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Operator
Good morning. My name is Alyson, and I will be your conference facilitator. At this time, I would like to welcome everyone to the SCM Microsystems Third Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period.
I will now turn the call over to Ms. Darby Dye. Ms, Dye, you may begin your conference.
Darby Dye - Moderator
Hello everyone, and thank you for joining us, today, as we discuss the results of SCM's third quarter 2004. Speaking on today's call are Steve Moore, CFO, and Robert Schneider, CEO.
As we begin today's call, let me remind you that during the course of this conference call, management will make certain forward-looking statements regarding future events or the future financial performance of the Company. We caution you that such statements involve risks and uncertainties, and that actual events or results may differ materially. We refer you to the Company's 10K for Fiscal 2003, filed March 12th 2004, and other SEC filings, which explain important factors that could cause actual results to differ from those contained in any projection for forward-looking statements. Please note also that a copy of our press release is posted on the website, today.
Any forward-looking statements made on this call are based on information that is currently available, and which is likely to change over time. Although our projections will likely change, we do not plan to update them. SCM will provide our analysts and investors with an information and forward-looking guidance in our quarterly financial news release and conference calls. We will not provide any further guidance during the quarter unless done through a news release, conference call or SEC filing, in accordance with Regulation Fair Disclosure.
Now I'd like to introduce Steve Moore.
Steven Moore - CFO, Secretary
Thank you, Darby. Hello, everyone, and thank you for joining us today. Our performance in the third quarter was very much as we had expected. We made good progress toward and following our plans to reduce operating expenses. Overall sales levels were at the high end of guidance, and underlying gross margins remain stable. In the next few moments, I'll go over some details of our Q3 performance, and then wrap up with guidance for the fourth quarter.
Revenues from continuing operations in the third quarter were $11 million -- within our previously communicated guidance of $8 million to $12 million. Year-over-year revenues were down approximately 31 percent, from revenues of $15.9 million recorded in the third quarter of 2003, and sequentially down slightly from revenues of $11.5 million in the second quarter of 2004.
Looking at revenues by product line, sales of our digital TV security modules were $4 million in Q3, which represented 37 percent of total revenues. These modules are used in conjunction with open architecture set-top boxes, and cable or satellite-ready digital television, to protect digital pay-TV broadcasts, and enable legitimate subscribers to decrypt broadcast content.
Revenue levels in the third quarter reflect the significant cost decline in sales of digital TV security modules we've experienced over the last several quarters. Aggressive competition from non-licensed modules has continued to shift the dynamics of this market, which consist of small operators in Europe. This small-operator revenue stream, which was an important components of SCM's business for several years, is now significantly reduced and unlikely to be fully regained.
Sales of our smart card readers and related products used to provide secure access to PCs and computer networks totaled $4.5 million in Q3, which represented 41 percent of revenue. Our market focus here continues to center around a mix of smart card based personal identification and authentication programs being implemented by European banks and by various governments around the world. We expect the positive trends we see here to continue.
And finally, sales of our third product area -- flash-media card readers, were $2.4 million in the quarter, or 22 percent of revenue. The geographic split of revenues in the third quarter included 49 percent of sales from Europe, 32 percent from the United States and 19 percent from the Asia-Pacific region.
Gross margin for the third quarter was 29 percent, and included a write-down of $1.1 million, of which approximately 600,000 related to excess flash-media interface product inventory, and $300,000 related digital TV product inventory -- and another $200,000 related to write-down in the value of digital television controller chips, due to pricing pressures. Without this write-down, gross margin would have been 39 percent, within the range of guidance for the quarter of 38-41 percent.
By product line, we recorded a gross margin of 18 percent for our digital TV products in Q3, including the half-million dollar inventory write-down. Gross margins for our PC security products were 45 percent, and gross margins for our flash-media interface product was 15 percent of revenue, including the $600,000 inventory write-down mentioned before.
As reported under US GAAP, operating expenses in the third quarter were $7.7 million, which included amortization of intangibles of approximately $278,000, as well as a credit to restructuring and other charges of $82,000 -- which resulted from a positive adjustment of accruals for European taxation issues -- offset by settlement costs from previously-announced European customer claims that were recorded in Q3. There are also payments due to SCM associated with the revolution of these claims, which we expect to be able to record over the next couple of quarters. Together, these will result in a small cumulative net benefit to SCM.
Q3 expense levels reflected a 14 percent sequential decline in costs from the second quarter. This figure has somewhat improved by the seasonal release of accruals for vacations which are normally taken in the summer quarter. But it also reflects real reductions in spending levels across all areas of our business.
