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, 2006

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

41740 Christy Street, Fremont, CA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)

(510) 360-2300
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

466 Kato Terrace, Fremont, CA 94539
(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 November 7, 2006, 15,693,932 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			29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			40
Item 3. Defaults Upon Senior Securities			40
Item 4. Submission of Matters to a Vote of Security Holders			40
Item 5. Other Information			40
Item 6. Exhibits			40
SIGNATURES			42
EXHIBIT INDEX
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 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,
		2006				2005				2006				2005
Net revenue		$	7,396			$	8,051			$	24,185			$	20,534
Cost of revenue			5,271				4,948				16,251				12,501
Gross profit			2,125				3,103				7,934				8,033
Operating expenses:
Research and development			1,085				1,048				3,115				2,947
Selling and marketing			2,292				1,609				6,053				5,282
General and administrative			2,208				2,492				6,340				6,958
Amortization of intangible assets			170				163				495				513
Restructuring and other charges			400				22				1,066				174
Total operating expenses			6,155				5,334				17,069				15,874
Loss from operations			(4,030	)			(2,231	)			(9,135	)			(7,841	)
Interest and other income			367				416				809				2,029
Loss from continuing operations before income taxes			(3,663	)			(1,815	)			(8,326	)			(5,812	)
Provision for income taxes			(17	)			(135	)			(46	)			(128	)
Loss from continuing operations			(3,680	)			(1,950	)			(8,372	)			(5,940	)
Income (loss) from discontinued operations, net of income taxes			(213	)			(8	)			2,793				(2,604	)
Gain (loss) on sale of discontinued operations, net of income taxes			24				(89	)			5,287				(74	)
Net loss		$	(3,869	)		$	(2,047	)		$	(292	)		$	(8,618	)
Loss per share from continuing operations:
Basic and diluted		$	(0.24	)		$	(0.12	)		$	(0.54	)		$	(0.39	)
Gain (loss) per share from discontinued operations:
Basic		$	(0.01	)		$	(0.01	)		$	0.52			$	(0.17	)
Diluted		$	(0.01	)		$	(0.01	)		$	0.52			$	(0.17	)
Net loss per share:
Basic		$	(0.25	)		$	(0.13	)		$	(0.02	)		$	(0.56	)
Diluted		$	(0.25	)		$	(0.13	)		$	(0.02	)		$	(0.56	)
Shares used to compute basic loss per share			15,648				15,542				15,623				15,517
Shares used to compute diluted loss per share			15,648				15,542				15,646				15,517
Comprehensive loss:
Net loss		$	(3,869	)		$	(2,047	)		$	(292	)		$	(8,618	)
Unrealized gain (loss) on investments			32				(59	)			61				150
Foreign currency translation adjustment			75				(81	)			272				(1,958	)
Total comprehensive gain (loss)		$	(3,762	)		$	(2,187	)		$	41			$	(10,426	)

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,
		2006				2005
ASSETS
Current assets:
Cash and cash equivalents		$	28,961			$	13,660
Short-term investments			7,316				18,780
Restricted short-term investments (see Note 10)			2,000				—
Accounts receivable, net of allowances of $1.088 and $972 as of September 30, 2006 and December 31, 2005, respectively			4,344				6,904
Inventories			2,226				6,005
Other current assets			2,808				2,038
Total current assets			47,655				47,387
Property and equipment, net			1,466				3,050
Intangible assets, net			432				879
Other assets			1,882				1,418
Total assets		$	51,435			$	52,734
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	4,959			$	5,700
Accrued compensation and related benefits			1,705				2,708
Accrued restructuring and other charges			3,600				3,897
Accrued professional fees			1,524				1,644
Accrued royalties			1,029				1,244
Other accrued expenses			2,710				2,565
Income taxes payable			2,479				2,258
Total current liabilities			18,006				20,016
Deferred tax liability			100				101
Commitments and contingencies (see Notes 10 and 12)			—				—
Total liabilities			18,106				20,117
Stockholders’ equity:
Common stock, $0.001 par value: 40,000 shares authorized; 15,663 and 15,593 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively			16				16
Additional paid-in capital			228,347				227,676
Treasury stock			(2,777	)			(2,777	)
Accumulated deficit			(193,048	)			(192,756	)
Other cumulative comprehensive gain			791				458
Total stockholders’ equity			33,329				32,617
Total liabilities and stockholders’ equity		$	51,435			$	52,734

