<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-Q


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

                  For the Quarterly Period Ended June 30, 2004



                         DREXLER TECHNOLOGY CORPORATION
                         ------------------------------
             (Exact name of registrant as specified in its charter)


           Delaware                    0-6377                  77-0176309
           --------                    ------                  ----------

(State or other jurisdiction of      (Commission            (I.R.S. Employer
incorporation or organization)       File Number)          Identification No.)


      1875 North Shoreline Boulevard, Mountain View, California 94043-1319
      --------------------------------------------------------------------
               (Address of principal executive offices) (Zip Code)


                                 (650) 969-7277
                                 --------------
              (Registrant's telephone number, including area code)


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. [X] Yes [ ] No

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). [X] Yes [ ] No

Number of outstanding shares of common stock, $.01 par value, at August 2, 2004:
11,410,064.

<PAGE>
<TABLE>
<CAPTION>
<S>                                                                             <C>
                                        TABLE OF CONTENTS

PART I.  FINANCIAL INFORMATION                                                       Page Number

         Item 1.   Condensed Consolidated Financial Statements (Unaudited)                2
                   Condensed Consolidated Balance Sheets                                  3
                   Condensed Consolidated Statements of Operations                        4
                   Condensed Consolidated Statements of Cash Flows                        5
                   Notes to Condensed Consolidated Financial Statements                   6

         Item 2.   Management's Discussion and Analysis of Financial
                   Condition and Results of Operations                                   13

         Item 3.   Quantitative and Qualitative Disclosures about Market Rate Risks      31

         Item 4.   Controls and Procedures                                               31

PART II. OTHER INFORMATION

         Item 1.   Legal Proceedings                                                     31

         Item 2.   Changes in Securities and Use of Proceeds                             31

         Item 3.   Defaults Upon Senior Securities                                       32

         Item 4.   Submission of Matters to a Vote of Security Holders                   32

         Item 5.  Other Information                                                      32

         Item 6.  Exhibits and Reports on Form 8-K                                       32

SIGNATURES                                                                               33


--------------------------------------------------------------------------------------------------


PART I.  FINANCIAL INFORMATION

ITEM 1.  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
</TABLE>


                                                2
<PAGE>
<TABLE>
<CAPTION>

                                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
                                      CONDENSED CONSOLIDATED BALANCE SHEETS
                                                   (UNAUDITED)

                                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
                                                                                       JUNE 30,         MARCH 31,
                                                                                         2004             2004*
                                                                                         ----             -----
                                                      ASSETS
<S>                                                                                    <C>              <C>
Current assets:
   Cash and cash equivalents                                                           $ 12,165         $ 11,688
   Short-term investments                                                                   292              981
   Accounts receivable, net                                                               2,599            2,550
   Inventories                                                                            6,729            6,799
   Prepaid and other current assets                                                       1,153            1,276
                                                                                       --------         --------
      Total current assets                                                               22,938           23,294
                                                                                       --------         --------

Property and equipment, at cost                                                          29,135           27,609
   Less--accumulated depreciation and amortization                                      (16,715)         (16,079)
                                                                                       --------         --------
      Property and equipment, net                                                        12,420           11,530

Long-term investments                                                                     8,246            8,246
Equipment held for resale                                                                 2,709            2,419
Patents and other intangibles, net                                                          941              978
Goodwill                                                                                  3,290            3,321
Other non-current assets                                                                     --               47
                                                                                       --------         --------
           Total assets                                                                $ 50,544         $ 49,835
                                                                                       ========         ========

                                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable                                                                    $  2,591         $  4,249
   Accrued liabilities                                                                    2,219            2,035
   Deferred tax liability                                                                   531              608
   Advance payments from customers                                                        3,009            3,102
   Deferred revenue                                                                         262              111
   Bank borrowings                                                                           55              726
   Current portion of long-term debt                                                        141              440
                                                                                       --------         --------
      Total current liabilities                                                           8,808           11,271
                                                                                       --------         --------

Long-term debt, net of current portion                                                    2,019            2,378
Deferred Revenue, net of current portion                                                  2,000               --
Advance payments from customers                                                           3,500              500
                                                                                       --------         --------
           Total liabilities                                                           $ 16,327         $ 14,149
                                                                                       --------         --------

Commitments and contingencies

Stockholders' equity:
     Preferred stock, $.01 par value:
      Authorized--2,000,000 shares
      Issued--none                                                                           --               --
   Common stock, $.01 par value:
      Authorized--30,000,000 shares
      Issued and outstanding--11,410,064 shares
           at June 30, 2004 and 11,399,764 shares at March 31, 2004                         114              114
   Additional paid-in capital                                                            53,926           53,816
   Accumulated deficit                                                                  (19,788)         (18,244)
   Accumulated other comprehensive loss                                                     (35)              --
                                                                                       --------         --------
           Total stockholders' equity                                                    34,217           35,686
                                                                                       --------         --------

               Total liabilities and stockholders' equity                              $ 50,544         $ 49,835
                                                                                       ========         ========

                    * Amounts derived from audited financial statements at the date indicated
        The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>


                                                        3
<PAGE>
<TABLE>
<CAPTION>

                          DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
                          CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                            (UNAUDITED)
                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


                                                                          THREE MONTHS ENDED
                                                                               JUNE 30,
                                                                         2004             2003
                                                                         ----             ----
<S>                                                                    <C>              <C>
Revenues:
         Total revenues                                                $  8,710         $  2,446
                                                                       --------         --------

Cost of product sales                                                     6,366            2,556
                                                                       --------         --------

         Gross profit (loss)                                              2,344             (110)
                                                                       --------         --------

Operating expenses:
     Selling, general, and administrative expenses                        3,034            1,769
     Research and engineering expenses                                      851              612
                                                                       --------         --------
         Total operating expenses                                         3,885            2,381
                                                                       --------         --------

              Operating loss                                             (1,541)          (2,491)

Other income, net                                                            23               64
                                                                       --------         --------

              Loss before income taxes                                   (1,518)          (2,427)

Income tax expense (benefit)                                                 26             (971)
                                                                       --------         --------

              Net loss                                                 $ (1,544)        $ (1,456)
                                                                       ========         ========

Net loss per share:
              Basic and diluted net loss per share                     $   (.14)        $   (.14)
                                                                       ========         ========

Weighted-average shares of common stock used in
     computing basic and diluted, net loss per share                     11,407           10,478
                                                                       ========         ========


The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>


                                                 4
<PAGE>
<TABLE>
<CAPTION>

                               DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
                               CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                 (UNAUDITED)
                                                (IN THOUSANDS)

                                                                                       THREE MONTHS ENDED
                                                                                            JUNE 30,
                                                                                     2004             2003
                                                                                     ----             ----
<S>                                                                                <C>              <C>
Cash flows from operating activities:
Net loss                                                                           $ (1,544)        $ (1,456)
     Adjustments to reconcile net loss to net cash provided by (used in)
        operating activities:
        Depreciation and amortization                                                   709              466
        Loss on disposal of fixed assets                                                  8               --
        Provision for doubtful accounts receivable                                       --                2
        Provision for excess and obsolete inventory                                      16               --
        Provision for product return reserve                                            115               --
        Expenses related to employee stock purchase plan                                 33               20
     Changes in operating assets and liabilities:
        Decrease in accounts receivable                                                 158            1,401
        Decrease in inventories                                                          33              263
        Decrease in other assets                                                          5              384
        Decrease in accounts payable and accrued liabilities                         (2,125)            (565)
        Changes in deferred income taxes                                                (72)            (971)
        Increase  in deferred revenue                                                 2,151                4
        Increase (decrease) in advance payments from customers                        3,033             (567)
                                                                                   --------         --------

           Net cash provided by (used in) operating activities                        2,520           (1,019)
                                                                                   --------         --------

Cash flows from investing activities:
     Purchases of property and equipment                                             (1,520)            (736)
     Investment in patents and other intangibles                                        (30)             (34)
     Proceeds from maturities of investments                                            689            5,891
                                                                                   --------         --------

           Net cash (used in) provided by investing activities                         (861)           5,121
                                                                                   --------         --------

Cash flows from financing activities:
     Proceeds from sale of common stock through stock plans                             110            1,115
     Repayment of bank loan                                                            (662)              --
     Repayment of long term debt                                                       (650)              --
                                                                                   --------         --------

           Net cash (used in) provided by financing activities                       (1,202)           1,115
                                                                                   --------         --------

           Effect of exchange rate changes on cash                                       20               --
                                                                                   --------         --------

Net increase in cash and cash equivalents                                               477            5,217

Cash and cash equivalents:
     Beginning of period                                                             11,688            5,754
                                                                                   --------         --------
     End of period                                                                 $ 12,165         $ 10,971
                                                                                   ========         ========


      The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>


                                                      5
<PAGE>

                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

        BASIS OF PRESENTATION. The condensed consolidated financial statements
contained herein include the accounts of Drexler Technology Corporation and its
wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.

        The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.

        The condensed consolidated financial statements included herein have
been prepared by the Company, without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been condensed or omitted pursuant to such rules and regulations,
although the Company believes the disclosures which are made are adequate to
make the information presented not misleading. Further, the condensed
consolidated financial statements reflect, in the opinion of management, all
adjustments (which include only normal recurring adjustments) necessary to
present fairly the financial position and results of operations as of and for
the periods indicated.

        These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and the notes thereto for
the year ended March 31, 2004, included in the Company's Annual Report on Form
10-K.

        The results of operations for the three-month period ended June 30, 2004
are not necessarily indicative of results to be expected for the entire fiscal
year ending March 31, 2005.

        FISCAL PERIOD: For purposes of presentation, the Company labels its
annual accounting period end as March 31 and its interim quarterly periods as
ending on the last day of the corresponding month. The Company, in fact,
operates and reports based on quarterly periods ending on the Friday closest to
month end. The 13-week first quarter of fiscal 2004 ended on June 27, 2003, and
the 13-week first quarter of fiscal 2005 ended on July 2, 2004.

        INVENTORIES: Inventories are stated at the lower of cost or market, with
cost determined on a first-in, first-out basis and market based on the lower of
replacement cost or estimated net realizable value. The components of
inventories are (in thousands):

                                    JUNE 30,               MARCH 31,
                                     2004                    2004
                                     ----                    ----

         Raw materials             $    3,540             $    3,243
         Work-in-process                1,622                  1,651
         Finished goods                 1,567                  1,905
                                   ----------             ----------
                                   $    6,729             $    6,799
                                   ==========             ==========

        RECLASSIFICATIONS. Certain items have been reclassified in the prior
year to conform to the current year presentation.

        NET LOSS PER SHARE: Basic and diluted net loss per share is computed by
dividing net loss by the weighted average number of shares of common stock
outstanding. As the effect of common stock equivalents would be antidilutive,
stock options and warrants were excluded from the calculation of diluted net
loss per share for the three-month periods ended June 30, 2004 and 2003.
Accordingly, basic and diluted net loss per share were the same for the three
months ended June 30, 2004 and 2003.

        REVENUE RECOGNITION. Product sales primarily consist of card sales and
sales of read/write drives. The Company recognizes revenue from product sales
when the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and (4)
collectibility is reasonably assured. The Company recognizes revenue on product
sales at the time of shipment when shipping terms are F.O.B. shipping point,


                                       6
<PAGE>

orders are placed pursuant to a pre-existing sales arrangement, and there are no
post-shipment obligations or customer acceptance criteria. Where appropriate,
provision is made at the time of shipment for estimated warranty costs and
estimated returns.

        The Company's U.S. government subcontract requires delivery into a
secure vault located on Company premises. Shipments are made from the vault on a
shipment schedule provided by the prime contractor, which is subject to
revision, but not cancellation, at the option of the prime contractor. At the
time the cards are delivered into the vault, title to the cards is transferred
to the government and all risks of ownership are transferred as well. The prime
contractor is invoiced, with payment due within thirty days, and the contract
does not contain any return (other than for warranty) or cancellation
provisions. Pursuant to the provisions of Staff Accounting Bulletin No. 104 (SAB
104), revenue is recognized on delivery into the vault as the Company has
fulfilled its contractual obligations and the earnings process is complete. If
the Company does not receive a shipment schedule, revenue is deferred and
recognized upon shipment from the vault. In addition, revenue recognition for
future deliveries into the vault would be affected if the U.S. government
cancels the shipment schedule. As a result, the Company's revenues may fluctuate
from period to period if the Company does not continue to obtain shipment
schedules under this subcontract or if the shipment schedules are cancelled.
During first quarter ended June 30, 2004, the Company received notification from
the prime contractor which delayed delivery of products subject to an existing
shipment schedule, and further amendments may be possible. The Company believes
that this extension does not preclude revenue recognition under SAB 104.

        In May 2003, the Emerging Issues Task Force ("EITF") finalized the terms
of EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables,"
(EITF 00-21) which provides criteria governing how to identify whether goods or
services that are to be delivered separately in a bundled sales arrangement
should be accounted for separately. Deliverables are accounted for separately if
they meet all of the following criteria: a) the delivered items have stand-alone
value to the customer; b) the fair value of any undelivered items can be
reliably determined; and c) if the arrangement includes a general right of
return, delivery of the undelivered items is probable and substantially
controlled by the seller. In situations where the deliverables fall within
higher-level literature as defined by EITF 00-21, the Company applies the
guidance in that higher-level literature. Deliverables that do not meet these
criteria are combined with one or more other deliverables. The Company adopted
EITF 00-21 for any new arrangements entered into after July 1, 2003 and now
assesses all revenue arrangements against the criteria set forth in EITF 00-21.