At the end of the second quarter, we announced our intention to reduce overall expense levels by 25 percent over a 6-month period. Including a reduction of headcount and related expenses of between 20 and 25 percent. To date, we have made good initial progress [inaudible] and expect to continue our cost-reduction efforts over the next several months. We now believe that we will record the structuring charges of around $1 million to effect these changes, rather than the $1-2 million estimates that we communicated to you last quarter. To date, we have incurred approximately half of these charges, which primarily relate to severance costs. We expect to incur the remainder of the charges over the next two quarters.
Continuing down the P&L. Operating loss for the third quarter was $4.6 million. Q3 interest and other income stood at a gain of $359,000, resulting from other income related to adjustments to our European tax accruals, and interest income from cash investments, offset by a small loss in foreign exchange.
Loss from continuing operations for the third quarter was $4.2 million, or $0.27 per share. That's important in accordance with GAAP. This compares with as-reported income from continuing operations of $1.1 million or $0.07 per share in the third quarter of 2003.
Before I address guidance for the fourth quarter, I'd like to quickly touch on the subject of the claims letter we received early in the third quarter. For those of you who may be unaware of the status, on October 21st, we announced that we had successfully resolved all claims made by a European digital television customer, which will result in a small net benefit to SCM.
As I have already mentioned, we incurred some settlement costs in the third quarter, and we will realize the net benefit through payments anticipated over the next couple of quarters. The key point here is that this issue did not result in litigation, that it is in fact now resolved, and that our relationship with this customer is positive -- leaving us encouraged that we can continue to do business with this customer, to our mutual benefit.
I'd now like to talk about management's outlook over the near-term, and provide some specific guidance for the fourth quarter of 2004. We expect revenues to be in the range of $8 million to $11 million, and gross margin to be in the range of 38-41 percent. Within this range of revenue, in gross margin performance, we expect to record an operating loss for continuing operations in the fourth quarter.
To wrap up, I'd like to turn to the balance sheet. As a result of our operating loss in the third quarter, cash and investments fell to $46.8 million at the end of Q3, compared to $50.1 million at the end of Q2. Net accounts receivable were $6.8 million at the end of Q3, compared with $7.2 million at the end of Q1 -- Q2, due both to lower revenues in the quarter and to effective collections.
Inventory levels were at $9.6 million at the end of Q3, compared with $10.9 million at the end of Q2. Excluding the write-downs in inventory taken in the third quarter, inventory levels were flat with the prior quarter.
With that, I'd like to now turn the call over to Robert.
Robert Schneider - CEO, Director
Thank you, Steve. As Steve had mentioned, the digital TV markets in needed for our traditional course model -- European operator business -- remained very challenging in the third quarter. Unlicensed digital security modules continue to take hold in the market, and licensing pressure has been increasing over the last couple of quarters.
We are undergoing a profound transition in our core customer base, from smaller specialized content operators to mid-sized, full-key operators that are even more likely to want to protect their pay-TV subscriptions against hackers and unauthorized access.
We have been working to develop these new opportunities with larger operators for some time, now -- and we continue to believe that these new market opportunities will result in significant revenue potential for SCM over the next few several years.
Furthermore, the start in penetration of digital TV sets, so-called integrated digital TV sets also favored the use of conditional excess modules. And of course, SCM using the strongest position to leverage these opportunities. We've made some positive progress in the third quarter already, with the signing of two new operator customers -- Top-Up TV in the UK and DigiTurk, which is the largest pay-TV operator in Turkey.
In Korea, as reported already, SCM has now announced contracts with two major operators to provide government-mandated digital TV security modules. Those two operators are BSI and CJ Cablenet. We continue to work closely with these operators and Korean government agencies in order to secure final approval for mass deployment.
In the last few weeks, we've started shipping our PC card mobile to act as a receiver for PCs, for those who've begun working with third-party application providers to integrate our mobile receiver with additional software and hardware platforms. Our small dish, which is a leading MHP software application developer is integrating their [inaudible] image the middleware software for interactive digital TV with SCM's PC card receiver.
This product line has left us two key features of the future of digital television -- mobility and convergence. Together, these technologies allow a PC user not only to watch and record digital channels from wherever they are, but also to enjoy a new level of entertainment with real interactivity and a host of new services.
We've also teamed up with Arigato -- a leading provider of digital TV media products for the Apple platform, and corporation partners [inaudible] to launch their new PC card receiver as the cross-platform solution for Windows and Apple OSM.
Our OEM [subtractable] markets -- the so-called easy-watch, which is the world's first PC card solution for digital terrestrial television. Over 50 percent of German households are now covered by digital terrestrial transmission, and are thus potential customers for our receiver. Looking toward future growth of these new market opportunities in the arrival of the integrated digital TVs, and a high-end set-top boxes and TVRs as the common interface slot for a digital TV security mode module will be a standard feature of these devices.
