,135	)
Interest and other income/expenses, net			279				367				999				809
Loss from continuing operations before income taxes			(84	)			(3,663	)			(3,531	)			(8,326	)
Provision for income taxes			(32	)			(17	)			(124	)			(46	)
Loss from continuing operations			(116	)			(3,680	)			(3,655	)			(8,372	)
Income (loss) from discontinued operations, net of income taxes			(83	)			(213	)			(202	)			2,793
Gain on sale of discontinued operations, net of income taxes			16				24				1,569				5,287
Net loss		$	(183	)		$	(3,869	)		$	(2,288	)		$	(292	)
Loss per share from continuing operations:
Basic and diluted		$	(0.01	)		$	(0.24	)		$	(0.23	)		$	(0.54	)
Gain (loss) per share from discontinued operations:
Basic and diluted		$	(0.00	)		$	(0.01	)		$	0.08			$	0.52
Net loss per share:
Basic and diluted		$	(0.01	)		$	(0.25	)		$	(0.15	)		$	(0.02	)
Shares used to compute basic and diluted loss per share			15,736				15,648				15,722				15,623
Comprehensive gain (loss):
Net loss		$	(183	)		$	(3,869	)		$	(2,288	)		$	(292	)
Unrealized gain (loss) on investments			1				32				11				61
Foreign currency translation adjustment			450				75				984				272
Total comprehensive gain (loss)		$	268			$	(3,762	)		$	(1,293	)		$	41

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,
		2007				2006
ASSETS
Current assets:
Cash and cash equivalents		$	24,143			$	32,103
Short-term investments			8,948				4,799
Accounts receivable, net of allowances of $422 and $867 as of September 30, 2007 and December 31, 2006			6,156				6,583
Inventories			2,870				1,927
Other current assets			1,049				2,489
Total current assets			43,166				47,901
Property and equipment, net			1,566				1,457
Intangible assets, net			—				272
Other assets			1,888				1,725
Total assets		$	46,620			$	51,355
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,995			$	4,572
Accrued compensation and related benefits			1,164				1,729
Accrued restructuring and other charges			3,040				3,431
Accrued professional fees			1,065				1,063
Accrued royalties			392				971
Other accrued expenses			2,106				2,289
Income taxes payable			247				1,879
Total current liabilities			10,009				15,934
Long-term income taxes payable			195				—
Deferred tax liability			101				103
Commitments and contingencies (see Notes 10 and 11)			—				—
Total liabilities			10,305				16,037
Stockholders’ equity:
Common stock, $0.001 par value: 40,000 shares authorized; 16,354 and 16,316 shares issued and 15,736 and 15,698 shares outstanding as of September 30, 2007 and December 31, 2006, respectively			16				16
Additional paid-in capital			229,323				228,580
Treasury stock			(2,777	)			(2,777	)
Accumulated deficit			(192,456	)			(191,714	)
Other cumulative comprehensive gain			2,209				1,213
Total stockholders’ equity			36,315				35,318
Total liabilities and stockholders’ equity		$	46,620			$	51,355