        The Company applies the provisions of Statement of Position 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1) in applicable contracts. Revenues on time and materials
contracts are recognized as services are rendered at contract labor rates plus
material and other direct costs incurred. Revenues on fixed price contracts are
recognized on the percentage of completion method based on the ratio of total
costs incurred to date compared to estimated total costs to complete the
contract. Estimates of costs to complete include material, direct labor,
overhead and allowable general and administrative expenses. In circumstances
where estimates of costs to complete a project cannot be reasonably estimated,
but it is assured that a loss will not be incurred, the percentage-of-completion
method based on a zero profit margin, rather than the completed-contract method,
is used until more precise estimates can be made. During the first quarter ended
June 30, 2004, the Company recognized approximately $65,000 of revenues based on
a zero profit margin. The full amount of an estimated loss is charged to
operations in the period it is determined that a loss will be realized from the
performance of a contract.

        The Company applies the provisions of Statement of Position (SOP) No.
97-2, "Software Revenue Recognition," as amended by Statement of Position 98-9,
"Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" to all transactions involving the sale of software products.
Revenue from the license of the Company's software products is recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered, the fee is fixed or determinable, and collectibility is probable,
and, if applicable, upon acceptance when acceptance criteria are specified or
upon expiration of the acceptance period.

        License revenue, which may consist of up-front license fees and
long-term royalty payments, is recognized as revenue when earned. The cost of
license revenue is not material and is included in selling, general and
administrative expenses. There was no license revenue for the fiscal 2005 first
quarter ended June 30, 2004 or the fiscal 2004 first quarter ended June 30,
2003.


                                       7
<PAGE>

        In the fiscal 2005 first quarter, the Company sold a card-manufacturing
license, effective April 3, 2004, to the Global Investments Group, based in
Auckland, New Zealand, for card manufacturing in Slovenia. This agreement
provides for payments to the Company of $29 million for the license over the
20-year term of the license (including a five-year training support package,
followed by an ongoing support phase for an additional 15 years). Additionally,
the Company is to sell approximately $12 million worth of manufacturing
equipment and installation support for the to-be-built new facility to provide a
targeted initial manufacturing capacity of 10 million optical cards annually. As
of June 30, 2004 the Company had $2.7 million of this equipment classified as
equipment held for resale on its balance sheet. Options to increase capacity to
30 million cards per year are provided in the agreement. The Company has
received the initial $5.5 million of payments called for in the agreements as of
June 30, 2004, consisting of a partial payment for the equipment of $1.5 million
and $4.0 million toward the licensing fee and training charges, which are
classified as long-term liabilities within the consolidated balance sheets. In
addition to the $41 million discussed above, Global Investments Group is to pay
the Company royalties for each card produced under the license. The territories
covered by the license include most of the European Union and eastern European
regions. The Global Investments Group has exclusive marketing rights in certain
territories, with performance goals to maintain these rights. The Company will
assign personnel on site during the license term to assist with quality,
security, and operational procedures, with a mutual goal that the facility and
the cards made there conform to the Company's standards. Global Investments
Group anticipates start up of the new facility is late in calendar 2005. Revenue
under this license will be allocated over the remaining term of the agreement
beginning when operation of the factory commences. The Company also retains
rights to utilize up to 20% of the new facility capacity as backup and capacity
buffer to augment its own card manufacturing facilities in Mountain View,
California. The granting of this license to GIG establishes a potential second
source supplier of optical memory cards for existing and prospective customers
who may request multiple sources for cards. The Company does not expect to
record material license revenues under this agreement prior to fiscal 2006,
after which revenue will be recorded over the remainder of the 20-year license
term.

        ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
consolidated financial statements, the Company is required to estimate income
taxes in each of the jurisdictions in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the consolidated balance
sheets. The Company must then assess the likelihood that the deferred tax assets
will be recovered from future taxable income and to the extent that management
believes recovery is not likely, the Company must establish a valuation
allowance. To the extent that a valuation allowance is established or increased
in a period, the Company includes an expense within the tax provision in the
statements of operations.

        Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. During fiscal 2002, the Company recorded a
tax benefit of $2.8 million, which included a $3.0 million reduction to the
valuation allowance on its deferred tax assets, net of federal alternative
minimum taxes, based on management's assessment that such portion of its
deferred tax assets would more likely than not be realized. Due to the Company's
recent cumulative tax loss history for the three-year period ending March 31,
2004, income statement loss history over the past five quarters, and the
continuing difficulty in forecasting the timing of future revenue as evidenced
by the deviations in achieved revenues from expected revenues during the past
few quarters and taking into account the newness of certain customer
relationships, the Company determined it was necessary to provide a full
valuation allowance under SFAS No.109 of the deferred tax asset. As a result,
the Company had recorded a valuation allowance of $14.8 million as of March 31,
2004, which included a charge to increase the valuation allowance against the
beginning of the year net deferred tax asset balance of $7.1 million and a
charge against its net deferred tax asset generated during fiscal 2004 in the
amount of $2.4 million for the year ended March 31, 2004, due to uncertainties
related to the Company's ability to utilize its deferred tax assets. As of June
30, 2004, the Company continues to provide for a full valuation allowance of
$14.8 million relating to its U.S. operations.

        STOCK-BASED COMPENSATION. The Company accounts for its stock-based
compensation plans using the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees."
Compensation cost for stock options, if any, is measured by the excess of the
quoted market price of the Company's stock at the date of grant over the amount
an employee must pay to acquire the stock. SFAS No. 123,


                                       8
<PAGE>

"Accounting for Stock-Based Compensation," established accounting and disclosure
requirements using a fair-value based method of accounting for stock-based
employee compensation plans. The following table illustrates the effect on net
loss and loss per share as if the Company had applied the fair value recognition
provisions of SFAS No. 123 (in thousands except per share amounts):

<TABLE>
<CAPTION>
                                                                            THREE MONTHS ENDED JUNE 30,
                                                                            ---------------------------
                                                                              2004               2003
                                                                              ----               ----
<S>                                                                        <C>                <C>
        Net loss, as reported                                              $   (1,544)        $   (1,456)
                                                                           ==========         ==========

        Add:     Stock-based employee compensation expense included                33                 20
                 in reported net loss, net of related tax effects in 2003

        Deduct: Total stock-based employee compensation
                 determined under fair value based method for all
                  awards, net of related tax effects in 2003                     (432)              (336)
                                                                           ----------         ----------
        Pro forma net loss                                                 $   (1,943)        $   (1,772)
                                                                           ==========         ==========

        Loss per common share:
            Basic and diluted - as reported                                $     (.14)        $     (.14)
                                                                           ==========         ==========
            Basic and diluted - as pro forma                               $     (.17)        $     (.17)
                                                                           ==========         ==========

        Common shares used in computing basic and diluted pro forma
            Net loss per share:
            Basic and diluted                                                  11,407             10,478
                                                                           ==========         ==========
</TABLE>

        The Company computed the fair value of each option grant on the date of
grant using the Black-Scholes option valuation model with the following
assumptions:

                                                          THREE MONTHS ENDED
                                                            JUNE 30, 2003
                                                            -------------

        Risk-free interest rate                                  2.74%
        Average expected life of option..                       5 years
        Dividend yield                                             0%
        Volatility of common stock                                50%
        Weighted average fair value of option grants            $10.06

During the three month period ended June 30, 2004, there were no options
granted.

        ISSUANCE OF STOCK, OPTIONS, AND WARRANTS. In December 2003, the Company
issued and sold 791,172 shares of common stock, options to purchase 122,292
shares of common stock, and warrants to purchase 174,057 shares of common stock
for an aggregate purchase price of $10 million in a private placement. The
Company received net proceeds of $9.4 million (net of fees and expenses). The
purchase price of the common stock was $12.76 per share, which was at a 15%
discount from the five-day average price as of December 23, 2003. The options
have an exercise price of $16.51 per share and a nine-month life. The warrants
have an exercise price of $17.26 per share and a life of five years. The options
and warrants were valued at $245,000 and $984,000, respectively, based on a
Black-Scholes calculation as of December 23, 2003 and pursuant to the provisions
of EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock," (EITF 00-19)
were recorded at those values in short-term and long-term liabilities. The
balance of the net proceeds was accounted for as additional paid-in capital.
Under EITF 00-19, the Company marks-to-market the fair value of the options and
warrants at the end of each accounting period. At March 31, 2004, this resulted
in options and warrants valued at $195,000 and $916,000, respectively. The
decrease in the valuation of the options and warrants, between December 23, 2003
and March 31, 2004, of $118,000 was recorded as other income in the accompanying
consolidated statements of operations and resulted from a decrease in the
Company's stock price. On February 6, 2004, the Company and the investors


                                       9
<PAGE>

entered into an amendment to their original agreement that resulted in the
reclassification of the options and warrants to equity. The amendment clarified
that the options and warrants granted in the financing may be exercised at a
time when a registration statement covering the resale of the underlying share
is not effective or available and that in such instance the Company would
deliver to the investors shares of common stock whose resale is not currently
registered. On the effective date of the amendment, the option and warrant value
was reclassified to equity as additional paid-in capital. As a result of the
increase in the value of the options and warrants from the closing date to the
amendment date due to increases in the Company's stock price, the Company
recognized an expense of $211,000 which is included in other expense in the
consolidated statements of operations for the fourth quarter of fiscal 2004. The
Company is subject to certain indemnity provisions included in the stock
purchase agreement entered into as part of the financing in connection with its
registration of the resale of the common stock issued and issuable in the
financing. Morgan Keegan & Company, Inc. acted as the Company's placement agent
for this transaction and was granted warrants to purchase 15,824 shares of
common stock.

        CONCENTRATION OF CREDIT RISK. Two customers comprised 30% and 13% of
accounts receivable as of June 30, 2004 and two customers comprised 26% and 23%,
respectively, of accounts receivable as of March 31, 2004.

        SEGMENT REPORTING. The Company's three reportable segments are: (1)
optical memory cards, (2) optical memory card drives, maintenance, and related
accessories ("optical card drives"), and (3) specialty cards & printers. The
segments were determined based on the information used by the chief operating
decision maker. The segments reported are not strategic business units which
offer unrelated products and services, rather these reportable segments utilize
compatible technology and are marketed jointly.

        The accounting policies used to derive reportable segment results are
the same as those described in the "Summary of Significant Accounting Policies."
Resources are allocated to the segments in a manner that optimizes optical
memory card revenues as determined by the chief operating decision maker.
Segment revenues are comprised of sales to external customers. Segment gross
profit (loss) includes all segment revenues less the related cost of sales.
Fixed assets and inventory are not separately reported by segment to the chief
operating decision maker. Accounts receivable, cash, deferred income taxes,
prepaid expenses, certain fixed assets, and other assets are not separately
identifiable to segments. Therefore, the amount of assets by segment is not
meaningful. There are no inter-segment sales or transfers. All of the Company's
long-lived assets are attributable to the United States except for $3.4 million
that are attributable to Germany.

        The Company's chief operating decision maker is currently the Company's
Co-Chief Executive Officers, prior to which the Company's Chairman and Chief
Executive Officer was considered to be the chief operating decision maker. The
chief operating decision maker reviews financial information presented on a
consolidated basis that is accompanied by disaggregated information about
revenues and gross profit (loss) by segment.

        The tables below present information for optical memory cards, optical
card drives and specialty cards and printers for the three-month periods ended
June 30, 2004 and 2003 (in thousands):

<TABLE>
<CAPTION>
                                     THREE MONTHS ENDED JUNE 30, 2004                      THREE MONTHS ENDED JUNE 30, 2003
                           -----------------------------------------------------          ----------------------------------

                           OPTICAL                       SPECIALTY                        OPTICAL
                           MEMORY         OPTICAL         CARDS &        SEGMENT          MEMORY     OPTICAL CARD     SEGMENT
                           CARDS        CARD DRIVES       PRINTERS        TOTAL           CARDS         DRIVES         TOTAL
                           -----        -----------       --------        -----           -----         ------         -----
<S>                        <C>             <C>            <C>             <C>             <C>           <C>            <C>
Revenue                    $ 5,634         $ 289          $  2,780       $ 8,703          $ 2,290       $  114        $ 2,404
Cost of sales                3,880           527             1,943         6,350            2,202          325          2,527
Gross profit (loss)          1,754          (238)              837         2,353               88         (211)          (123)
Depreciation and
  amortization expense         358            60                63           481              271           32            303
</TABLE>

The following is a reconciliation of segment results to amounts included in the
Company's condensed consolidated financial statements:


                                       10
<PAGE>
<TABLE>
<CAPTION>
                                       THREE MONTHS ENDED JUNE 30, 2004                   THREE MONTHS ENDED JUNE 30, 2003
                                       --------------------------------                   --------------------------------

                                     SEGMENT                                            SEGMENT
                                      TOTAL        OTHER (A)        TOTAL                TOTAL        OTHER (A)        TOTAL
                                      -----        ------           -----                -----        ------           -----
<S>                                  <C>            <C>            <C>                  <C>            <C>            <C>
Revenue                              $ 8,703        $  7           $ 8,710              $ 2,404        $ 42           $ 2,446
Cost of sales                          6,350          16             6,366                2,527          29             2,556
Gross profit (loss)                    2,353          (9)            2,344                 (123)         13              (110)
Depreciation and
  amortization expense                   481         228               709                  303         163               466
</TABLE>

        (a) Other revenue consists miscellaneous items not associated with
segment activities. Other cost of sales, depreciation and amortization expense
represents corporate and other costs not directly associated with segment
activities.