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,
		2006				2005
Cash flows from operating activities:
Net income (loss)		$	(292	)		$	(8,618	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Loss (gain) from discontinued operations			(8,080	)			2,678
Depreciation and amortization			795				1,396
Loss (gain) on disposal of fixed assets			46				—
Stock compensation expense			485				—
Deferred income taxes			(1	)			(20	)
Changes in operating assets and liabilities:
Accounts receivable			(216	)			1,896
Inventories			64				(21	)
Other assets			(910	)			85
Accounts payable			361				1,018
Accrued expenses			(3,548	)			(4,863	)
Income taxes payable			218				129
Net cash used in operating activities from continuing operations			(11,078	)			(6,320	)
Net cash provided by (used in) operating activities from discontinued operations			13,074				(2,828	)
Net cash provided by (used in) operating activities			1,996				(9,148	)
Cash flows from investing activities:
Capital expenditures			(65	)			(57	)
Proceeds from disposal of fixed assets			11				76
Maturities of short-term investments			14,392				6,768
Purchase of restricted short-term investments			(2,000	)			—
Purchases of short-term investments			(2,878	)			(12,399	)
Net cash provided by (used in) investing activities from continuing operations			9,460				(5,612	)
Net cash provided by (used in) investing activities from discontinued operations			3,484				(6	)
Net cash provided by (used in) investing activities			12,944				(5,618	)
Cash flows from financing activities:
Proceeds from issuance of equity securities, net			174				158
Net cash provided by financing activities			174				158
Effect of exchange rates on cash and cash equivalents			187				(1,350	)
Net increase (decrease) in cash and cash equivalents			15,301				(15,958	)
Cash and cash equivalents at beginning of period			13,660				31,181
Cash and cash equivalents at end of period		$	28,961			$	15,223
Supplemental disclosures of cash flow information:
Income tax refunds received		$	—			$	—
Income taxes paid		$	106			$	34

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006

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, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems’ (“SCM” or “the Company”) Annual Report on Form 10-K for the year ended December 31, 2005.

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 total consideration of $11 million in cash, of which $9 million has been paid. Based on recent actions by Kudelski and the terms of the purchase agreement, the Company has made demand for payment of the remaining $2 million. The obligation to make the additional $2 million payment is disputed by Kudelski. Accordingly, the Company has not recorded the $2 million as receivable. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144 (“SFAS 144”), Accounting for the Impairment or Disposal of Long Lived Assets, for the three and nine months ended September 30, 2006 and 2005, 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.

Stock-based Compensation

     During the first quarter of fiscal 2006, the Company adopted the provisions of, and accounted for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (“FASB”) SFAS No. 123 — revised 2004 (“SFAS 123(R)”), Share-Based Payment, which replaced SFAS No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period. The Company elected to use the modified-prospective method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123(R) apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS 123 pro forma disclosures.

     The adoption of SFAS 123(R) did not have a material impact on the Company’s consolidated financial position, results of operations and cash flows. See Note 2 for further information regarding the Company’s stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if the Company had recorded stock-based compensation expense in accordance with SFAS 123.

Recent Accounting Pronouncements

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

     In July 2006, the FASB issued FASB Interpretation No. 48 Accounting for Uncertain Tax Positions (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109 Accounting for Income Taxes. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of FIN 48 to its financial position and results of operations.

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

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

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, vesting 25% each year over four years and expire ten years from the grant date. Additionally, the Company has an Employee Stock Purchase Plan (“ESPP”) that allows 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. As of September 30, 2006, the Company had approximately 3.7 million shares of common stock reserved for future issuance under the stock option plans and ESPP.