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,
		2007				2006
Cash flows from operating activities:
Net loss		$	(2,288	)		$	(292	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Gain from discontinued operations			(1,367	)			(8,080	)
Depreciation and amortization			500				795
Loss (gain) on disposal of fixed assets			(6	)			46
Stock compensation expense			639				485
Deferred income taxes			(2	)			(1	)
Changes in operating assets and liabilities:
Accounts receivable			542				(216	)
Inventories			(893	)			64
Other assets			1,246				(910	)
Accounts payable			(2,143	)			361
Accrued expenses			(1,619	)			(330	)
Income taxes payable			98				218
Net cash used in operating activities from continuing operations			(5,293	)			(7,860	)
Net cash provided by operating activities from discontinued operations			697				9,856
Net cash provided by (used in) operating activities			(4,596	)			1,996
Cash flows from investing activities:
Capital expenditures			(178	)			(65	)
Proceeds from disposal of fixed assets			—				11
Maturities of short-term investments			12,656				14,392
Purchase of restricted short-term investments			—				(2,000	)
Purchases of short-term investments			(16,793	)			(2,878	)
Net cash provided by (used in) investing activities from continuing operations			(4,315	)			9,460
Net cash provided by investing activities from discontinued operations			—				3,484
Net cash provided by (used in) investing activities			(4,315	)			12,944
Cash flows from financing activities:
Proceeds from issuance of equity securities, net			104				174
Net cash provided by financing activities			104				174
Effect of exchange rates on cash and cash equivalents			847				187
Net increase (decrease) in cash and cash equivalents			(7,960	)			15,301
Cash and cash equivalents at beginning of period			32,103				13,660
Cash and cash equivalents at end of period		$	24,143			$	28,961
Supplemental disclosures of cash flow information:
Income tax refunds received		$	—			$	—
Income taxes paid		$	108			$	106

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007

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 for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by 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 have been included. Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems Inc.’s (“SCM” or “the Company”) Annual Report on Form 10-K for the year ended December 31, 2006.

     During the review of the preparation of the cash flows from discontinued operations for the nine months ended September 30, 2007, the Company determined that an adjustment was needed to the condensed consolidated statements of cash flows for the nine months ended September 30, 2006. Consequently, in the section “Cash flows from operating activities”, the amounts in lines “Accrued expenses” and “Net cash used in operating activities from continuing operations” were reduced by $3.2 million compared to the condensed consolidated statements of cash flows submitted with Form 10-Q for the quarterly period ended September 30, 2006. Simultaneously, the amount in line “Net cash provided (used) in operating activities from discontinued operations” was increased by $3.2 million compared to the condensed consolidated statements of cash flows submitted with Form 10-Q for the quarterly period ended September 30, 2006. The adjustment did not have any impact to the cash flows from operating activities in total and was not considered to be material.

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 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, 2007 and 2006, 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.

Accounting Changes

     During the first quarter of fiscal 2007, the Company adopted the provisions of, and accounted for uncertain tax positions in accordance with the Financial Accounting Standards Board’s (“FASB”) Interpretation No. 48, Accounting For Uncertain Tax Positions (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption are to be accounted for as an adjustment to the beginning balance of retained earnings.

     As a result of the implementation, the Company recognized a $1.5 million decrease to income taxes payable for uncertain tax positions. This decrease was accounted for as an adjustment to the beginning balance of accumulated deficit on the balance sheet. Including this decrease, at the beginning of 2007, the Company had $0.1 million of unrecognized tax benefits included in income taxes payable on the consolidated balance sheet. At September 30, 2007, the Company had $0.2 million of unrecognized tax benefits disclosed in income taxes payable on the consolidated balance sheet. As a result of adoption of FIN 48, unrecognized tax benefits were reclassified to long-term income taxes payable, where applicable.

     In addition, $1.6 million of unrecognized tax benefits existed as of January 1, 2007, which do not have any impact on the consolidated balance sheet or income statement, as these only impact the amounts of losses carried forward by the various entities of the Company because any deferred tax assets on these losses carried forward have been fully reserved for. The amount of these unrecognized tax benefits reduced to $1.5 million in the third quarter of 2007 primarily due to a reduction in the enacted tax rate in one country where the Company has unrecognized tax benefits.

     The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2007, approximately $47,000 of accrued interest and penalties related to uncertain tax positions.

     The Company files U.S. federal, U.S. state and foreign tax returns. The Company is generally no longer subject to tax examinations for years prior to 1999. When loss carry forwards of tax years prior to 1999 would be utilized in the U.S., these tax years also might become subject to investigation by the tax authorities.

     While timing of the resolution and/or finalization of audits is very uncertain, the Company does not believe that its unrecognized tax benefits would materially change in the next 12 months.