OTHER COMPREHENSIVE LOSS. The following are the components of other
comprehensive loss (in thousands):

                                                   THREE MONTHS ENDED JUNE 30,
                                                   ---------------------------

                                                     2004              2003
                                                     ----              ----

        Net loss                                  $  (1,544)         $  (1,456)
        Net change in cumulative foreign
          currency translation adjustments              (35)                --
                                                  ---------          ---------
        Other comprehensive loss                  $ ( 1,579)         $  (1,456)
                                                  =========          =========


        The components of accumulated other comprehensive loss mainly consist of
cumulative foreign currency translation adjustments of approximately $35,000 as
of June 30, 2004.

        RECENT ACCOUNTING PRONOUNCEMENTS. In December 2003, the Financial
Accounting Standards Board issued Interpretation No. 46 (Revised December 2003),
"Consolidation of Variable Interest Entities," originally issued in January
2003. FIN 46 requires an investor with a majority of the variable interests
(primary beneficiary) in a variable interest entity (VIE) to consolidate the
entity and also requires majority and significant variable interest investors to
provide certain disclosures. A VIE is an entity in which the voting equity
investors do not have a controlling interest, or the equity investment at risk
is insufficient to finance the entity's activities without receiving additional
subordinated financial support from other parties. We currently do not have any
financial interest in variable interest entities that would require
consolidation or any significant exposure to VIEs that would require disclosure.
Therefore, the provisions of this Interpretation do not have a material impact
on our consolidated financial position or results of operations.

In May 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. SFAS No. 149 is effective for contracts entered into or modified after
June 30, 2003 and for hedging relationships designated after June 30, 2003. The
adoption of SFAS No. 149 did not have an impact on the Company's consolidated
financial position or results of operations.


                                       11
<PAGE>

        In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS
No. 150 establishes standards for how companies classify and measure certain
financial instruments with characteristics of both liabilities and equity. It
requires companies to classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). SFAS No. 150 is effective
beginning with the third quarter of fiscal 2004. The adoption of SFAS No. 150
did not have an impact on the Company's consolidated financial position or
results of operations.

        In July 2003, the EITF reached a consensus on Issue No. 03-5,
"Applicability of AICPA Statement of Position 97-2 (SOP 97-2) to Non-Software
Deliverables" (EITF 03-5). The consensus was reached that SOP 97-2 is applicable
to non-software deliverables if they are included in an arrangement that
contains software that is essential to the non-software deliverables'
functionality. This consensus is to be applied to Company's financial year
beginning after October 1, 2003. The adoption of EITF 03-5 did not have an
impact on the Company's consolidated financial position or results of
operations.


                                       12
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
        FINANCIAL CONDITION

        The following discussion and analysis of the Company's financial
condition and results of operations should be read in conjunction with the
condensed consolidated financial statements and related notes included elsewhere
in this Form 10-Q Report and the consolidated financial statements and notes
thereto for the year ended March 31, 2004, included in the Company's fiscal 2004
Annual Report on Form 10-K.

FORWARD-LOOKING STATEMENTS

        All statements contained in this report that are not historical facts
are forward-looking statements. The forward-looking statements in this report
are made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. They are not historical facts or guarantees of
future performance or events. Rather, they are based on current expectations,
estimates, beliefs, assumptions, and goals and objectives and are subject to
uncertainties that are difficult to predict. As a result, the Company's actual
results may differ materially from the statements made. Often such statements
can be identified by their use of words such as "may," "will," "intends,"
"plans," "believes," "anticipates," "visualizes," "expects," and "estimates."
Forward-looking statements made in this report include statements as to current
and potential market segments, customers, and applications for and deployment of
the products of the Company; statements as to the business benefits to the
Company as a result of the March 2004 acquisition of two German
companies--including increased revenue potential, card production capacity and
product flexibility; statements as to the advantages of, potential income from,
and duties to be performed under the sale of a second-source card manufacturing
license; statements as to the Global Investments Group (GIG) license for
second-source card production in Slovenia, including future scheduled payments
and royalties, targeted startup date and production capacity, and that the
Company will sell equipment to GIG, provide GIG with installation support, and
have on-site personnel; production quantities, delivery rates and expected
delivery schedule, backlog, and revenue recognition for Company products for
U.S. or foreign government programs; statements as to potential deployment and
use of the Company's products in the Department of Homeland Security (DHS) U.S.
Visitor and Immigration Status Indication Technology (US-VISIT) program;
expectations as to the new sheet-lamination production facilities and the
short-term effect on gross margins; uncertainties associated with achieving
adequate production capacity for sheet-lamination process cards to meet order
requirements and delivery schedules; anticipated continued use of the Company's
products by the governments of the United States, Canada, and Italy; reliance on
value-added resellers and system integrators to generate sales, perform customer
system integration, develop application software, test products, and work with
governments to implement card programs; the Company's efforts to recruit new
value-added resellers (VARs); the need for, expected success of, and potential
benefits from the Company's research and engineering efforts, including
developing new or enhanced card capabilities, software products,
production-model read-only drives, or drives with advanced security features or
lower manufacturing costs; whether introduction of new drives will increase
sales, and the effects of read/write drive prices and sales volume on gross
profits or gross margins from read/write drive sales; the Company's belief that
the read/write drive inventory is reflected at its net realizable value; belief
that there is a market for both designs of its read/write drives to support and
expand optical card sales and that the read/write drive inventory on hand will
be ordered by customers; expectations regarding revenues, margins, capital
resources, and capital expenditures and investments, and the Company's deferred
tax asset and related valuation allowance; anticipated reductions of federal tax
cash payments due to current Company tax benefits; statements as to expected
card delivery volumes, estimates of optical card production capacity, expected
card yields there from, the Company's ability to expand production capacity, and
the Company's plans and expectations regarding the growth and associated capital
costs of such capacity; estimates that revenues will be sufficient to generate
cash from operating activities over the next 12 months despite expected
quarterly fluctuations; expectations regarding market growth, product demand,
and the continuation of current programs; potential expansion or implementation
of government programs utilizing optical memory cards, including without
limitation, those in Senegal, India, an Saudi Arabia, and the timing of the
award of any prime contracts for such programs; and the Company's plans,
objectives, and expected future economic performance.

        These forward-looking statements are based upon the Company's
assumptions about and assessment of the future, which may or may not prove true,
and involve a number of risks and uncertainties including, but not limited to,
whether there is a market for cards for homeland security in the U.S. and
abroad, and if so whether such market will utilize optical memory cards as
opposed to other technology; customer concentration and reliance on continued
U.S.


                                       13
<PAGE>

and Italian government business; risks associated with doing business in and
with foreign countries; whether the Company can successfully integrate and
operate its recently acquired German subsidiaries; whether the Company will be
successful in assisting GIG with factory startup and training; whether GIG will
have the financial wherewithal to make its required payments to the Company and
to operate the facility; whether the facility will efficiently produce high
quality optical memory cards in volume; whether GIG will be able to procure and
satisfy customers so that it owes and pays royalties; and whether GIG will
encounter unexpected delays in constructing and staffing the facility; lengthy
sales cycles and changes in and dependence on government policy-making; reliance
on value-added resellers and system integrators to generate sales, perform
customer system integration, develop application software, integrate optical
card systems with other technologies, test products, and work with governments
to implement card programs; risks and difficulties associated with development,
manufacture, and deployment of optical cards, drives, and systems; the impact of
litigation or governmental or regulatory proceedings; the ability of the Company
or its customers to initiate and develop new programs utilizing the Company's
card products; risks and difficulties associated with development, manufacture,
and deployment of optical cards, drives, and systems; potential manufacturing
difficulties and complications associated with increasing manufacturing capacity
of cards and drives, implementing new manufacturing processes, and outsourcing
manufacturing; the Company's ability to produce and sell read/write drives in
volume; the unpredictability of customer demand for products and customer
issuance and release of corresponding orders; government rights to withhold
order releases, reduce the quantities released, and extend shipment dates;
whether the Company receives a fixed payment schedule and/or a schedule,
notification, or plan for shipments out of the government-funded vault located
on the Company's premises, enabling the Company to recognize revenues on cards
delivered to the vault instead of when cards later are shipped from the vault;
the impact of technological advances, general economic trends, and competitive
products; and the possibility that optical memory cards will not be purchased
for the full implementation of card programs in Italy, Saudi Arabia, India, and
Senegal or for DHS programs in the U.S., or will not be selected for other
government programs in the U.S. and abroad, including the US-VISIT program; the
risks set forth in the section entitled "Risks and Other Factors That May Affect
Future Operating Results" and elsewhere in this report; and other risks detailed
from time to time in the Company's SEC filings. These forward-looking statements
speak only as to the date of this report, and, except as required by law, the
Company undertakes no obligation to publicly release updates or revisions to
these statements whether as a result of new information, future events, or
otherwise.

CRITICAL ACCOUNTING POLICIES

        REVENUE RECOGNITION. Product sales primarily consist of card sales and
sales of read/write drives. The Company recognizes revenue from product sales
when the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and (4)
collectibility is reasonably assured. The Company recognizes revenue on product
sales at the time of shipment when shipping terms are F.O.B. shipping point,
orders are placed pursuant to a pre-existing sales arrangement, and there are no
post-shipment obligations or customer acceptance criteria. Where appropriate,
provision is made at the time of shipment for estimated warranty costs and
estimated returns. To date, actual warranty costs and returns activity have not
been material.

        The Company's U.S. government subcontract requires delivery into a
secure vault located on the Company's premises. Shipments are made from the
vault on a shipment schedule provided by the prime contractor, which is subject
to revision, but not cancellation, at the option of the prime contractor. At the
time the cards are delivered into the vault, title to the cards is transferred
to the government and all risks of ownership are transferred as well. The prime
contractor is invoiced, with payment due within thirty days, and the contract
does not contain any return (other than for warranty) or cancellation
provisions. Pursuant to the provisions of SEC Staff Accounting Bulletin (SAB)
No. 104, revenue is recognized on delivery into the vault as the Company has
fulfilled its contractual obligations and the earnings process is complete. If
the Company does not receive a shipment schedule for shipment of cards from the
vault, revenue is recognized upon shipment from the vault. In addition, revenue
recognition for future deliveries into the vault would be affected if the U.S.
government cancels the shipment schedule. As a result, the Company's revenues
may fluctuate from period to period if the Company does not continue to obtain
shipment schedules under this subcontract or if the shipment schedules are
cancelled. During first quarter ended June 30, 2004, the Company received
notification from the prime contractor which delayed delivery of products
subject to an existing shipment schedule, and further amendments may be
possible. The Company believes that this extension does not preclude revenue
recognition under SAB 104.


                                       14
<PAGE>

        In May 2003, the Emerging Issues Task Force ("EITF") finalized the terms
of EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables,"
(EITF 00-21) which provides criteria governing how to identify whether goods or
services that are to be delivered separately in a bundled sales arrangement
should be accounted for separately. Deliverables are accounted for separately if
they meet all of the following criteria: a) the delivered items have stand-alone
value to the customer; b) the fair value of any undelivered items can be
reliably determined; and c) if the arrangement includes a general right of
return, delivery of the undelivered items is probable and substantially
controlled by the seller. In situations where the deliverables fall within
higher-level literature as defined by EITF 00-21, the Company applies the
guidance in that higher-level literature. Deliverables that do not meet these
criteria are combined with one or more other deliverables. The Company adopted
EITF 00-21 for any new arrangements entered into after July 1, 2003 and now
assesses all revenue arrangements against the criteria set forth in EITF 00-21.

        The Company applies the provisions of Statement of Position 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1) in applicable contracts. Revenues on time and materials
contracts are recognized as services are rendered at contract labor rates plus
material and other direct costs incurred. Revenues on fixed price contracts are
recognized on the percentage of completion method based on the ratio of total
costs incurred to date compared to estimated total costs to complete the
contract. Estimates of costs to complete include material, direct labor,
overhead and allowable general and administrative expenses. In circumstances
where estimates of costs to complete a project cannot be reasonably estimated,
but it is assured that a loss will not be incurred, the percentage-of-completion
method based on a zero profit margin, rather than the completed-contract method,
is used until more precise estimates can be made. During the first quarter ended
June 30, 2004, the Company recognized approximately $65,000 of revenues based on
a zero profit margin. The full amount of an estimated loss is charged to
operations in the period it is determined that a loss will be realized from the
performance of a contract.

        License revenue, which may consist of up-front license fees and
long-term royalty payments, is recognized as revenue when earned. The
second-source card manufacturing license sold in April 2004 to Global
Investments Group provides for license fees, training charges, and royalty
payments to the Company for each card produced during the 20-year term of the
license agreement. This is a multi-element arrangement as described in Emerging
Issues Task Force (EITF) Issue No. 00-21; revenue derived from the up-front
payments will be recognized ratably over the remainder of the 20-year license
term once the plant has begun production. The cost of license revenue is not
material and is included in selling, general, and administrative expenses.