     On January 1, 2006, the Company adopted the provision of 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 previously accounted for its employee stock option and employee stock purchase plans under the intrinsic value recognition and measurement principles of APB 25 and related Interpretations, and adopted the disclosure-only provisions of SFAS 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosures. The pro forma effects on net loss and loss per share for stock options and ESPP awards were disclosed in a footnote to the unaudited condensed consolidated financial statements.

     The Company has 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, 2006, 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 to 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, 2006 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), the Company’s loss from continuing operations before the income tax provision and net loss from discontinued operations for the three and nine months ended September 30, 2006 were $0.1 million and $0.5 million higher, respectively, than they would have been had the Company continued to account for share-based compensation under APB 25. 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, 2006 from adopting 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, 2006 (in thousands):

		Three months				Nine months
		Ended September 30,				Ended September 30,
		2006				2006
Cost of revenue		$	10			$	24
Research and development			29				92
Selling and marketing			38				119
General and administrative			66				250
Stock-based compensation expense before income taxes		$	143			$	485
Income tax benefit			—				—
Stock-based compensation expense after income taxes		$	143			$	485

     The following table illustrates the effect on reported net loss and net loss per share for the three and nine months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation (in thousands, except per share data):

		Three months				Nine months
		Ended September 30,				Ended September 30,
		2005				2005
Net loss as reported		$	(2,047	)		$	(8,618	)
Add: Stock-based compensation expense included in reported net loss, net of related tax effects			—				—
Less: Stock-based compensation expense determined under fair value method for all awards			(333	)			(1,172	)
Pro forma net loss		$	(2,380	)		$	(9,790	)
Net loss per share, as reported — basic and diluted		$	(0.13	)		$	(0.56	)
Pro forma loss per share — basic and diluted		$	(0.15	)		$	(0.63	)

Stock Option Plans

     A total of 3,344,674 shares of common stock are currently reserved for future grant under the Plans.

Summary of activity under stock option plans for the nine months ended September 30, 2006 is as follows:

										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, 2005			3,036,308				2,822,761			$	16.26				—				6.07
Options granted			(288,384	)			288,384			$	3.24				—				—
Options cancelled or expired			596,750				(596,750	)		$	6.90				—				—
Options exercised			—				(21,130	)		$	2.78			$	7,293				—
Balance at September 30, 2006			3,344,674				2,493,265			$	17.11			$	207,176				5.37
Vested or expected to vest at September 30, 2006							2,360,452			$	17.89			$	171,948				—
Exerciseable at September 30, 2006							1,973,504			$	20.76			$	98,325				4.45

     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 weighted-average grant date fair value per option for options granted during the three and nine months ended September 30, 2005 was $2.36 and $2.79, 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. The total intrinsic value of options exercised during the three and nine months ended September 30, 2005 was $0 and $2,000, 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. Cash proceeds from the exercise of stock options were $0 and $6,000 for the three and nine months ended September 30, 2005, respectively. No income tax benefit was realized from the stock option exercises during the three and nine months ended September 30, 2006 and 2005. Stock-based compensation expense related to stock options recognized under SFAS 123(R) for the three and nine months ended September 30, 2006 was $0.1 million and $0.5 million, respectively. At September 30, 2006, 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 1.93 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, 2006 and 2005, respectively:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Expected volatility			64	%			89	%			69	%			90	%
Dividend yield			0				0				0				0
Risk-free interest rate			4.62	%			4.10	%			4.85	%			3.85	%
Expected term (in years)			3.92				4.00				3.92				4.00

     Expected Volatility: The Company’s computation of expected volatility for the three and nine months ended September 30, 2006 is based on the historical volatility of the Company’s stock for a time period equivalent to the expected life. Prior to the three and nine months ended September 30, 2006, the Company had used its historical stock price volatility in accordance with SFAS 123 for purposes of its pro forma information.