Recent Accounting Pronouncements

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

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 ten years from the grant date. 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 date of grant. Additionally, 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 the ESPP are newly issued shares. The Company’s ESPP, director option plan and 1997 stock option plan all expired in March 2007. As of September 30, 2007, the Company had approximately 1.8 million options outstanding and 1.8 million shares of common stock reserved for future issuance upon exercise of those options under all its stock option plans, including those that have expired.

     On January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), Share-Based Payments (“SFAS 123(R)”), for its share-based compensation plans. Under SFAS 123(R), the Company is required to recognize stock-based compensation costs based on the estimated fair value at the grant date for its share-based awards. In accordance to this standard, the Company recognizes the compensation cost of all share-based awards on a straight-line basis over the requisite service period, which is the vesting period of the award.

     The Company elected to use the modified prospective transition method as permitted by SFAS 123(R) and therefore has not restated its financial results for prior periods. Under this transition method, in the three and nine months ended September 30, 2007, the compensation cost recognized includes the cost for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123. Compensation cost for all share-based compensation awards granted on or subsequent to January 1, 2006 was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation expense from the accelerated multiple-option approach to the straight-line single option method. Compensation expense for all share-based payment awards granted prior to January 1, 2006 will continue to be recognized using the accelerated multiple-option approach, while compensation expense for all share-based payment awards granted on or subsequent to January 1, 2006 has been and will continue to be recognized using the straight-line single-option approach.

     Compensation expense recognized in the unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2007, is based on awards ultimately expected to vest and reflects estimated forfeitures. 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.

     In calculating the 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.

     As a result of adopting SFAS 123(R), for the three and nine months ended September 30, 2007, the Company’s loss from continuing operations before income tax provision and net loss from continuing operations was $0.2 million and $0.6 million higher, respectively, than if it had continued to account for share-based compensation under Accounting Principles Board Opinion No 25, Accounting for Stock Issued to Employees (“APB 25”). For the three and nine months ended September 30, 2006, the Company’s loss from continuing operations before income tax provision and net loss from continuing operations was $0.1 million and $0.5 million higher, respectively, than under APB 25. Basic and diluted net loss per share for the three and nine months ended September 30, 2007 would have been $0.01 and $0.04 lower, respectively, and basic and diluted net loss per share from continuing operations for the three and nine months ended September 30, 2006 would have been $0.01 and $0.03 lower, respectively, if the Company had not adopted SFAS 123(R). There was no effect on the condensed consolidated statements of cash flows for the nine months ended September 30, 2007 from adopting SFAS 123(R).

     On November 10, 2005, the FASB issued FASB Staff Position No. 123(R)-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (“FAS 123(R)-3”). The Company has elected to adopt the alternative transition method provided in FAS 123(R)-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

     The following table illustrates the stock-based compensation expense resulting from stock options and ESPP included in the unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2007 and 2006 (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Cost of revenue		$	18			$	10			$	51			$	24
Research and development			21				29				65				92
Selling and marketing			77				38				177				119
General and administrative			117				66				346				250
Stock-based compensation expense before income taxes		$	233			$	143			$	639			$	485
Income tax benefit			—				—				—				—
Stock-based compensation expense after income taxes		$	233			$	143			$	639			$	485

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. A total of 88,301 shares of common stock are reserved for future option grants under the remaining 2000 stock plan as of September 30, 2007. In addition, in November 2007, stockholders approved the 2007 Stock Option Plan, which authorizes an additional 1.5 million stock option grants. 1.5 million shares of common stock are reserved for future option grants under the 2007 Stock Option Plan..