        The Company applies the provisions of Statement of Position (SOP) No.
97-2, "Software Revenue Recognition," as amended by SOP No. 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions"
to all transactions involving the sale of software products. Revenue from the
license of the Company's software products is recognized when persuasive
evidence of an arrangement exists, the software product has been delivered, the
fee is fixed or determinable, and collectibility is probable, and, if
applicable, upon acceptance when acceptance criteria are specified or upon
expiration of the acceptance period.

        ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
consolidated financial statements, the Company is required to estimate income
taxes in each of the jurisdictions in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the consolidated balance
sheets. The Company must then assess the likelihood that the deferred tax assets
will be recovered from future taxable income and to the extent that management
believes recovery is not likely, the Company must establish a valuation
allowance. To the extent that a valuation allowance is established or increased
in a period, the Company includes an expense within the tax provision in the
statements of operations.

        Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. During fiscal 2002, the Company recorded a
tax benefit of $2.8 million, which included a $3.0 million reduction to the
valuation allowance on its deferred tax assets, net of federal alternative
minimum taxes, based on management's assessment that such portion of its
deferred tax assets would more likely than not be realized. Due to the Company's
recent cumulative tax loss history for the three-year period ending March 31,
2004, income statement loss history over the past five quarters, and the
continuing difficulty in forecasting the timing of future revenue as evidenced
by the deviations in achieved revenues from expected revenues during the past
few quarters and taking into account the newness of certain customer
relationships, the Company determined it was necessary as of March 31, 2004, to
increase the valuation allowance under SFAS No.


                                       15
<PAGE>

109 to the full amount of the deferred tax asset. As a result, the Company had
recorded a valuation allowance of $14.8 million as of March 31, 2004, which
included a charge to increase the valuation allowance against the beginning of
the year net deferred tax asset balance of $7.1 million and a charge against its
net deferred tax asset generated during fiscal 2004 in the amount of $2.4
million for the year ended March 31, 2004, due to uncertainties related to the
Company's ability to utilize its deferred tax assets. As of June 30, 2004, the
Company continues to provide for a full valuation allowance of $14.8 million
relating to its U.S. operations.

        The Company's methodology for determining the realizability of its
deferred tax assets involves estimates of future taxable income; the estimated
impact of future stock option deductions; and the expiration dates and amounts
of net operating loss carryforwards. These estimates are based on near-term
projections and assumptions which management believes to be reasonable. For
recent prior periods, the Company had been estimating future taxable income from
its core business, which assumed on-going business under the U.S. government
subcontract for Permanent Resident Cards and Laser Visa Border Crossing Cards
and the Canadian government's Permanent Resident Card program, as well as
estimated operating expenses to support that level of business, as offset by the
estimated impact of future stock option deductions. The Company went back to
estimating future taxable income based upon its expectations for the current and
next three years because this past core business has not proven to be as stable
as the Company had believed it to be and because this past core business is
expected to represent an increasingly smaller part of the business. This is
because the Company expects revenues from these U.S. programs to stabilize at
revenue levels lower than had been expected in the past and because the Company
expects new foreign business, which has fluctuated considerably quarter to
quarter, to comprise a larger portion of the core business. The Company has had
difficulty in the past, and expects to have continued difficulty in the future,
in reliably forecasting its foreign business and the revenue to be received from
it. This, in combination with the anticipated three-year cumulative tax loss for
the period ended June 30, 2004, has resulted in the Company basing its estimates
of future income for these purposes to booked orders only. As circumstances
change, the Company may in the future be able to revert back to estimating
future revenue based upon its forecast revenues rather than only using booked
orders, although the Company cannot say when this will occur.

        In concluding that a valuation allowance was required, the Company
considered both the positive and negative evidence regarding its ability to
generate sufficient future taxable income to realize its deferred tax assets.
Positive evidence included having achieved profitability for financial reporting
purposes from fiscal 1999 through fiscal year 2003. Other positive evidence
included (1) the level of sales and business experienced under the contract with
the Canadian government's Permanent Resident Card program; (2) prospects in
Italy and Saudi Arabia for national identification card programs; (3) the
heightened interest in border security initiatives following the events of
September 11, 2001; and (4) expected future orders. Negative evidence included
(1) the Company's reliance on a limited number of customers for a substantial
portion of its business; (2) the uncertainty in timing of anticipated orders
from customers; (3) the impact of future stock option deductions on taxable
income; and (4) recent experience of net operating loss carryforwards expiring
unused; (5) the loss for the first quarter of fiscal 2005 and the losses in
fiscal 2004; and (6) the prospect of three years' cumulative tax net operating
losses. In weighing the positive and negative evidence above, the Company
considered the "more likely than not" criteria pursuant to SFAS No. 109 as well
as the risk factors related to its future business described under the
subheadings: "Dependence on VARs and on a Limited Number of Customers," "Lengthy
Sales Cycles," "Technological Change," and "Competition" as noted in the section
entitled "Factors That May Affect Future Operating Results." As described above,
the Company concluded that the negative evidence outweighed the positive
evidence and has continued to record a valuation allowance to be equal to the
full amount of the deferred tax asset as of June 30, 2004 relating to its U.S.
operations.

        In the event that actual results differ from these estimates or that
these estimates are adjusted in future periods, the Company may need to adjust
the amount of the valuation allowance based on future determinations of whether
it is more likely than not that some or all of its deferred tax assets will be
realized. A decrease in the valuation allowance would be recorded as an income
tax benefit or a reduction of income tax expense or a credit to stockholders'
equity. The Company's net operating losses available to reduce future taxable
income expire on various dates from fiscal 2005 through fiscal 2024. To the
extent that the Company generates taxable income in jurisdictions where the
deferred tax asset relates to net operating losses that have been offset by a
full valuation allowance, the utilization of these net operating losses would
result in the reversal of the related valuation allowance in the Company's
results of operations. The Company would need $8.2 million of income on its
federal income tax return to avoid the expiration of $2.8 million of the
deferred tax asset now set to expire in fiscal 2005. In these regards it should
be noted that certain


                                       16
<PAGE>

payments from Global Investments Group might be treated as income on the
Company's tax return even though they are being deferred for financial reporting
purposes. This could result in the utilization of net operating losses that
otherwise might have expired which would result in a tax benefit for financial
reporting purposes as the valuation allowance would be correspondingly reduced.

        INVENTORIES. The Company values its inventory at the lower of the actual
cost to purchase and/or manufacture the inventory or the current estimated
market value of the inventory. Management regularly reviews inventory quantities
on hand and records a provision for excess and obsolete inventory based
primarily on forecasts of product demand. Demand for read/write drives can
fluctuate significantly. In order to obtain favorable pricing, purchases of
certain read/write drive parts are made in quantities that exceed the historical
annual sales rate of drives. The Company purchases read/write drive parts for
its anticipated read/write drive demand and takes into consideration the
order-to-delivery lead times of vendors and the economic purchase order quantity
for such parts. In addition, the Company keeps a supply of card raw materials it
deems necessary for anticipated demand. Therefore, the calculation of inventory
turnover will vary when actual demand differs from anticipated demand.

        Management's analysis of the carrying value of card and read/write drive
inventory is performed on a quarterly basis. With respect to inventory carrying
values, the Company follows the principles articulated in Accounting Research
Bulletin 43, Chapter 4, "Inventory Pricing," paragraphs 5 through 7 and 10 and
other authoritative guidance (SAB 100) as it relates to determining the
appropriate cost basis of inventory and determining whether firm, noncancelable
purchase commitments should be accrued as a loss if forecasted demand is not
sufficient to utilize all such committed inventory purchases. As part of the
Company's quarterly excess/obsolete analysis, management also determines whether
lower of cost or market adjustments (i.e., where selling prices less certain
costs are not sufficient to recover inventory carrying values) are warranted;
during the first three months of fiscal 2005, the Company has not recorded any
significant lower of cost or market adjustments. In those instances where the
Company has recorded charges for excess and obsolete inventory, management
ensures that such new cost basis is reflected in the statement of operations if
that inventory is subsequently sold. The Company's inventory reserves are based
upon the lower of cost or market for slow moving or obsolete items. As a result,
the Company believes a 10% increase or decrease of sales would not have a
material impact on such reserves.

RESULTS OF OPERATIONS--FISCAL 2005 FIRST QUARTER
COMPARED WITH FISCAL 2004 FIRST QUARTER

Overview

        Headquartered in Mountain View, Drexler Technology Corporation
manufactures LaserCard(R) optical memory cards, chip-ready OpticalSmart(TM)
cards, and other advanced-technology cards. In addition, the Company operates
three wholly owned subsidiaries. LaserCard Systems Corporation, of Mountain
View, manufactures optical card read/write drives; develops optical card system
software; and markets cards, card-related data systems, and peripherals.
Challenge Card Design Plastikkarten GmbH, of Rastede, Germany, manufactures
advanced-technology cards; and cards & more GmbH, of Ratingen, Germany, markets
cards, system solutions, and thermal card printers.

        During the June 30, 2004 quarter, the Company began the integration of
the two related German card companies acquired on March 31, 2004, Challenge Card
Design Plastikkarten GmbH of Rastede, Germany, and cards & more GmbH of
Ratingen, Germany. These acquisitions provide the Company with a card
manufacturing base to serve the European, Middle Eastern, African, and Asian
markets, supplementing the Company's newly expanded manufacturing operations in
California. These operations accounted for 31% of total Company revenues during
the first quarter of fiscal 2005. This is the first quarter that the German
operations are included in the Company's Statement of Operations. During the
June fiscal 2005 quarter, the Company incurred approximately $220,000 of SG&A
expense related to this integration.

        Prior to fiscal 2005, the largest purchaser of LaserCard products was
Anteon International Corporation, a value-added reseller (VAR) of the Company.
Anteon is the government contractor for LaserCard product sales to the U.S.
Department of Homeland Security (DHS), U.S. Department of State (DOS), U.S.
Department of Defense (DOD), and the government of Canada. Under government
contracts with Anteon, the DHS purchases U.S. Permanent


                                       17
<PAGE>

Resident Cards (Green Cards) and DOS "Laser Visa" Border Crossing Cards (BCCs);
the DOD purchases Automated Manifest System cards; and the Canadian government
purchases Permanent Resident Cards. Encompassing all of these programs, the
Company's product sales to Anteon represented 22% for the three months ended
June 30, 2004. Another unaffiliated Company VAR, Laser Memory Card of Italy,
accounted for 42% of the Company's total revenues in the first quarter of fiscal
2005 for programs in Italy and Senegal. The Company's product sales to Anteon
represented 93% of total revenues for the three-months periods ended June 30,
2003.

        Revenues for the major programs are shown below as a percentage of total
Company revenues:

<TABLE>
<CAPTION>
                                                       THREE MONTHS ENDED JUNE 30,
                                                       ---------------------------
                                                            2004       2003
                                                            ----       ----
<S>                                                          <C>        <C>
        United States Green Cards and Laser Visa BCCs        12%        43%
        Canadian Permanent Resident Cards                     8%        42%
        Italian Carta d'Identica Elettronica (CIE) Cards     40%         0%
</TABLE>

        For the government of Italy, the Company has received orders for CIE
cards (Carta d'Identita Elettronica) and anticipates orders for a new program
for the PSE cards (Permesso di Soggiorno Elettronico). As of June 30, 2004, the
Company has a backlog, in the amount of $2.6 million for CIE cards scheduled for
delivery in the September fiscal 2005 quarter for Phase 2 of this program.
According to program descriptions released by the Italian government, CIE card
orders could potentially reach more than $32 million per year if Phase 2 is
successful and Phase 3 is fully funded and implemented.

        Optical memory card revenues for the quarter ended June 30, 2004 mainly
included sales of CIE cards for the Italian government for its national ID card
program; U.S. Permanent Resident Cards (Green Cards), DOS "Laser Visa" Border
Crossing Cards (BCCs), and Automated Manifest System cards for the U.S.
government; and sales of Permanent Resident Cards made for the Canadian
government.

        The Company completed delivery in the June fiscal 2005 quarter of a $2.6
million order by delivery of $814,000 of U.S. Permanent Resident Cards (Green
Cards) for the U.S. Department of Homeland Security (DHS). As of June 30, 2004,
between its own on-site inventory and the inventory it owns and maintains in
their vault on Company premises, the U.S. government has inventories of Laser
Visa BCCs and Green Cards which would last approximately 15 and 9 to 11 months,
respectively, at the U.S. government's card-personalization rates. Since the
Company believes that the US government desires to maintain about a six-month
safety stock, the Company does not expect any orders of LaserVisa BCC's this
year but anticipates receiving an order during the next few months for Green
Cards for shipment during this fiscal year. During first quarter ended June 30,
2004, the Company received notification from the prime contractor which delayed
delivery of products subject to an existing shipment schedule, and further
amendments may be possible. The Company believes that this extension does not
preclude revenue recognition under SAB 104.

        The Company estimates that fiscal 2005 optical memory card revenues from
sales of U.S. Green Cards and Laser Visa BCCs may not exceed $4.0 million
depending on how the DHS manages their inventory levels. The U.S. government is
currently personalizing cards at $9.0 million annualized run rate. The value is
based upon the Company's selling price of cards to Anteon. The Company believes
that annual revenues under these two programs will approximate the U.S.
government personalization rate over time, subject to fluctuations in the level
of inventory deemed appropriate by the U.S. government.