     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 month ended September 30, 2006 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

     Under the Company’s ESPP, up to 1,021,887 shares of the Company’s common stock may be issued. The Company’s ESPP permits 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 has a two year rolling plan with four purchases every six months within the offering period. If the fair market value per share is lower on the purchase date than the beginning of the offering period, the current offering period terminates and a new two year offering period will commence. The Company’s ESPP restricts the maximum amount of shares purchased by an individual to $25,000 worth of common stock each year. As of September 30, 2006, 384,616 shares were available for future issuance under the Company’s ESPP.

     The fair value of issuances under the Company’s ESPP is estimated on the issuance date by applying the principles of FASB Technical Bulletin 97-1 (“FTB 97-1”), Accounting under Statement 123 for Certain Employee Stock Purchase Plan 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, 2006 was $26,000 and $101,000, respectively. At September 30, 2006, there was $53,000 of unrecognized stock-based compensation expense related to outstanding ESPP shares that is expected to be recognized over a nineteen month period.

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 total expected consideration of $11 million in cash, of which $9 million has been paid. Based on recent actions by Kudelski and the terms of the purchase agreement, the Company has made demand for payment of the remaining $2 million. The obligation to make the additional $2 million payment is disputed by Kudelski. Accordingly, the Company has not recorded the $2 million as receivable. 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, 2006 and 2005, the DTV solutions 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.

     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, excluding the $2 million noted above.

     The operating results for the discontinued operations of the DTV solutions business for the three and nine months ended September 30, 2006 and for the same period of 2005 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Net revenue		$	1,877			$	5,261			$	12,288			$	13,802
Operating gain (loss)		$	(115	)		$	107			$	(1,276	)		$	(2,452	)
Net income (loss) before income taxes		$	(141	)		$	162			$	2,919			$	(2,337	)
Income tax benefit (provision)		$	(8	)		$	(3	)		$	75			$	167
Income (loss) from discontinued operations		$	(149	)		$	158			$	2,994			$	(2,171	)

     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, 2006 and for the same period of 2005 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Net revenue		$	—			$	—			$	—			$	—
Operating loss		$	(75	)		$	(59	)		$	(201	)		$	(244	)
Net loss before income taxes		$	(51	)		$	(96	)		$	(134	)		$	(365	)
Income tax provision		$	(13	)		$	(70	)		$	(67	)		$	(70	)
Loss from discontinued operations		$	(64	)		$	(166	)		$	(201	)		$	(435	)

4. Short-Term Investments

     At September 30, 2006, approximately 50% of the short-term investment portfolio matures in 2006 and the remaining 50% in 2007. The fair value of short-term investments at September 30, 2006 and December 31, 2005 was as follows (in thousands):

		September 30, 2006
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	1,783			$	0			$	(2	)		$	1,781
U.S. government agencies			5,550				—				(15	)			5,535
Total		$	7,333			$	0			$	(17	)		$	7,316

		December 31, 2005
						Unrealized				Unrealized				Estimated
		Amortized				Gain on				Loss on				Fair
		Cost				Investments				Investments				Value
Corporate notes		$	9,369			$	6			$	(34	)		$	9,341
U.S. government agencies			9,490				—				(51	)			9,439
Total		$	18,859			$	6			$	(85	)		$	18,780

Cumulative Adjustment to Interest Income and Other Cumulative Comprehensive Gain

     In July 2005, during a review of the Company’s investment holdings and the calculation of interest income and unrealized gains and losses on investments, the Company discovered an error in the recording of the amortization of investment premiums and discounts and the related interest income and unrealized gain (loss) on investments. As a result, interest income and unrealized loss on investments and the balance of unrealized loss included in other cumulative comprehensive gain for the years ended December 31, 2004 and 2003 have been overstated. The cumulative overstatement of interest income and unrealized loss on investments for periods prior to the three months ended June 30, 2005 was approximately $0.3 million. The effect of the error was not material to any relevant prior period and had the amounts been recorded correctly in the prior periods, there would have been no effect on reported comprehensive loss or total stockholder’s equity. To correct this error, the Company recorded the cumulative $0.3 million as a reduction in interest income and a decrease in unrealized loss on investments during the three-month period ended June 2005.