     Summary of activity under all the Company’s stock option plans, including those plans that expired in March 2007, for the nine months ended September 30, 2007 is as follows:

																		Weighted
										Weighted								Average
		Options				Number of				Average								Remaining
		Available				Options				Exercise Price				Aggregate				Contractual Life
		for Grant				Outstanding				per share				Intrinsic Value				(in years)
Balance at December 31, 2006			4,084,775				1,783,255			$	12.58			$	81,808				5.79
Options granted			(405,701	)			405,701			$	4.02				—				—
Options cancelled or expired			(3,590,773	)			(371,740	)		$	8.84				—				—
Options exercised							(10,788	)		$	3.07			$	8,331				—
Balance at September 30, 2007			88,301				1,806,428			$	11.48			$	32,797				5.83
Vested or expected to vest at September 30, 2007							1,698,581			$	11.97			$	31,174
Exerciseable at September 30, 2007							1,254,980			$	14.92			$	22,346				4.58

     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 weighted-average grant date fair value per option for options granted during the three and nine months ended September 30, 2006 was $1.69 and $1.72, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2007 was zero and $8,331, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $7,100 and $7,300, 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. Cash proceeds from the exercise of stock options were $58,000 and $58,700 for the three and nine months ended September 30, 2006, respectively. No income tax benefit was realized from the stock option exercises during the three and nine months ended September 30, 2007 and 2006. Stock-based compensation expense related to stock options recognized under SFAS 123(R) for the three and nine months ended September 30, 2007 was $0.2 million and $0.6 million, respectively. At September 30, 2007, there was $0.8 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 1.84 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, 2007 and 2006, respectively:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Expected volatility			54	%			64	%			57	%			69	%
Dividend yield			0				0				0				0
Risk-free interest rate			4.13	%			4.62	%			4.53	%			4.85	%
Expected term (in years)			4.00				3.92				4.00				3.92

     Expected Volatility: The Company’s computation of expected volatility for the three and nine months ended September 30, 2007 is based on the historical volatility of the Company’s stock for a time period equivalent to the expected life.

     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 the three and nine months ended September 30, 2007 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.

1997 Employee Stock Purchase Plan

     Until its expiration in March 2007, the Company’s ESPP permitted eligible employees to purchase common stock through payroll deductions up to 10% of their base wages at a purchase price of 85% of the lower of fair market value of the 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 common stock each year. As of September, 2007, no shares were available for future issuance under the Company’s ESPP, due to the plan’s expiration in March 2007.

     The fair value of issuances under the Company’s ESPP was estimated on the issuance date by applying the principles of FASB Technical Bulletin 97-1, Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look Back Option, and using the Black-Scholes-Merton options pricing model. 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, 2007, 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 million was paid at the time of sale and $1.6 million was paid in May 2007.

     In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, for the three and nine months ended September 30, 2007, the DTV solutions business has been presented as discontinued operations in the 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 this period.

     The operating results for the discontinued operations of the DTV solutions business for the three and nine months ended September 30, 2007 and for the same period of 2006 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Net revenue		$	—			$	1,877			$	496			$	12,288
Operating gain (loss)		$	45			$	(115	)		$	33			$	(1,276	)
Net income (loss) before income taxes		$	45			$	(141	)		$	56			$	2,919
Income tax benefit (provision)		$	—			$	(8	)		$	(16	)		$	75
Income (loss) from discontinued operations		$	45			$	(149	)		$	40			$	2,994

     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.

     The operating results for the discontinued operations of the retail Digital Media and Video business for the three and nine months ended September 30, 2007 and for the same period of 2006 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Net revenue		$	—			$	—			$	—			$	—
Operating loss		$	(82	)		$	(75	)		$	(236	)		$	(201	)
Net loss before income taxes		$	(72	)		$	(51	)		$	(186	)		$	(134	)
Income tax provision		$	(56	)		$	(13	)		$	(56	)		$	(67	)
Loss from discontinued operations		$	(128	)		$	(64	)		$	(242	)		$	(201	)

4. Short-Term Investments

     At September 30, 2007, approximately 80% of the short-term investment portfolio matures in 2007 and the remaining 20% matures in 2008. The fair value of short-term investments at September 30, 2007 and December 31, 2006 was as follows (in thousands):