Over 10 million new cable-ready and satellite-ready TVs are projected to be sold worldwide by 2007. And all will require an interface slot for a security module to decrypt pay-TV broadcasts. SCM is the leading supplier of the controller chip that creates the module interface for these slots. And we're more [inaudible] than any other company in the world in developing the security modules which are then required for pay-TV services. We're in a strong and unique position to win module business in the emerging, integrated digital TV-set market.
One final note on digital TV, as Steve has mentioned, in Q3 we have successfully resolved claims made by the major European digital TV customer that we talked about last quarter, and we can now put this situation behind us. This was a very good result, and we are encouraged about again working positively with this distribution partner.
In our smart card reader business, we've seen very positive trends over the last 2 quarters in terms of order rights for smart card readers, for personal identification and user-point indication. During the quarter, we have shipped readers for several innovative smart card based programs, including Belgium's national ID e-card program, which will use our readers at regional centers to assist citizens with a range of electronic filing applications. Then the EU's net card healthcare health card program at the Olympics, and the US government's Veteran's Administration project to leverage the common-access smart card for all of their employees.
Over the next several years, we believe that the greatest growth in smart card applications and therefore growth in smart card readers will come from 3 areas. First, logic-connect -- that is PC or network logons. Second, mobile internet banking for SCM is now [inaudible], and multiple products for secure banking and generating secured [inaudible] numbers. And third, large-scale personal identification programs such as national ID cards, health cards and e-passports.
This last category is today the lest-developed, as it is in the very early stages. However, SCM's successfully participating in some of the first pilots of this program, such as the Belgium ID card project. Over time, new smart card applications will also drive demand for new types of cards and readers. Contactless technology is growing increasingly popular because of the gained convenience for the user of just holding up a card in proximity to a reader, for applications ranging from identification to making purchases.
As this is an important and growing part of the smart card market, SCM has been focused on forging some initial key partnerships in this area. In recent weeks, we've announced partnership with Sharp Electronics to provide readers for their line of smart cards, Contact Lab smart cards for electronic payment, and ID card application. We also shipped the first 10,000 Contact Lab smart card readers for a major Japanese telecom operator for their internal employee identification program, which uses Contact Lab smart cards.
One of the opportunities we have talked often about in the past is physical access control based on smart cards. Currently, the US government is putting together a program to add physical access capabilities to their logical access, so for common access cards, which has already been issued to 4 million military persons to provide secure physical identification and port indication for PC network logon.
While plans to implement physical access cover several areas of government -- from military to federal facilities, to border, to airports -- these programs continue to move forward at a slow pace. Most cases, we're finding for the transportation worker out on the yard, which is the largest identified component of this program -- were significantly reduced. The plans of Qwik, as it is called, call for the implementation of physical-access controls for up to 12 million transportation workers at airports, seaports, railroads and other key ports of entry. There have been many delays in model tracking and of elevating the identity card potentials for this program, and therefore it has been dramatically slow, until these issues can be resolved. SCM continues to participate in this program, to supply our readers for the pilot implementation.
We were the final resource of smart card readers for the common-access card program of the DoD, and delivered over 1.5 million readers through 2002. We have strong relationships with mature system integrators in both, with the new programs -- and believe that we will be able to leverage our experience and new product offering to gain share of the new physical-access programs once they move forward.
In summary, smart cards are becoming the method of choice for physical identification and online authentication. For many of the cases including citizen ID cards, healthcare cards, banking and network-access, while there are many large programs planned around the world, to date there have been only a few high-rolling deployments of cards involving smart-card [use].
SCM has been successful in participating with the early projects, and is well-positioned to grow with the market when applications become more stable and implementations expand in scope and [inaudible]. For the digital TV platform, SCM remains the only experienced supplier of legal, authorized security modules. [inaudible] security requirements of large and small operators. And we are very well positioned to penetrate from the goals of integrated cable and satellite-ready digital TV sets, as these devices enter the consumer market.
And the meantime cost-reduction continues to be a goal. And we are committed to returning the Company to profitability and goals.
Now I would like to turn the call over to the operator for questions-and-answers.
Operator
Sir, at this time there are no questions.
Robert Schneider - CEO, Director
If there are no further questions, I'm closing here. In summary, we've successfully started in Q3, the restructuring program to adjust our operating expenses with revenue levels. And we are very confident to participate, based on our own leading [inaudible] in the future growth potential for secure access technology. Thank you for joining us today.