     During each quarter, SCM evaluates 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. In addition, the Company evaluates severity and duration in each reporting period. At September 30, 2006,

approximately $6.5 million of the short-term investment portfolio has an unrealized loss and approximately $4.5 million of those investments have been in an unrealized loss position for more than one year. Of the $17,000 unrealized loss at September 30, 2006, approximately $14,000 relates to investments that have been in an unrealized loss position for more than one year. The Company believes these fair value declines are the result of rising short-term interest rates. For the three and nine months ended September 30, 2006 and 2005, no impairment of the investments was identified based on the evaluations performed.

5. Inventories

     Inventories consist of (in thousands):

		September 30,				December 31,
		2006				2005
Raw materials		$	1,405			$	2,430
Work-in-process			—				2,435
Finished goods			821				1,140
Total		$	2,226			$	6,005

     The reduction in inventories and in particular work-in-progress is primarily the result of the outsourcing of the Company’s manufacturing operations from its Singapore facility to contract manufacturers.

6. Property and Equipment

     Property and equipment consists of (in thousands):

		September 30,				December 31,
		2006				2005
Land		$	122			$	260
Building and leasehold improvements			1,827				3,187
Furniture, fixtures and office equipment			3,115				5,333
Automobiles			1				58
Purchased software			3,138				4,018
Total			8,203				12,856
Accumulated depreciation			(6,737	)			(9,806	)
Property and equipment, net		$	1,466			$	3,050

7. Intangible Assets

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

						September 30, 2006												December 31, 2005
						Gross												Gross
		Amortization				Carrying				Accumulated								Carrying				Accumulated
		Period				Value				Amortization				Net				Value				Amortization				Net
Customer relations		60 months				$	1,582			$	(1,387	)		$	195			$	1,476			$	(1,071	)		$	405
Core technology		60 months					1,793				(1,556	)			237				1,673				(1,199	)			474
Total intangible assets						$	3,375			$	(2,943	)		$	432			$	3,149			$	(2,270	)		$	879

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

     Amortization expense related to intangible assets for continuing operations was $0.2 million and $0.5 million for the three and nine months ended September 30, 2006, respectively, and $0.2 million and $0.5 million for the three and nine months ended September 30, 2005.

     Estimated future amortization of intangible assets is as follows (in thousands):

Fiscal Year		Amount
2006 (remaining 3 months)		$	170
2007			262
Total		$	432

8. Restructuring and Other Charges

     Continuing Operations

     During the three and nine months ended September 30, 2006, SCM incurred net restructuring and other charges related to continuing operations of approximately $0.4 million and $1.3 million, respectively. During the three and nine months ended September 30, 2005, SCM incurred net restructuring and other charges related to continuing operations of approximately $0.2 million and $0.4 million, respectively.

     Accrued liabilities related to restructuring actions and other activities during the nine months ended September 30, 2006 and during the year ended December 31, 2005 consist of the following (in thousands):

		Lease/Contract								Other
		Commitments				Severance				Costs				Total
Balances as of January 1, 2005		$	52			$	431			$	5,132			$	5,615
Provision for 2005			—				699				25				724
Changes in estimates			7				(12	)			127				122
			7				687				152				846
Payments and other changes in 2005			(27	)			(966	)			(4,994	)			(5,987	)
Balances as of December 31, 2005			32				152				290				474
Provision for Q1 2006			—				519				—				519
Changes in estimates			(2	)			—				—				(2	)
			(2	)			519				—				517
Payments and other changes in Q1 2006			(4	)			(52	)			7				(49	)
Balances as of March 31, 2006		$	26			$	619			$	297			$	942
Provision for Q2 2006			—				342				—				342
Changes in estimates			—				—				—				—
			—				342				—				342
Payments and other changes in Q2 2006			(3	)			(248	)			10				(241	)
Balances as of June 30, 2006		$	23			$	713			$	307			$	1,043
Provision for Q3 2006			33				394				—				427
Changes in estimates			—				—				—				—
			33				394				—				427
Payments and other changes in Q3 2006			(38	)			(806	)			4				(840	)
Balances as of September 30, 2006		$	18			$	301			$	311			$	630

     For the three and nine months ended September 30, 2006, restructuring and other charges primarily related to severance costs 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 from California to Germany. Approximately $0.2 million of the restructuring amount relates to severance for manufacturing personnel for the nine month period and is therefore recorded in cost of revenue. The remaining $1.1 million in the nine month period is recorded in operating expenses and is primarily made up of severance for non-manufacturing personnel. The Company believes the restructuring activity is substantially completed and that any future costs incurred will be insignificant.