		September 30, 2007
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	7,934			$	1			$	(3	)		$	7,932
U.S. government agencies			1,017				—				(1	)			1,016
Total		$	8,951			$	1			$	(4	)		$	8,948

		December 31, 2006
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	1,021			$	—			$	(2	)		$	1,019
U.S. government agencies			3,792				—				(12	)			3,780
Total		$	4,813			$	—			$	(14	)		$	4,799

     During each quarter, the Company evaluates its investments for possible asset impairment by examining a number of factors, including the current economic conditions and markets for each investment, as well as its cash position and anticipated cash needs for the short and long term. At September 30, 2007, approximately $7.0 million of the short-term investment portfolio had an unrealized loss and approximately $1.0 million of those investments have been in an unrealized loss position for more than one year. Of the $4,000 unrealized loss at September 30, 2007, approximately $1,000 relates to investments that have been in an unrealized loss position for more than one year. For the three and nine months ended September 30, 2007 and 2006, no impairment of the investments was identified by the Company based on the evaluations performed.

5. Inventories

     Inventories consist of (in thousands):

		September 30,				December 31,
		2007				2006
Raw materials		$	1,483			$	754
Work-in-process			184				0
Finished goods			1,203				1,173
Total		$	2,870			$	1,927

6. Property and Equipment

     Property and equipment consists of (in thousands):

		September 30,				December 31,
		2007				2006
Land		$	141			$	127
Building and leasehold improvements			1,945				1,789
Furniture, fixtures and office equipment			3,178				2,851
Automobiles			34				1
Purchased software			3,442				3,209
Total			8,740				7,977
Accumulated depreciation			(7,174	)			(6,520	)
Property and equipment, net		$	1,566			$	1,457

     Depreciation expense was $0.1 million and $0.2 million for the three and nine months ended September 30, 2007, respectively, and $0.1 million and $0.3 million for the three and nine months ended September 30, 2006, respectively.

7. Intangible Assets

     Intangible assets are primarily associated with the Company’s European operations and consist of the following (in thousands):

				September 30, 2007												December 31, 2006
				Gross												Gross
		Amortization		Carrying				Accumulated								Carrying				Accumulated
		Period		Value				Amortization				Net				Value				Amortization				Net
Customer relations		60 months		$	1,762			$	(1,762	)		$	—			$	1,639			$	(1,520	)		$	119
Core technology		60 months			1,996				(1,996	)			—				1,858				(1,705	)			153
Total intangible assets				$	3,758			$	(3,758	)		$	—			$	3,497			$	(3,225	)		$	272

     In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, only the Company’s intangible assets relating to core technology and customer relations are subject to amortization.

     Amortization expense related to intangible assets for continuing operations was zero and $0.3 million for the three and nine months ended September 30, 2007, respectively, and $0.2 million and $0.5 million for the three and nine months ended September 30, 2006, respectively. No further amounts remain to be amortized in future periods.

8. Restructuring and Other Charges

     Continuing Operations

     During the three and nine months ended September 30, 2007, the Company realized an income from the release of a severance accrual related to continuing operations of $4,000. During the three and nine months ended September 30, 2006, the Company incurred net restructuring and other charges related to continuing operations of approximately $0.4 million and $1.3 million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the nine months ended September 30, 2007 and during the year ended December 31, 2006 consist of the following (in thousands):

		Lease/Contract				Other
		Commitments				Severance				Costs				Total
Balances as of January 1, 2006		$	32			$	152			$	9			$	193
Provision for 2006			33				1,320				—				1,353
Changes in estimates			(2	)			4				—				2
			31				1,324				—				1,355
Payments and other changes in 2006			(48	)			(1,370	)			—				(1,418	)
Balances as of December 31, 2006			15				106				9				130
Provision for Q1 2007			—				—				—				—
Changes in estimates			—				—				—				—
			—				—				—				—
Payments and other changes in Q1 2007			(1	)			(101	)			—				(102	)
Balances as of March 31, 2007			14				5				9				28
Provision for Q2 2007			—				—				—				—
Changes in estimates			—				—				—				—
			—				—				—				—
Payments and other changes in Q2 2007			(1	)			—				—				(1	)
Balances as of June 30, 2007			13				5				9				27
Provision for Q3 2007			—				—				—				—
Changes in estimates			—				(4	)			—				(4	)
			—				(4	)			—				(4	)
Payments and other changes in Q3 2007			—				(1	)			—				(1	)
Balances as of September 30, 2007		$	13			$	—			$	9			$	22