        The Company has established sheet-lamination production facilities to
make Canadian Permanent Resident Cards, Italian National ID cards, and cards for
other potential programs. This process is currently more labor intensive than
its roll-lamination process but allows the use of high security offset printing
and other special features, resulting in a premium card. To date, gross margins
on the sheet-process cards have been less than 40%. In particular, largely due
to a card production problem that has since been rectified, the gross margin on
sheet-process cards was about 23% during the first quarter of fiscal 2005. The
Company believes that over time it will be able to improve margins to above the
40% level on cards made by the sheet-lamination process, through automation and
yield improvements. In


                                       18
<PAGE>

addition, roll-lamination card gross margins have been hampered by low sales and
production volume and could return to 50% at higher volumes, however, there is
no assurance that such margins will be achieved or sustained by the Company.

        Application areas with major growth potential for LaserCard optical
memory cards include government-sponsored identification programs in several
countries, motor vehicle registration in India, and the possible expansion of
U.S. government ID programs due to the need for enhanced border security. Since
governmental card programs typically rely on policy-making, which in turn is
subject to technical requirements, budget approvals, and political
considerations, there is no assurance that these programs will be implemented as
expected or that they will include optical cards.

        In addition to using its own marketing staff in California, New York,
and Germany, the Company utilizes VAR companies and card distribution licensees
for the development of markets and applications for LaserCard products. Product
sales to VARs and licensees consist primarily of the Company's optical memory
cards and optical card read/write drives. The Company also offers for sale, its
customized software applications and add-on peripherals made by other companies
(such as equipment for adding a digitized photo, fingerprint, hand template, or
signature to the cards). The VARs/licensees may add application software,
personal computers, and other peripherals, and then resell these products
integrated into data systems. The Company is continuing its efforts to recruit
new VARs and eliminate nonproductive VARs.

        The Company's current five-year U.S. government subcontract for Green
Cards and Laser Visa BCCs was announced in June 2000 and will expire on May 25,
2005. This subcontract was received by the Company through Anteon, a LaserCard
VAR that is a U.S. government prime contractor, under a competitively bid,
government procurement contract. When the contract expires, the government could
issue a new competitively bid contract or issue sole-source purchase orders.
There is no assurance that a follow-on contract or sole-source purchase orders
will be issued by the DHS upon expiration of the current contract.

        In 2002, the Company was awarded a subcontract for production of
Canada's new Permanent Resident Cards. Shipments began in fiscal 2003 and have
totaled $7.3 million as of June 30, 2004. The Company's cancelable backlog at
June 30, 2004 relating to this contract of $2.4 million called for deliveries
through January 2005.

        In March 2004, the Company quoted on a tender issued by the Kingdom of
Saudi Arabia for three million cards and 220 read/write drives for a secure
personal identification card program. The products would be delivered over a
one-year period after contract issuance. The current prime contractor has
informed the Company that this second-phase contract is expected to be awarded
to one of the prime contractors in September 2004; however, there is no
assurance that the contract will be issued, that the Company would be the
selected vendor, or that the Company will receive additional orders for this
program under any contract that may ultimately be issued by the Saudi Arabian
government. The Company previously sold 120 read/write drives for this program,
most of which were shipped in the fiscal 2004 second quarter, for installation
of the infrastructure required for card issuance, and also has shipped 35,000
optical memory cards for phase 1. The first-phase contract allows for the
procurement of 300,000 cards and the Company expects a purchase order release
during the quarter ending September 30, 2004 for the 265,000-card balance for
shipment prior to calendar year end.

        Effective April 3, 2004, the Company sold a second-source
card-manufacturing license to the Global Investments Group, based in Auckland,
New Zealand, for card manufacturing in Slovenia. This agreement provides for
payments to the Company of $29 million for the license over the 20-year term of
the license (including a five-year training support package, followed by an
ongoing support phase for an additional 15 years). Additionally, the Company is
to sell approximately $12 million worth of the required manufacturing equipment
and installation support for the to-be-built new facility to provide a targeted
initial manufacturing capacity of 10 million optical cards annually. The Company
has received $5.5 million of payments called for in the agreements as of June
30, 2004, consisting of a partial payment for the equipment and installation
support of $3.5 million, recorded as advance payments, and $2.0 million toward
the license fee, recorded as deferred revenue, which are classified as long-term
liabilities within the consolidated balance sheets. Global Investments Group is
to pay the Company royalties for each card produced during the 20-year term of
the license agreement. Global Investments Group anticipates that start up of the
Global Investments Group facility will be late in calendar 2005. Revenue will be
recognized over the remaining term of the


                                       19
<PAGE>

agreement beginning when operation of the factory commences.

        Kodak is the Company's sole-source supplier of raw material for its
optical memory card media. The Company currently has an order which Kodak has
accepted with deliveries scheduled through December, 2004. Kodak announced in
the Company's prior fiscal year that it is reducing its emphasis on emulsion
based films. Subsequently, however, Kodak has reassured us that it has no plans
to discontinue the fine-grained monochrome emulsion used in our optical memory
card since it is similar to those used in military and commercial
high-resolution products for which Kodak continues to maintain production. If
Kodak were nonetheless to discontinue manufacturing the raw material from which
the Company's optical memory card media is made, the Company would order the
maximum amount of final-run stock for use while endeavoring to establish an
alternate supplier for such raw material, although the purchase price could
increase from a new supplier.

        The company uses a second photographic emulsion for the preparation of
mastering loops. The Company has purchased a long-term supply of this emulsion
and believes it has on hand an adequate supply and on order to meet anticipated
demand.

        The Company plans to invest approximately $9.5 million in additional
capital equipment and leasehold improvement expenditures in fiscal 2005, as more
fully discussed under "Liquidity and Capital Resources."

Revenues

        PRODUCT REVENUES. The Company's total revenues for the fiscal 2005 first
quarter ended June 30, 2004 consisted of sales of optical memory cards, optical
card read/write drives, drive accessories, maintenance, specialty cards, card
printers, and other miscellaneous items. The Company's total revenues were $8.7
million for the fiscal 2005 first quarter compared with $2.5 million for the
fiscal 2004 first quarter. The increase in revenues for the three months ended
June 30, 2004 was due to $2.7 million in revenues from net sales to external
customers from the newly-acquired German companies and increases in optical
memory card product sales described below.

        Revenue on optical memory cards totaled $5.6 million for the fiscal 2005
first quarter compared with $2.3 million for the fiscal 2004 first quarter. The
increase in optical memory card revenue was mainly due to the sale of optical
memory cards for the Italian National ID card program of $3.4 million for the
fiscal 2005 first quarter versus $23,000 in last years first quarter.

        Revenue on read/write drives, drive service, and related accessories
totaled $289,000 for the fiscal 2005 first quarter compared with $114,000 for
the fiscal 2004 first quarter. The increase was due to an increase in unit sales
volume for read/write drives.

        LICENSE FEES AND OTHER REVENUES. There were no license revenues for the
fiscal 2005 first quarter ended June 30, 2004 or the fiscal 2004 first quarter
ended June 30, 2003. However, in the fiscal 2005 first quarter, the Company
announced the sale of a royalty-bearing, optical memory card manufacturing
license to the Global Investments Group, of New Zealand, for card manufacturing
in Slovenia. The license agreement provides for payments to the Company of $29
million for the license (including a five-year training support package,
followed by an ongoing support phase for an additional 15 years). Additionally,
the Company agreed to sell approximately $12 million worth of manufacturing
equipment and installation support for the new facility to provide a targeted
initial manufacturing capacity of 10 million optical cards annually, with
options to increase capacity to 30 million cards per year. As of June 30, 2004,
the Company has received the initial $5.5 million of payments called for in the
agreements, consisting of a partial payment for the equipment and support of
$3.5 million, recorded as advance payments, and $2.0 million toward the license
fee, recorded as deferred revenue. Subsequent to quarter end, the Company
received an additional $2.1 million in payments for the equipment and support.
The payments of $41.0 million called for in the agreements will be recognized as
revenue over the remaining term of the arrangement beginning when operation of
the factory commences, presently targeted by Global Investments Group for late
in 2005. Direct and incremental costs will also be deferred and recorded as cost
of sales along with the revenue.

Backlog


                                       20
<PAGE>

        As of June 30, 2004, the backlog for LaserCard optical memory cards
totaled $4.1 million scheduled for delivery this fiscal year, of which $3.3
million is scheduled for delivery during the quarter ended September 30, 2004.
Order backlog as of June 30, 2004 includes orders for the Italian government
national ID cards (CIE cards), and Canadian government Permanent Resident Cards.
Backlog is subject to fluctuation due to having few customers and the timing of
orders. As of June 30, 2003, the backlog for LaserCard optical memory cards had
totaled approximately $1.7 million. The Company has no significant backlog for
read/write drives.

        In addition, the backlog for Challenge Card Design Plastikkarten GmbH
and cards & more GmbH products and services totaled 1.7 million euros
(approximately $2.0 million) as of June 30, 2004. This backlog includes about
$1.1 million for a partially completed contract with $735,000 in advance
payments on the Company's balance sheet. The Company does not anticipate that it
will record any gross profit or loss from this contract when completed because
the contract was substantially completed prior to the March 31, 2004 acquisition
and all profit accrued to the prior entity.

Gross Margin

        Gross margin on overall product sales was 27% for the fiscal 2005 first
quarter compared with negative 4% for the fiscal 2004 first quarter. The overall
gross profit increased $2.4 million, to $2.3 million for the first quarter of
fiscal 2005 from a negative $110,000 for the first quarter of fiscal 2004. This
increase was due primarily to higher volume of optical memory card sales

        OPTICAL MEMORY CARDS. Optical memory card gross profit and margins can
vary significantly based on yields, average selling price, sales and production
volume, mix of card types, production efficiency, and changes in fixed costs.
The gross margin on optical memory cards increased to 31% for the first quarter
of fiscal 2005 compared to 4% for the first quarter of fiscal 2004. The increase
was primarily due to the increase in sales and production volume and the
corresponding increased absorption of fixed costs. The margin in the June 30,
2004 quarter just was negatively impacted by a card production problem that
caused excessive rejects resulting in increased cost of about $350,000 or 6.2%
of card revenues. Shipments were also limited due to the excessive rejects. The
problem has been rectified and product yields have recently returned to
historical levels.

        READ/WRITE DRIVES. Read/write drive gross profit and margins can vary
significantly based upon sales and production volume, changes in fixed costs,
and the inclusion of optional features and software licenses on a per-drive
basis. Read/write drive gross profits are generally negative, inclusive of fixed
overhead costs, due to low sales volume. For the fiscal 2005 first quarter,
gross profit on read/write drive sales was a negative $238,000 compared with a
negative gross profit of $211,000 for the fiscal 2004 first quarter. The Company
believes that margins will be below 10% when sales volume is sufficient to
result in positive gross profit.

        SPECIALTY CARDS AND PRINTERS. Gross margin on specialty cards and
printers was 30% for the June 30, 2004 quarter which was the first quarter of
operation of this segment.

Expenses

        SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES (SG&A). SG&A expenses were
$3.0 million for the fiscal 2005 first quarter compared with $1.8 million for
the fiscal 2004 first quarter. The increase of $1.3 million was primarily due to
$757,000 in SG&A expenses recorded by the acquired German entities, an increase
in the U.S. operation marketing expenses of $151,000, increases in legal,
accounting, and consulting of $220,000 mainly related to the integration of the
acquired German companies, and a $55,000 increase in occupancy costs. SG&A
expenses for fiscal 2005 will be higher than fiscal 2004 levels, as represented
by the quarter ended June 30, 2004, mainly due to the inclusion of SG&A of the
acquired German companies, integration of the acquired companies, increases in
marketing and selling expenses, and the cost of compliance with internal control
auditing mandated by Section 404 of the Sarbanes-Oxley Act.

        RESEARCH AND ENGINEERING EXPENSES (R&E). The Company is continuing its
efforts to develop new optical memory card features and structures, including
various sheet-lamination card structures, the insertion of contactless chips
with radio frequency (RF) capability, Optichip(TM), OVD (optically variable
device) products, and associated


                                       21
<PAGE>

media development; enhanced optical memory card read/write drives and read-only
drives (readers); and new software products in an effort to provide new products
that can stimulate optical memory card sales growth. For example, the Company
has developed a prototype of a LaserCard handheld reader. The Company
anticipates that these ongoing research and engineering efforts will result in
new or enhanced card capabilities, production-model read-only drives, or drives
with advanced security features and lower manufacturing costs; however, there is
no assurance that such product development efforts will be successful. These
features are important for the Company's existing and future optical memory card
markets. Total R&E expenses were $851,000 for the first quarter of fiscal 2005
compared with $612,000 for the first quarter of fiscal 2004. The $239,000
increase is mainly due to handheld read-only drive development, optical memory
card development, and the inclusion of $64,000 of R&E expenses of the acquired
German companies. Increases in R&E expenses are anticipated for fiscal 2005 for
development of production-model read-only drives, including a $150,000 expense
anticipated in the September fiscal 2005 quarter, for prototypes of a hand-held
read-only drive, optical memory card media development, and other card and
hardware related programs.