     As shown in the table above in “Payments or write offs in 2005 — Other Costs,” in April 2005, SCM made a payment to the French government of approximately $4.7 million as then calculated, related to Value Added Tax (“VAT”) in respect of sales transactions with a former customer. In connection with this payment, SCM entered into an agreement with the customer whereby the customer agreed to seek a refund from the French government for the VAT paid with respect to the products it purchased from the Company, and then remit the refunded amount to SCM. On June 9, 2006, the customer remitted to the Company the full amount including currency gains totaling $5.0 million, of which $4.2 million was recognized as other income from discontinued operations. See Note 12 for further discussion.

     Discontinued Operations

     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. During the three and nine months ended September 30, 2005, SCM incurred restructuring and other charges related to discontinued operations of approximately $0.1 million and $0.1 million, respectively.

     Accrued liabilities related to the Digital Media and Video restructuring actions and other activities during the nine months ended September 30, 2006 and during the year ended December 31, 2005 consist of the following (in thousands):

		Legal				Lease/Contract				Other
		Settlements				Commitments				Costs				Total
Balances as of January 1, 2005		$	—			$	3,960			$	304			$	4,264
Provision for 2005			1,700				—				648				2,348
Changes in estimates			—				(111	)			—				(111	)
			1,700				(111	)			648				2,237
Payments and other changes			(1,700	)			(651	)			(727	)			(3,078	)
Balances as of December 31, 2005			—				3,198				225				3,423
Provision for Q1 2006			—				—				5				5
Changes in estimates			—				(24	)			—				(24	)
			—				(24	)			5				(19	)
Payments and other changes in Q1 2006			—				(124	)			(190	)			(314	)
Balances as of March 31, 2006		$	—			$	3,050			$	40			$	3,090
Provision for Q2 2006			—				—				—				—
Changes in estimates			—				75				—				75
			—				75				—				75
Payments and other changes in Q2 2006			—				(107	)			—				(107	)
Balances as of June 30, 2006		$	—			$	3,018			$	40			$	3,058
Provision for Q3 2006			—				—				—				—
Changes in estimates			—				(25	)			—				(25	)
			—				(25	)			—				(25	)
Payments and other changes in Q3 2006			—				(63	)			—				(63	)
Balances as of June 30, 2006		$	—			$	2,930			$	40			$	2,970

     Discontinued operation costs for the three and nine months ended September 30, 2006 primarily related to changes in estimates for lease obligations.

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 Marketing.

     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. 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, 2006 and 2005, 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.

     The Company’s continuing operations provide secure digital access solutions to OEM customers in two markets segments: PC Security and Flash Media Interface. 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, 2006 and for the same periods of 2005 is as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
PC Security:
Net revenue		$	5,096			$	3,898			$	16,438			$	12,566
Gross profit			1,621				1,414				6,480				4,147
Gross profit %			32	%			36	%			39	%			33	%
Flash Media Interface:
Net revenue		$	2,300			$	4,153			$	7,747			$	7,968
Gross profit			504				1,689				1,454				3,886
Gross profit %			22	%			41	%			19	%			49	%
Total:
Net revenue		$	7,396			$	8,051			$	24,185			$	20,534
Gross profit			2,125				3,103				7,934				8,033
Gross profit %			29	%			39	%			33	%			39	%

     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,
		2006				2005				2006				2005
Net revenue
United States		$	3,242			$	3,807			$	10,407			$	8,825
Europe			3,045				3,094				10,212				6,996
Asia-Pacific			1,109				1,150				3,566				4,713
Total		$	7,396			$	8,051			$	24,185			$	20,534
% of net revenue
United States			44	%			48	%			43	%			43	%
Europe			41	%			38	%			42	%			34	%
Asia-Pacific			15	%			14	%			15	%			23	%