     During 2006, SCM executed and completed restructuring activities in connection with a reduction in force resulting from the Company’s decision to transfer all manufacturing operations from its Singapore facility to contract manufacturers as well as the decision to transfer the corporate headquarter functions of the Company from California to Germany. For the three and nine months ended September 30, 2007, no further restructuring costs from continuing operations were incurred.

     Discontinued Operations

     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. During the three and nine months ended September 30, 2006, SCM incurred restructuring and other credits of approximately $25,000 and restructuring and other charges of approximately $31,000, respectively, related to discontinued operations.

     Accrued liabilities related to the Digital Media and Video restructuring actions and other activities during the nine months ended September 30, 2007 and during the year ended December 31, 2006 consist of the following (in thousands):

		Lease/Contract				Other
		Commitments				Costs				Total
Balances as of January 1, 2006		$	3,198			$	506			$	3,704
Provision for 2006			2				5				7
Changes in estimates			87				—				87
			89				5				94
Payments and other changes in 2006			(338	)			(159	)			(497	)
Balances as of December 31, 2006			2,949				352				3,301
Provision for Q1 2007			—				—				—
Changes in estimates			(13	)			—				(13	)
			(13	)			—				(13	)
Payments and other changes in Q1 2007			(92	)			4				(88	)
Balances as of March 31, 2007			2,844				356				3,200
Provision for Q2 2007			—				—				—
Changes in estimates			(23	)			(40	)			(63	)
			(23	)			(40	)			(63	)
Payments and other changes in Q2 2007			(66	)			5				(61	)
Balances as of June 30, 2007			2,755				321				3,076
Provision for Q3 2007			—				—				—
Changes in estimates			(16	)			—				(16	)
			(16	)			—				(16	)
Payments and other changes in Q3 2007			(56	)			14				(42	)
Balances as of September 30, 2007		$	2,683			$	335			$	3,018

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 and Vice President Sales.

     The Company’s continuing operations provide secure digital access solutions to mainly OEM customers in two markets segments: PC Security and Flash 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 profit 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, 2007 and during the same periods of 2006 is as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
PC Security:
Net revenue		$	6,140			$	5,096			$	17,100			$	16,438
Gross profit			2,846				1,621				7,345				6,480
Gross profit %			46	%			32	%			43	%			39	%
Flash Media Readers:
Net revenue		$	1,477			$	2,300			$	3,621			$	7,747
Gross profit			601				504				1,175				1,454
Gross profit %			41	%			22	%			32	%			19	%
Total:
Net revenue		$	7,617			$	7,396			$	20,721			$	24,185
Gross profit			3,447				2,125				8,520				7,934
Gross profit %			45	%			29	%			41	%			33	%

     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,
		2007				2006				2007				2006
Europe
Net revenue
United States		$	3,635			$	3,242			$	9,574			$	10,407
Europe			2,603				3,045				6,716				10,212
Asia-Pacific			1,379				1,109				4,431				3,566
Total		$	7,617			$	7,396			$	20,721			$	24,185
% of net revenue
United States			48	%			44	%			47	%			43	%
Europe			34	%			41	%			32	%			42	%
Asia-Pacific			18	%			15	%			21	%			15	%

     Customers comprising 10% or greater of the Company’s net revenue are summarized as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Customer A based in the USA			13	%			*				14	%			*
Customer B based in the USA			11	%			14	%			12	%			12	%
Customer C based in Europe			*				13	%			*				*
Total			24	%			27	%			26	%			12	%