        OTHER INCOME AND EXPENSE. Total net other income for the first quarter
of fiscal 2005 was $23,000 consisting of $90,000 in interest income, partially
offset by $61,000 in interest expense, and a $8,000 loss on the sale of capital
equipment. Total net other income for the first quarter of fiscal 2004 in the
amount of $64,000 included $62,000 of interest income. The increase in interest
income was mainly due to the increase in invested funds. Interest expense of
about $32,000 recorded in the June fiscal 2005 quarter on long-term debt will
continue at this approximate amount through fiscal 2005 and decline over time as
annual payments are made on the debt. Interest expense of $29,000 was mainly on
debt that was retired near the end of the June 30, 2004 quarter. There may be
minimal interest expense on an ongoing basis when the German companies use their
credit lines for current working capital requirements.

        INCOME TAXES. The Company recorded an income tax expense of $26,000 for
the fiscal 2005 first quarter compared with an income tax benefit of $971,000 in
the first quarter of fiscal 2004. The Company's income tax expense for fiscal
2005 first quarter was recorded on profit generated in Germany. The amount of
income tax expense recorded in Germany was based upon the Company's anticipated
tax rate for the full fiscal year. No income tax benefit was recognized during
the fiscal 2005 first quarter on operating losses generated in the U.S.

LIQUIDITY AND CAPITAL RESOURCES

        As of June 30, 2004, the Company had cash, cash equivalents, and
short-term investments of $12.5 million and a current ratio of 2.6 to 1. The
Company also had $8.2 million in long-term investments with original maturities
from one year to two and one-half years. Cash, short-term investments, and
long-term investments were $20.7 million at June 30, 2004 and $20.9 million at
March 31, 2004.

        Net cash provided by operating activities was $2.5 million for the first
three months of fiscal 2005 compared with $1.0 million used in operating
activities for the first three months of fiscal 2004. The increase in cash
provided by operating activities from the first quarter of fiscal 2004 to the
first quarter of fiscal 2005 is due primarily to increases in advance payments
from customers and deferred revenue offset by the decrease in accounts payable
and accrued liabilities. During the three months period ended June 30, 2004, the
amount of $3.0 million in advance payments and $2.0 million in deferred revenue
were received from Global Investments Group related to the contract of
card-manufacturing license, sales of required equipment and support services.
The decrease in accounts payable and accrued liabilities was due mainly to $1.0
million of leasehold improvement accrued in the fourth quarter of fiscal 2004
but paid in the first quarter of fiscal 2005 and $568,000 of accounts payable
paid down by the Company's subsidiaries in Germany.

        Cash and investments decreased during the fiscal 2005 first quarter by
$212,000. Cash and investments will fluctuate based upon the timing of advance
payments from customers relative to shipments and the timing of inventory
purchases and subsequent manufacture and sale of products.

        The Company believes that the estimated level of revenues and advance
payments over the next 12 months will be sufficient to generate cash from
operating activities over the same period. However, quarterly fluctuations are
expected. Operating cash flow could be negatively impacted to a significant
degree if Global Investment Group does not make the required payments as
scheduled, or if either of the Company's largest U.S. government programs were
to be further delayed, reduced, canceled, or not extended, if the Italian CIE
card program does not grow as planned


                                       22
<PAGE>

internally, and if these programs are not replaced by other card orders or other
sources of income.

        The Company has not established a line of credit and has no current
plans to do so. The Company may negotiate a line of credit if and when it
becomes appropriate, although no assurance can be made that such financing would
be available on favorable terms or at all, if needed.

        As a result of the $1.5 million net loss recorded for the fiscal 2005
first quarter, the Company's accumulated deficit increased to $19.8 million.
Stockholders' equity decreased to $34.2 million mainly due to the net loss
recorded.

        Net cash used for investing activities was $861,000 for fiscal 2005
first quarter compared with $5.1 million provided by investing activities in the
first quarter of fiscal 2004. These amounts include maturities of liquid
investments; purchases of property and equipment of $1.5 million in the first
quarter of fiscal 2005 versus $736,000 in the first quarter of fiscal 2004; and
acquisitions of patents and other intangibles of $30,000 in the first quarter of
fiscal 2005 and $34,000 in the first quarter of fiscal 2004.

        The Company considers all highly liquid investments, consisting
primarily of commercial paper, taxable notes, and U.S. government bonds, with
original or remaining maturities of three months or less at the date of
purchase, to be cash equivalents. All investments with original or remaining
maturities of more than three months but not more than one year at the date of
purchase are classified as short-term. Investments with original or remaining
maturities of more than one year at the date of purchase are classified as
long-term. The Company determines the length of its investments after
considering its cash requirements and yields available for the type of
investment considered by the Company. Management also determines the appropriate
classification of debt and equity securities at the time of purchase and
reevaluates the classification of investments as of each balance sheet date. As
of June 30, 2004 the Company had $8.5 million classified as short-term and
long-term investments, compared with $9.2 million at March 31, 2004. All
marketable securities were accounted for as held-to-maturity.

        The Company made capital equipment and leasehold improvement purchases
of approximately $1.5 million during fiscal 2005 first quarter compared with
approximately $700,000 during the fiscal 2004 first quarter. As of June 30,
2004, the Company has non-cancelable purchase orders of $225,000 for equipment
and $1.4 million for raw materials. The Company's current card capacity,
assuming optimal card type mix, is estimated at approximately 16 million cards
per year. The Company plans to purchase additional production equipment in a
series of steps when deemed appropriate by the Company. The Company is also
increasing production capacity for cards with new structures used by the
Canadian and Italian programs. In addition to investment used for expansion, the
Company expects to make additional capital expenditures for cost savings,
quality improvements, and other purposes. The Company plans to use cash on hand
and cash generated from operations to fund additional capital expenditures of
approximately $9.5 million during fiscal 2005 for equipment and leasehold
improvements for card production, read/write drive tooling and assembly, and
general support items.

        Net cash used in financing activities was $1.2 million for the fiscal
2005 first quarter compared with $1.1 million provided by financing activities
for the fiscal 2004 first quarter. Financing activities consisted of repayments
of bank loans and long-term debt in the amount of $1.3 million in the fiscal
2005 first quarter and proceeds on sales of common stock through the Company's
stock-option and stock-purchase plans of $110,000 for the fiscal 2005 first
quarter compared with $1.1 million for the fiscal 2004 first quarter.

        There were no new debt financing activities for the fiscal 2005 first
quarter ended June 30, 2004.

RISK FACTORS AND FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

        OUR CURRENT AND FUTURE EXPECTED REVENUES ARE DERIVED FROM A SMALL NUMBER
OF ULTIMATE CUSTOMERS SO THAT THE LOSS OF OR REDUCTIONS IN PURCHASES BY ANY ONE
ULTIMATE CUSTOMER COULD MATERIALLY REDUCE OUR REVENUES AND LEAD TO LOSSES.
During fiscal 2004 and each of the previous two fiscal years, we have derived
more than 90% of our revenues from four programs-two U.S. government programs
and two foreign government programs. Due to the lengthy sales cycles, we believe
that these programs, with perhaps the addition of one or two other foreign
programs, will be the basis for a substantial majority of our revenues in the
near-term. The loss of or reductions in purchases by any one customer due


                                       23
<PAGE>

to program cutbacks, competition, or other reasons would materially reduce our
revenue base. Our U.S. government subcontract expires on May 25, 2005. There is
no assurance that a follow-on contract will be issued by the U.S. government
upon expiration of the current contract. Annual or quarterly losses would occur
if there are material reductions, gaps or delays in card orders from our largest
U.S. or foreign government programs or if such programs were to be reduced in
scope, delayed, canceled, or not extended and not replaced by other card orders
or other sources of income.

        WE HAVE INCURRED NET LOSSES DURING THE PAST SIX QUARTERS AND MAY NOT BE
ABLE TO GENERATE SUFFICIENT REVENUE IN THE FUTURE TO ACHIEVE OR SUSTAIN
PROFITABILITY. As of June 30, 2004, we had an accumulated deficit of $19.8
million and we incurred a loss of $1.5 million during the first quarter of
fiscal 2005 then ended. Although we operated profitably for fiscal 1999 through
fiscal 2003, we have incurred significant losses in the past, including in
fiscal 1997 and 1998, and we incurred losses in fiscal 2004 and in the first
quarter of fiscal 2005 due primarily to delays in orders for our cards, and in
the third fiscal quarter of fiscal 2004, by the increase in the valuation
allowance we recorded against our deferred tax assets. There can be no assurance
that we will generate enough card revenues in the near term or ever to become
profitable. We are relying upon our optical memory card technology to generate
future product revenues, earnings, and cash flows. If alternative technologies
emerge or if we are otherwise unable to compete, we may not be able to achieve
or sustain profitability on a quarterly or annual basis. Annual or quarterly
losses would also occur if increases in product revenues or license revenues do
not keep pace with increased marketing, research and engineering expenses and
the depreciation and amortization associated with capital expenditures.

        OUR PRODUCT REVENUES WILL NOT GROW IF WE DO NOT WIN NEW BUSINESS IN THE
U.S. AND ABROAD. Revenues during fiscal 2003 included sales of approximately
$21.5 million of U.S. government Green Cards and Laser Visa BCCs. Fiscal 2004
revenues included sales of approximately $5 million of cards for these
government programs, with annual sales in the near-term after fiscal 2005
expected to approximate the card personalization rate of the U.S. government,
which currently is approximately $9 million of cards per year ($6.6 million for
Green Cards and $2.4 million for Laser Visa BCCs). During fiscal 2005, we expect
our revenue from these programs to be less as we anticipate that the U.S.
government will draw down its excess inventory; and, as a worst case, we could
have almost no revenue if the inventory levels are drawn down substantially.
These revenue levels are less than the approximately $13 million level of
revenues we had previously expected to receive from these programs on an annual
basis. During the first quarter of fiscal 2005, revenues generated from these
programs were approximately $1.0 million. We believe that in order for our
overall card revenues during fiscal 2005 to return to their fiscal 2003 levels,
we will need significant additional orders from new and other existing programs
to supplement the revenue, which may not exceed $4.0 million depending on how
the government manages its inventory levels, from the U.S. Green Cards and Laser
Visa BCCs. Optical memory card digital governance programs that are emerging
programs or prospective applications in various countries include identification
cards for Italy and Saudi Arabia; motor vehicle registration cards in India; and
several new U.S. government ID card programs due to the increasing need for
enhanced U.S. border security. In the United States, the US-VISIT program, the
TWIC (Transportation Worker Identification Credential) program, and the proposed
Registered Flier program are possible market opportunities for secure
identification using optical memory cards. However, there is no assurance that
our products will be selected for any of these programs. In particular, we are
uncertain whether we will be chosen as a US-VISIT subcontractor directly or
through a VAR teaming partner with Accenture, which was announced as the prime
contractor for the full implementation of this program on June 1, 2004. Since
governmental card programs typically rely on government policy-making, which in
turn is subject to technical requirements, budget approvals, and political
considerations, there is no assurance that the US-VISIT program will be
implemented as expected or that it will include optical cards in its solution.

        From Italy, we received orders in July 2003, December 2003, and May 2004
valued at $2.4 million, $3.8 million, and $3.3 million, respectively, for Phase
2 of the Italian CIE card program and we anticipate receiving orders during
fiscal 2005 for one of Italy's new programs, the Permesso di Soggiorno
Elettronico (PSE) card. We did not receive any order for this program during the
first quarter of fiscal 2005. There is no assurance that the foregoing
government programs will be continued or implemented as anticipated or that the
U.S. government will select our cards for its new homeland security programs.

        OUR PROGRAM WITH ITALY, WHICH WE BELIEVE WILL BE OUR LARGEST ULTIMATE


                                       24
<PAGE>

CUSTOMER FOR THE NEXT FEW YEARS, IS IN AN EXPERIMENTAL STAGE AND MAY BE DELAYED
OR CANCELLED FOR REASONS OUTSIDE OUR CONTROL. THIS WOULD CAUSE US TO HAVE LESS
REVENUE THAN PLANNED AND WOULD LEAD TO CONTINUED LOSSES. The Company believes
that the Italian CIE card program will be our largest ultimate customer for the
next few years, comprising a significant portion of future revenues. We are
increasing capacity to meet the anticipated demand. However, since the program
is in Phase 2, which is its second experimental phase, there can be no assurance
that demand will increase as anticipated by the Company. Losses would occur if
Phase 3 of this program, which is full implementation, was to be delayed,
canceled, or not extended and not be replaced by other card orders or other
sources of income, or if the government were to change its technology decisions.