     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,
		2006				2005				2006				2005
Customer A based in the USA			14	%			*				12	%			*
Customer B based in the USA			*				27	%			*				20	%
Customer C based in Asia			*				*				*				10	%
Customer D based in Europe			13	%			17	%			*				*
Total			27	%			44	%			12	%			30	%

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

		September 30,				December 31,
		2006				2005
Customer A based in Asia			*				18	%
Customer B based in the USA			16	%			17	%
Total			16	%			35	%

     Long-lived assets by geographic location as of September 30, 2006 and December 31, 2005, are as follows (in thousands):

		September 30,				December 31,
		2006				2005
Property and equipment, net:
Asia-Pacific		$	1,264			$	1,644
Europe			171				1,369
United States			31				37
Total		$	1,466			$	3,050

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.

     As of September 30, 2006, the Company had a $2 million time deposit with a financial institution, which was restricted as to use and represented compensating balances for a bank guarantee for the benefit of inventory purchases by a contract manufacturing supplier. This balance is included in restricted short-term investment on the balance sheet.

     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, 2006, purchase and contractual commitments were approximately $6.0 million, of which approximately $1.7 million relate to the sold DTV solutions business.

     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, 2006 and 2005 were as follows (in thousands):

		2006				2005
Balances at January 1		$	153			$	244
Additions related to sales during the period			210				288
Warranty costs incurred during the period			(62	)			(95	)
Adjustments to accruals related to prior period sales			(90	)			(266	)
Adjustments to accruals related to sale of the DTV Solutions business			(28	)			—
Balances at September 30		$	183			$	171

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,
		2006				2005				2006				2005
Net loss from continuing operations		$	(3,680	)		$	(1,950	)		$	(8,372	)		$	(5,940	)
Income (loss) from discontinued operations			(189	)			(97	)			8,080				(2,678	)
Net income (loss)		$	(3,869	)		$	(2,047	)		$	(292	)		$	(8,618	)
Shares used in income (loss) per common share — basic			15,648				15,542				15,623				15,517
Effect of dilutive securities:
Employee and director stock options			—				—				23				—
Shares used in income (loss) per common share — diluted			15,648				15,542				15,646				15,517
Net income (loss) per common share — basic and diluted
Continuing operations		$	(0.24	)		$	(0.12	)		$	(0.54	)		$	(0.39	)
Discontinued operations		$	(0.01	)		$	(0.01	)		$	0.52			$	(0.17	)
Net income (loss) per common share — basic and diluted		$	(0.25	)		$	(0.13	)		$	(0.02	)		$	(0.56	)

     The computation of diluted net loss per common share from continuing operations 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 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.

     The computation of diluted net loss per common share for the three and nine months ended September 30, 2005, excludes the effect of the potential exercise of options to purchase approximately 14,000 and 59,000 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, 2005, also excludes the effect of the potential exercise of options to purchase approximately 2.6 million and 2.5 million shares, respectively because the option exercise price was greater that the average market price of the common shares and the effect would have been anti-dilutive.

12. Legal Proceedings

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

     In its complaint filed in France, Aston claims damages in the amount of approximately $69 million. The Company believes, however, that the allegations made by Aston in their complaint are in contradiction to the statements made by Aston as part of the 2002 Settlement. On February 2, 2006, the Company filed a counterclaim against Aston in Germany alleging damages in the amount of approximately $14 million resulting from Aston’s fraudulent misrepresentation and breach of contract in connection with the 2002 Settlement. Aston filed its response to the Company’s counterclaim on July 28, 2006. The Company replied on September 18, 2006 and expects a first court hearing to be scheduled soon.