     Customers representing 10% or greater of the Company’s accounts receivable are summarized as follows:

		September 30,				December 31,
		2007				2006
Customer A based in Asia			*				19	%
Customer B based in the USA			13	%			17	%
Customer C based in the USA			16	%			*
Total			29	%			36	%

     Long-lived assets by geographic location as of September 30, 2007 and December 31, 2006, are as follows (in thousands):

		September 30,				December 31,
		2007				2006
Property and equipment, net:
United States		$	17			$	27
Europe			188				150
Asia-Pacific			1,361				1,280
Total		$	1,566			$	1,457

10. Commitments

     The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These lease agreements expire at various dates during the next ten years.

     Purchases for inventories are highly dependent upon forecasts of the customers’ 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. As of September 30, 2007, total purchase and contractual commitments were approximately $4.0 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, 2007 and 2006 were as follows (in thousands):

		2007				2006
Balances at January 1		$	34			$	153
Additions related to sales during the period			46				210
Warranty costs incurred during the period			(49	)			(62	)
Adjustments to accruals related to prior period sales			(2	)			(90	)
Adjustments to accruals related to sale of the DTV Solutions business							(28	)
Balances at September 30		$	29			$	183

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,
		2007				2006				2007				2006
Net loss from continuing operations		$	(116	)		$	(3,680	)		$	(3,655	)		$	(8,372	)
Income (loss) from discontinued operations			(67	)			(189	)			1,367				8,080
Net income (loss)		$	(183	)		$	(3,869	)		$	(2,288	)		$	(292	)
Shares used in income (loss) per common share — basic			15,736				15,648				15,722				15,623
Net income (loss) per common share — basic and diluted Continuing operations		$	(0.01	)		$	(0.24	)		$	(0.23	)		$	(0.54	)
Discontinued operations		$	(0.00	)		$	(0.01	)		$	0.08			$	0.52
Net income (loss) per common share — basic and diluted		$	(0.01	)		$	(0.25	)		$	(0.15	)		$	(0.02	)

     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.

     The computation of diluted net income (loss) per common share for the three and nine months ended September 30, 2006, excludes the effect of the potential exercise of options to purchase approximately 16,000 and 23,000 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, 2006 also excludes the effect of the potential exercise of options to purchase approximately 2.3 million and 2.5 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, SCM could be subject to claims arising in the ordinary course of business or could be a defendant in lawsuits. While the outcome of such claims or other proceedings cannot be predicted with certainty, 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 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 the Private Securities Litigation Reform Act of 1995. For example, statements, other than statements of historical facts regarding our strategy, future operations, financial position, projected results, estimated revenues or losses, projected costs, prospects, plans, market trends, competition and objectives of management constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “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 and Amended Annual Report on Form 10-K/A for the year ended December 31, 2006.

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 into two market segments: PC Security and Flash Media Readers.

	•		For the PC Security market, we offer smart card reader technology that enables authentication of individuals for applications such as electronic passports, electronic healthcare cards, secure logical access to PCs and networks, and physical access to facilities.
	•		For the Flash 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 products primarily to original equipment manufacturers, or OEMs, who typically either bundle our products with their own solutions, or repackage our products for resale to their customers. Our OEM customers include: government contractors, systems integrators, large enterprises and computer manufacturers, as well as banks and other financial institutions for our smart card readers; and computer electronics and photographic equipment manufacturers for our digital media readers. We sell and license our products through a direct sales and marketing organization, as well as through distributors, value added resellers and systems integrators worldwide.

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

     In our continuing operations, we have experienced significant variations in demand for our products quarter to quarter. In our PC Security business, variations in demand are primarily the result of timing of orders associated with 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, roll-out schedules for application deployments and budget cycles and changes, all of which contribute to variability in demand from quarter to quarter. In our Flash Media Reader business, variability in demand is primarily the result of our dependence on a small number of customers in this business, which can result in significant fluctuation in sales levels from one period to another. Two customers have historically accounted for approximately 65% of revenues in our Flash Media Reader business.

     We have adopted a strategy to grow revenue that is based on introducing new PC Security and Flash Media Reader products to address emerging market opportunities. During 2006 and in the first and third quarters of 2007, we experienced increased demand from prior periods for our smart card readers, primarily from the government sector, where we are providing readers for new and emerging programs such as e-passports and e-healthcare. In the second quarter of 2007, sales of our smart card readers were negatively impacted by budget freezes in the U.S. government sector, which contributed to delayed orders, demand fluctuations with a major customer in Asia and project delays in various European smart card security programs. In the third quarter of 2007, revenue for our PC Security business returned to more stable levels, as U.S government budgets relaxed and we received additional orders from our customer in Asia.

     In our Flash Media Reader business, sales in the first nine months of 2007 have been below 2006 levels, as we experienced significantly reduced orders from one of our two major Flash Media Reader customers, which we believe was primarily due to significantly reduced demand in their end markets. This was particularly pronounced in the second quarter of 2007. Order levels from this customer increased in the third quarter of 2007, but did not reach the levels of a year ago. Orders from this customer may not return to historic levels and this business remains subject to significant variability in terms of the timing of orders in any given period.

     In both our PC Security and Flash Media Reader businesses, pricing pressure has increased over the last several quarters. To address an increasingly competitive environment, during 2006 we put in place cost reduction programs that, beginning in the fourth quarter of 2006 and continuing into the third quarter of 2007, have resulted in improvements to gross product margin.

     During late 2005 and throughout 2006, we implemented a number of measures to reduce operating expenses, including the outsourcing of our manufacturing operations and the consolidation of facilities and functions. The full effect of our cost cutting actions was first experienced in the fourth quarter of 2006, when our GAAP operating expenses decreased from an average of $5.7 million for the first three quarters of fiscal 2006 to $3.5 million in the fourth quarter of 2006. Through the first nine months of 2007, our GAAP operating expenses for research and development, sales and marketing, and general and administrative have been under $4.0 million per quarter, with the exception of a $1.4 million charge taken in general and administrative expenses in the second quarter of 2007 for severance and other costs associated with the resignation of Robert Schneider, our former CEO.

Critical Accounting Policies and Estimates

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

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

•

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 Financial Accounting Standards Board’s (“FASB”) Interpretation No. 48, Accounting For Uncertain Tax Positions (“FIN 48”) in the first quarter of 2007. See “Note 1” in the Notes to Consolidated Financial Statements of this Form 10-Q for further discussion. 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, 2007 we have recorded valuation allowances against substantially 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.

Recent Accounting Pronouncements

     In September 2006, FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands

disclosures about fair value measurements. The provisions of SFAS 157 are effective for the fiscal year beginning January 1, 2008. We are currently evaluating the impact of the provisions of SFAS 157 on our financial position, results of operations and cash flows and do not believe the impact of the adoption will be material.

Results of Operations

     Net Revenue. Summary information by product segment for the three and nine months ended September 30, 2007 and 2006 is as follows (in thousands):

										% change												% change
		Three months ended								period to				Nine months ended								period to
		September 30,								period				September 30,								period
		2007				2006								2007				2006
PC Security
Revenue		$	6,140			$	5,096				20	%		$	17,100			$	16,438				4	%
Gross profit			2,846				1,621								7,345				6,480
Gross profit %			46	%			32	%							43	%			39	%
Flash Media Readers
Revenue		$	1,477			$	2,300				(36	)%		$	3,621			$	7,747				(53	)%
Gross profit			601				504								1,175				1,454
Gross profit %			41	%			22	%							32	%			19	%
Total:
Revenue		$	7,617			$	7,396				3	%		$	20,721			$	24,185				(14	)%
Gross profit			3,447				2,125								8,520				7,934
Gross profit %			45	%			29	%							41	%			33	%