     In November 2005, Aston obtained a preliminary injunction in France to stay the Company’s claim for recovery of the VAT Refund and on February 21, 2006, the court that issued the injunction revised its order such that only approximately $1.2 million of VAT Refund amount was still covered by the injunction. Both Aston and the Company appealed against this order. On June 1, 2006, a French appeals court released the injunction with respect to the entire amount of the VAT Refund and this decision has become final. Thereafter, the Company was able to enforce its claim for the VAT Refund and obtain a seizure of considerable amounts of Aston’s assets. Subsequently, on June 9, 2006, Aston paid to the Company the full VAT Refund, including currency gains, in an amount of approximately $5.0 million. The Company is currently attempting to enforce a contractual penalty payment under the April 2005 agreement relating to the VAT Refund and to obtain interest on the amount of the VAT Refund for late payment.

     The Company believes that the claims made by Aston in its complaint are without merit and were for the sole purpose of preventing or delaying the Company’s recovery of the VAT Refund. The Company intends to vigorously defend itself against the claims made by Aston and prosecute its counterclaims against Aston. Such efforts, however, may result in the incurrence of significant expense and cost and demand significant use of management’s limited time and resources. There is no assurance that the Company will be successful in defending itself against Aston’s claims or in prosecuting its counterclaim against Aston, in each case, in a timely manner, in full or at all. If these claims are decided against the Company, the result may have a material and adverse effect on the Company.

     From time to time, the Company could be subject to other claims arising in the ordinary course of business or could be a defendant in other lawsuits. While the outcome of such claims or other proceedings can not be predicted with certainty, SCM’s management currently 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 for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 17, 2006, as amended by Form 10-K/A filed on April 28, 2006.

Overview

     SCM Microsystems, Inc. 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 Interface.

	•		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 Interface 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 solution”) business to Kudelski S.A. As a result, we have accounted for the DTV solutions business as discontinued operations, and the statements of operations and cashflows for all periods presented reflect the discontinuance of this business. (See Note 3 to the Condensed Consolidated Financial Statements.)

     In our continuing operations, revenues have grown over the past few quarters, but the rate and sustainability of this progress is unpredictable due to significant variations in demand for our products quarter to quarter. This is particularly true for our PC Security products, many of which are targeted at new smart card-based ID programs run by various U.S., European and Asian governments. Sales of our smart card readers and chips for government programs are impacted by the immature nature of the applications being addressed, testing and compliance schedules of government bodies and roll-out schedules for application deployments, all of which contribute to variability in demand from quarter to quarter. Sales of our Flash Media Interface products

are less subject to this variability; however, we are dependent on a small number of customers in both of our primary product segments, which can result in significant fluctuations in sales levels from one period to another.

     We have adopted a strategy to grow revenue that is based on introducing new PC Security and Flash Media Interface products to address new market opportunities. To date, this strategy has been only partially successful. Our target markets have not grown or developed as quickly as we had expected and we have experienced delays in the development and shipment of new products designed to take advantage of new market opportunities.

     In both our PC Security and Flash Media Interface businesses, pricing pressure has increased over the last few months, resulting in lower gross profits. To address an increasingly competitive environment, we have put in place cost reduction programs that we believe will result in margin improvements going forward.

     We have taken measures to reduce operating expenses over the last several quarters, including reducing headcount, reducing the use of outside contract personnel and limiting certain expenses such as tradeshow participation. Through September 2005, we manufactured our products primarily using internal resources in Singapore, supplemented by contract manufacturers in Asia. Since October 2005, we have ceased to manufacture any of our own components or products internally and have shifted these activities to external contract manufacturers, which we believe will yield further savings and efficiencies. In addition, during fiscal 2006 we consolidated our global business operations into fewer locations, which included the closure of some facilities and the transition of certain corporate functions from California to Germany. As this consolidation of our global business operations is now substantially complete, we expect that our general and administrative expenses will decrease in the fourth quarter of 2006.

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 may be required.
	•		We write down inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
	•		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, 2006 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. The divestiture of our retail Digital Media and Video business and the sale of our DTV solutions business, as well as future changes to the operating structure of our strategic focus on our continuing operations, may limit our ability to utilize our deferred tax assets.

	•		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.
	•		Statement of Financial Accounting Standard 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. 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. 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 plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.