        ONE VALUE ADDED RESELLER IS THE CONTRACTOR FOR OUR U.S. AND CANADIAN
GOVERNMENT CUSTOMERS AND ANOTHER VAR PURCHASES CARDS FROM US FOR THE ITALIAN
NATIONAL ID CARD PROGRAM. HAVING TO REPLACE EITHER OF THESE VARS COULD INTERRUPT
OUR U.S., CANADIAN, OR ITALIAN GOVERNMENT BUSINESS. AND, IF OUR VARS LOSE THEIR
GOVERNMENT BUSINESS, OUR REVENUES WOULD LIKEWISE DECLINE MATERIALLY. The largest
purchaser of LaserCard products is Anteon International Corporation, one of our
value-added resellers (VARs). Anteon is the government contractor for LaserCard
product sales to the U.S. Department of Homeland Security, U.S. Department of
State, U.S. Department of Defense, and the government of Canada. Under
government contracts with Anteon, the DHS purchases U.S. Green Cards and DOS
Laser Visa BCCs; the DOD purchases Automated Manifest System cards; and the
Canadian government purchases Permanent Resident Cards. Encompassing all of
these programs, our product sales to Anteon represented 72% of total revenues
for fiscal 2004 ended March 31, 2004; 94% of total revenues for fiscal 2003
ended March 31, 2003; and 81% of total revenues for fiscal 2002 ended March 31,
2002. However, since the ultimate customers are national governments, we are not
dependent upon any one specific contractor for continued revenues from these
programs. Although not anticipated, if Anteon were to discontinue its
participation as contractor, other qualified contractors could be utilized by
those governments for purchasing our products, although the process of doing so
could cause program delays. Concerning Italy, during fiscal 2004, 22% of the
Company's revenues were derived from sales of cards and read/write drives for
the government of Italy for its CIE card program. Card orders under this program
are channeled to the Company through a value-added reseller, Laser Memory Card
SRL, of Rome, Italy. According to Italian government sources, the distribution
of this new national ID card has started in a number of the 56 Italian
communities scheduled to be activated under the program during 2004. The
government's publicly stated plan is to issue up to two million CIE cards this
year. However, if this program were to be discontinued or interrupted by the
Italian government, the Company would lose one of its significant sources of
optical memory card revenues.

        ONE OF OUR LARGER ULTIMATE CUSTOMERS, THE U.S. GOVERNMENT, HAS THE RIGHT
TO DELAY ITS ORDERS OR COULD CHANGE ITS TECHNOLOGY DECISIONS, WHICH WOULD RESULT
IN ORDER DELAYS OR LOSSES. Under U.S. government procurement regulations, the
government reserves certain rights, such as the right to withhold releases, to
reduce the quantities released, extend delivery dates, reduce the rate at which
cards are issued, and cancel all or part of its unfulfilled purchase orders. Our
U.S. government card deliveries depend upon the issuance of corresponding order
releases by the government to its prime contractor and, in turn, to us, and we
believe that these orders will continue in accordance with our government
subcontract. Losses would occur if either of our largest U.S. government
programs were to be delayed, canceled, or not extended and not be replaced by
other card orders or other sources of income, or if the government were to
change its technology decisions, or if increases in product revenues or licenses
do not keep pace with increased marketing, research and engineering, and
depreciation on capital equipment. For example, the latest order of cards under
our U.S. government subcontract, $2.6 million worth of optical memory cards for
the newly enhanced Green Cards, called for deliveries from December 2003 through
May 2004. During first quarter ended June 30, 2004, the Company received
notification from the prime contractor which delayed delivery of products
subject to an existing shipment schedule, and further amendments may be
possible. We have not yet received a follow-on order for Green Cards and do not
expect one until later this year and we do not expect a follow-on order for BCCs
until next year. As a result, we are experiencing a gap in production of several
months, which is significantly affecting our operating results for the first
quarter and first half of fiscal 2005. The delay in the U.S. government's order
is the result of the U.S. government's desire to reduce its inventory levels.
Any future excess inventory held by the U.S. government for example due to
delayed funding or a slower than anticipated program rollout, or any future
changes to the design of the cards may result in future gaps in orders or
production which may negatively impact our operating results.


                                       25
<PAGE>

U.S. government subcontract release orders for DHS Green Cards and DOS Laser
Visa BCCs represented approximately 12% of the Company's revenue during the
first quarter of fiscal 2005; 44% of the Company's revenue for the entire fiscal
2004; 82% of revenues for fiscal year 2003; and 75% of revenues for fiscal 2002
The percentage declined during the first quarter of fiscal 2005 as U.S.
government orders decreased due to the U.S. governments' desire to reduce
inventory levels, while at the same time orders of cards from foreign
governments increased as planned over prior years' levels and the Company
received revenue from its new German operations. The U.S. government's agreement
with our VAR expires on May 25, 2005. There can be no assurance that the U.S.
government will enter into a new contract with our VAR or renew its current
contract to purchase our cards, in which case one of our major sources of
revenues would be eliminated.

There is no assurance of continuing read/write drive orders from the U.S.
government. The fiscal 2004 order of 1,000 drive units for use by the U.S.
government with our Biometric Verification System application software may not
result in similar orders in the future. The system performance, including
biometric verification speed, accuracy, and card reading performance may not
meet government objectives for further system expansion. There is no assurance
that the government will have budgeted sufficient funds to expand the system to
its full potential or that the Company will be successful in winning any new
U.S. government procurements for similar systems or application software.

        SINCE THE SALES CYCLE FOR OUR PRODUCTS IS TYPICALLY LONG AND
UNPREDICTABLE, WE HAVE DIFFICULTY PREDICTING FUTURE REVENUE GROWTH. Initial
product sales to VARs for their use or use by their ultimate customers are
generally in small quantities, for evaluation purposes and trial programs.
Obtaining substantial, follow-on orders from these customers usually involves a
lengthy sales cycle, requiring marketing and technical time and expense with no
guarantee that substantial orders will result. This long sales cycle results in
uncertainties in predicting operating results, particularly on a quarterly
basis. In addition, since our major marketing programs involve the U.S.
government and various foreign governments and quasi-governmental organizations,
additional uncertainties and extended sales cycles can result. Factors which
increase the length of the sales cycle include government regulations, bidding
procedures, budget cycles, and other government procurement procedures, as well
as changes in governmental policy-making.

        THE TIMING OF OUR U.S. GOVERNMENT REVENUES IS NOT UNDER OUR CONTROL AND
CANNOT BE PREDICTED BECAUSE WE DO NOT RECOGNIZE REVENUE UNTIL CARDS ARE SHIPPED
OUT OF A VAULT OR WE RECEIVE A FIXED SHIPMENT SCHEDULE FROM THE GOVERNMENT. We
recognize revenue from product sales when the following criteria are met: (a)
persuasive evidence of an arrangement exists; (b) delivery has occurred; (c) the
fee is fixed or determinable; and (d) collectibility is reasonably assured.

        Our U.S. government subcontract requires delivery of cards to a secure
vault built on our premises. Deliveries are made into the vault on a fixed
schedule specified by the government or one of its specified agents. When the
cards are delivered to the vault, all title and risks of ownership are
transferred to the government. At the time of delivery, the prime contractor is
invoiced, with payment due within thirty days. The contract does not provide for
any return provisions other than for warranty. We recognize revenue when the
cards are delivered into the vault because we have fulfilled our contractual
obligations and the earnings process is complete. However, if we do not receive
such a shipment schedule, revenue is not recognized until the cards are shipped
from the vault. In addition, revenue recognition for future deliveries into the
vault would be affected if the U.S. government cancels the shipment schedule. As
a result, our revenues may fluctuate from period to period if we do not continue
to obtain shipment schedules under this subcontract or if the shipment schedules
are cancelled. We would no longer recognize revenue when cards are delivered to
the vault, but instead such revenue recognition would be delayed until the cards
are shipped from the vault to the U.S. government.

        WE COULD EXPERIENCE EQUIPMENT, RAW MATERIAL, QUALITY CONTROL, OR OTHER
PRODUCTION PROBLEMS UNDER VERY HIGH-VOLUME PRODUCTION. There can be no assurance
that we will be able to meet our projected card manufacturing capacity if and
when customer orders reach higher levels. We have made and intend to continue to
make significant capital expenditures to expand our card manufacturing capacity.
However, since customer demand is difficult to predict, we may be unable to ramp
up our production quickly enough to timely fill new customer orders. This could
cause us to lose new business and possibly existing business. In addition, if we
overestimate customer demand, we could incur significant costs from creating
excess capacity. We


                                       26
<PAGE>

may experience manufacturing complications associated with increasing our
manufacturing capacity of cards and drives, including the adequate production
capacity for sheet-lamination process cards to meet order requirements and
delivery schedules. We may also experience difficulties implementing new
manufacturing processes or outsourcing some of our manufacturing. The addition
of fixed overhead costs results in lower profit margins unless compensated for
by increased product sales. When purchasing raw materials for our anticipated
optical card demand, we take into consideration the order-to-delivery lead times
of vendors and the economic purchase order quantity for such raw materials. If
we over-estimate customer demand, excess raw material inventory can result.

        IF WE ARE UNABLE TO BUY RAW MATERIALS IN SUFFICIENT QUANTITIES AND ON A
TIMELY BASIS, WE WILL NOT BE ABLE TO DELIVER PRODUCTS TO CUSTOMERS ON TIME. AS A
RESULT, WE COULD LOSE CUSTOMERS, AND REVENUES COULD DECLINE. We depend on sole
source and limited source suppliers for optical card raw materials. Such
materials include plastic films used in optical memory card production, which
are available from one supplier in the U.S. and from multiple foreign suppliers.
Processing chemicals, inks, and bonding adhesives are obtained from various U.S.
and foreign suppliers. Certain photographic films are commercially available
solely from Eastman Kodak Company, of the United States. No assurance can be
given that Kodak will continue to supply such photographic films on a
satisfactory basis and in sufficient quantities. If Kodak were to discontinue
manufacturing the film from which the Drexon optical stripe is made, we would
endeavor to establish an alternate supplier for such film, although the purchase
price could increase and reliability and quality could decrease from a new
supplier. Considering that the U.S. government is a major end-user of our
optical memory cards, we anticipate that an alternate supplier of these films
could be established and qualified; however, no assurance can be given that
there will be adequate demand to attract a second source. In addition, an
alternate supplier could encounter technical issues in producing the film as
there may be know-how and manufacturing expertise which Kodak has developed over
the years which an alternate supplier may have difficulty to replicate. We have
pre-purchased a long-term supply of the film used to produce mastering loops for
prerecording cards. With regard to the film from which the Drexon optical stripe
is made, we currently have an order which Kodak has accepted with deliveries
scheduled through December, 2004. If Kodak announced that it was no longer going
to sell film, we would request that Kodak provide us with a last-buy opportunity
which we would plan to take maximum advantage of, although no assurance can be
given that Kodak would provide us with such an opportunity. We have film on hand
plus on order that we believe would provide us with an adequate supply to meet
anticipated demand until we could locate and begin volume purchases from a
second source.

        AN INTERRUPTION IN THE SUPPLY OF READ/WRITE DRIVE PARTS OR DIFFICULTIES
ENCOUNTERED IN READ/WRITE DRIVE ASSEMBLY COULD CAUSE A DELAY IN DELIVERIES OF
DRIVES AND OPTICAL MEMORY CARDS AND A POSSIBLE LOSS OF SALES, WHICH WOULD
ADVERSELY AFFECT OUR OPERATING RESULTS. Several major components of our
read/write drives are designed specifically for our read/write drive. For
example, the optical recording head for the current drive is a part obtained
from one supplier; and at current production volumes, it is not economical to
have more than one supplier for this custom component. The ability to produce
read/write drives in high-volume production, if required, will be dependent upon
maintaining or developing sources of supply of components that meet our
requirements for high volume, quality, and cost. In addition, we could encounter
quality control or other production problems at high-volume production of
read/write drives. We are also investing in research and engineering in an
effort to develop new drive products.

        IF WE ARE UNABLE TO DEVELOP UPGRADED READ/WRITE DRIVES THAT COST LESS TO
MANUFACTURE AND ALSO A READ-ONLY DRIVE, WE COULD LOSE POTENTIAL NEW BUSINESS.
Prior to fiscal 2002, we had been selling read/write drives for less than three
thousand dollars per unit in quantities of six or more, and these units
generally include our interface software/device drivers. In fiscal 2002, we
reduced the selling price by 20% for these read/write drives for typical
purchase quantities in an effort to develop a broader market and customer base
for LaserCard optical memory cards. Since fiscal 2002, there has not been a
further reduced selling price for these read/write drives. However, in fiscal
2004, we introduced a new drive with a 25% reduction in price for typical
quantities as compared with the previous model. We believe the price of our
drives is competitive in applications requiring a large number of cards per each
drive, because the relatively low cost for our cards offsets the high cost per
drive when compared with our major competition, IC card systems. In addition, we
have undertaken a product development program for a hand-held read-only drive,
which we believe would increase our prospects for winning future business.
However, there can be no assurance that our development program will be
successful, that


                                       27
<PAGE>

production of any new design will occur in the near term, or that significantly
lower manufacturing costs or increased sales will result.

        IF WE ARE UNABLE TO ADAPT TO TECHNOLOGICAL CHANGES IN THE DATA CARD
INDUSTRY AND IN THE INFORMATION TECHNOLOGY INDUSTRY GENERALLY, WE MAY NOT BE
ABLE TO EFFECTIVELY COMPETE FOR FUTURE BUSINESS. The information technology
industry is characterized by rapidly changing technology and continuing product
evolution. The future success and growth of our business will require the
ability to maintain and enhance the technological capabilities of the LaserCard
product line. There can be no assurance that the Company's products currently
sold or under development will remain competitive or provide sustained revenue
growth.

        IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY
BE ABLE TO USE OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR COMPETITIVE POSITION,
REDUCE REVENUES, OR INCREASE COSTS. We use a combination of patent, trademark,
and trade secret laws, confidentiality procedures, and licensing arrangements to
establish and protect our proprietary rights. Our existing and future patents
may not be sufficiently broad to protect our proprietary technologies. Despite
our efforts to protect proprietary rights, we cannot be certain that the steps
we have taken will prevent the misappropriation or unauthorized use of our
technologies, particularly in foreign countries where the laws may not protect
proprietary rights as fully as U.S. law. Any patents we may obtain may not be
adequate to protect our proprietary rights. Our competitors may independently
develop similar technology, duplicate our products, or design around any of our
issued patents or other intellectual property rights. Litigation may be
necessary to enforce our intellectual property rights or to determine the
validity or scope of the proprietary rights of others. This litigation could
result in substantial costs and diversion of resources and may not ultimately be
successful. We cannot predict whether the expiration or invalidation of our
patents would result in the introduction of competitive products that would
affect our future revenues adversely. However, since our technology is now in
the commercial stage, our know-how and experience in volume card production,
system development and software capabilities, brand-name recognition within our
card markets, and dominant-supplier status for optical memory cards are of far
greater importance than our patents. At this time, we believe that our existing
patent portfolio is helpful but is no longer essential for maintaining the
LaserCard's market position.

        THE MARKETS FOR OUR PRODUCTS ARE COMPETITIVE, AND IF WE ARE UNABLE TO
COMPETE SUCCESSFULLY, REVENUES COULD DECLINE OR FAIL TO GROW. Our optical memory
cards may compete with optical memory cards that can be manufactured and sold by
three of our licensees (although none is currently doing so) and with other
types of portable data storage cards and technologies used for the storage and
transfer of digital information. These may include integrated circuit/chip
cards; 2-dimensional bar code cards and symbology cards; magnetic-stripe cards;
thick, rigid CD-read only cards or recordable cards; PC cards; radio frequency,
or RF, chip cards; and small, digital devices such as data-storage keys, tokens,
finger rings, and small cards and tags. The financial and marketing resources of
some of the competing companies are greater than our resources. Competitive
product factors include system/card portability, interoperability,
price-performance ratio of cards and associated equipment, durability,
environmental tolerance, and card security. Although we believe our cards offer
key technological and security advantages for certain applications, the current
price of optical card read/write drives is a competitive disadvantage in some of
our targeted markets. However, we believe the price of our drives is competitive
in applications requiring a large number of cards per each drive, because the
relatively low cost for our cards offsets the high cost per drive when compared
with our major competition, IC card systems. In countries where the
telecommunications infrastructure is extensive and low cost, centralized
databases and wide-area networks may limit the penetration of optical memory
cards. These trends toward Internet, intranet, and remote wireless networks will
in some cases preclude potential applications for our cards.

        THE PRICE OF OUR COMMON STOCK IS SUBJECT TO SIGNIFICANT VOLATILITY. The
price of our common stock is subject to significant volatility, which may be due
to fluctuations in revenues, earnings, liquidity, press coverage, financial
market interest, low trading volume, and stock market conditions, as well as
changes in technology and customer demand and preferences. As a result, our
stock price might be low at the time a stockholder wants to sell the stock.
Also, since we have a relatively low number of shares outstanding, approximately
11 million shares, there will be more volatility in our stock if one or two
major holders, for example, large institutional holders, attempt to sell a large
number of shares in the open market. There also is a large short position in our
stock, which can create volatility when borrowed shares are sold short and later
if shares are purchased to cover the short position.


                                       28
<PAGE>

Furthermore, our trading volume is often small, meaning that a few trades may
have disproportionate influence on our stock price. In addition, someone seeking
to liquidate a sizeable position in our stock may have difficulty doing so
except over an extended period or privately at a discount. Thus, if one or more
of the selling stockholders were to sell or attempt to sell a large number of
its shares within a short period of time, such sale or attempt could cause our
stock price to decline. There can be no guarantee that the selling stockholders
will be able to sell the shares that they acquired at a price per share equal to
the price they paid for the stock.

        WE ARE SUBJECT TO RISKS ASSOCIATED WITH CHANGES IN FOREIGN CURRENCY
EXCHANGE RATES. Most of the manufacturing process of the LaserCard products that
we sell in Italy takes place in Europe. The prices charged to us by the European
manufacturer for products are denominated in euros, the currency used in much of
Europe. However, when we sell our finished products to the Italian government,
the prices that we charge are denominated in United States dollars. Also, as of
June 30, 2004, the Company had debt relating to the acquisition of Challenge
Card Design Plastikkarten GmbH and cards & more GmbH, of Germany, in the amount
of 1.8 million euros. Accordingly, we are subject to exposure if the exchange
rate for euros increases in relation to the United States dollar. As of June 30,
2004, we had not entered into a forward exchange contract to hedge against or
potentially minimize the foreign currency exchange risk.

        WE HAVE RECENTLY ACQUIRED TWO CARD COMPANIES LOCATED IN GERMANY AND MAY
ENCOUNTER DIFFICULTIES IN INTEGRATING THEM INTO OUR BUSINESS. We may encounter
unforeseen difficulties in managing Challenge Card Design GmbH and cards & more
GmbH, in which case we may not obtain some of the hoped-for benefits of these
acquisitions, such as expanded manufacturing capacity and establishment of a
significant European presence. Integration of these acquired companies may
result in problems related to integration of technology, management, personnel,
or products. If we fail to successfully integrate these acquisitions or if they
fail to perform as we anticipated, our operations and business could be harmed.
Likewise, if the due diligence and audit of these operations performed by third
parties on our behalf was inadequate or flawed, we could later discover
unforeseen financial or business liabilities. Additionally, in the future we may
evaluate other acquisition opportunities that could provide additional product
or services offerings or technologies. Any recent or future acquisition could
result in difficulties assimilating acquired operations and products, diversion
of capital and management's attention away from other business issues and
opportunities and may result in an expense if goodwill is impaired or other
intangible assets acquired are subsequently determined to be impaired.

        WE ARE CONTINUING TO IMPLEMENT DISCLOSURE CONTROLS AND PROCEDURES AND TO
EXTEND OUR INTERNAL CONTROL OVER FINANCIAL REPORTING TO OUR NEWLY ACQUIRED
GERMAN OPERATIONS. IN ADDITION, WE ARE BEGINNING TO PREPARE FOR OUR ASSESSMENT
OF OUR INTERNAL CONTROL OVER FINANCIAL REPORTING AS OF MARCH 31, 2005, AND THAT
OF OUR INDEPENDENT AUDITORS, BOTH OF WHICH WILL BE CONTAINED IN OUR FISCAL 2005
REPORT ON FORM 10-K. THESE ASSESSMENTS MAY INDICATE SIGNIFICANT DEFICIENCIES OR
A MATERIAL WEAKNESS IN SUCH INTERNAL CONTROL. SIGNIFICANT DEFICIENCIES OR
MATERIAL WEAKNESSES, IF ANY, IDENTIFIED THROUGH THIS PROCESS WOULD NEED TO BE
CORRECTED BY MANAGEMENT AND WOULD IMPACT THE AUDIT REPORT OF OUR INDEPENDENT
AUDITORS. We are continuing to implement disclosure controls and procedures and
to extend our internal control over financial reporting to our newly acquired
German operations. These two private German companies previously had accounted
only to their six shareholders who were also Managing Directors and to German
tax authorities. Other than in connection with their acquisition by the Company,
these companies had not previously prepared financial statements in accordance
with accounting principles generally accepted in the United States of America.
As a result, we have added an experienced Controller, and are continuing the
process of implementing disclosure controls and internal control procedures. The
disclosure controls and internal control procedures used in our German
operations are tailored to their business circumstances and we anticipate that
it will take several months until they are strengthened and made more robust in
order to be comparable to those used in our U.S. operations. At the same time,
we are beginning to prepare for our and our auditor's assessment of our internal
controls over financial reporting. This continued implementation in Germany, any
changes required in the U.S., and the overall assessment is a costly and complex
task requiring large amounts of internal personnel resources as well as
consultants, significant management time and attention, and material amounts of
training. Ultimately, we or our outside independent auditors may assess our
internal control over financial reporting as having significant deficiencies,
especially relative to our German operations, which could lead to a
determination that our internal control over financial reporting has a material
weakness. Any such significant deficiency or material weakness, if any, would
need


                                       29
<PAGE>

to be corrected by management and would impact the audit report of our
independent auditors.

        WE RECENTLY SOLD A SECOND-SOURCE CARD MANUFACTURING LICENSE TO GLOBAL
INVESTMENTS GROUP (GLOBAL), UNDER WHICH WE WILL PROVIDE CERTAIN FACTORY SET-UP
AND TRAINING SERVICES. IF WE ARE NOT SUCCESSFUL OR IF GLOBAL IS UNABLE TO
FINANCE THIS OPERATION, THE SECOND-SOURCE SUPPLY OF OPTICAL CARDS WILL NOT
MATERIALIZE. IF WE AND GLOBAL ARE SUCCESSFUL, THE SECOND-SOURCE WILL COMPETE
WITH US FOR BUSINESS. If Global is not successful, but current and potential
customers require a second source of optical memory cards ( which is a common
business practice) they could decide to use alternate technology cards, such as
chip cards, that have multiple-source suppliers. We are planning to sell to
Global approximately $12 million worth of the required manufacturing equipment
and installation support for its to-be-built new card manufacturing facility in
Slovenia, to provide a targeted initial manufacturing capacity of 10 million
optical cards annually. If successful, this will supply a second source for
optical memory cards. We will also be assigning personnel to be on site during
the license term to assist with quality, security, and operational procedures,
with a mutual goal that the facility and the cards made in Slovenia conform to
our standards. If cards are not produced in conformance with our quality
standards, the reputation and marketability of optical memory card technology
could be damaged. If the factory does not become operational and produce quality
cards in high volume, or if Global Investments Group is unable to raise
sufficient capital to build, equip and operate this facility, we would not
obtain the hoped-for benefits--including ongoing royalties, sales of raw
materials to Global, expansion of the European market, and a bona fide second
source for optical memory cards. On the other hand, if and when the factory is
successfully manufacturing the cards in high volume, it will compete against us
for business in certain territories, which could reduce our potential card
revenues if the market does not expand.

        WE MAY NOT BE ABLE TO ATTRACT, RETAIN OR INTEGRATE KEY PERSONNEL, WHICH
MAY PREVENT US FROM SUCCEEDING. We may not be able to retain our key personnel
or attract other qualified personnel in the future. Our success will depend upon
the continued service of key management personnel. The loss of services of any
of the key members of our management team, including either of our co-chief
executive officers, the managing directors of our German operations, or our vice
president of finance and treasurer, or our failure to attract and retain other
key personnel could disrupt operations and have a negative effect on employee
productivity and morale, thus decreasing production and harming our financial
results. In addition, the competition to attract, retain and motivate qualified
personnel is intense.

        OUR CALIFORNIA FACILITIES ARE LOCATED IN AN EARTHQUAKE ZONE AND THESE
OPERATIONS COULD BE INTERRUPTED IN THE EVENT OF AN EARTHQUAKE, FIRE, OR OTHER
DISASTER. Our card manufacturing, corporate headquarters, and drive assembly
operations, administrative, and product development activities are located near
major earthquake fault lines. In the event of a major earthquake, we could
experience business interruptions, destruction of facilities and/or loss of
life, all of which could materially adversely affect us. Likewise, fires,
floods, or other events could similarly disrupt our operations and interrupt our
business.

        ACTS OF TERRORISM OR WAR MAY ADVERSELY AFFECT OUR BUSINESS. Acts of
terrorism, acts of war, and other events may cause damage or disruption to our
properties, business, employees, suppliers, distributors, resellers, and
customers, which could have an adverse effect on our business, financial
condition, and operating results. Such events may also result in an economic
slowdown in the United States or elsewhere, which could adversely affect our
business, financial condition, and operating results.


                                       30
<PAGE>

ITEM 3.         QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RATE
                RISKS

        INTEREST RATE RISK. The Company invests its cash, beyond that needed for
daily operations, in high quality debt securities. In doing so, the Company
seeks primarily to preserve the value and liquidity of its capital and,
secondarily, to safely earn income from these investments. To accomplish these
goals, the Company invests only in debt securities issued by (a) the U.S.
Treasury and U.S. government agencies and corporations and (b) debt instruments
that meet the following criteria:

        --      Commercial paper rated A1/P1 or debt instruments rated AAA, as
                rated by the major rating services
        --      Can readily be sold for cash

        There were no material changes during the first quarter of fiscal 2005
to the Company's exposure to market risk for changes in interest rates.

        FOREIGN CURRENCY EXCHANGE RATE RISK. The Company sells products in
various international markets. All of these sales are denominated in U.S.
dollars. However, some raw material and purchased services are denominated in
euros. Also, as of June 30, 2004, the Company had debt relating to the
acquisition of Challenge Card Design Plastikkarten GmbH and cards & more GmbH,
of Germany, in the amount of approximately 1.8 million euros. Accordingly, the
Company is subject to exposure if the exchange rate for euros increases in
relation to U.S. dollars. As of June 30, 2004, the Company had not entered into
a forward exchange contract to hedge against or potentially minimize the foreign
currency exchange risk. We will continue to evaluate our exposure to foreign
currency exchange rate risk on a regular basis.

ITEM 4.         CONTROLS AND PROCEDURES

        EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. We are continuing to
implement disclosure controls and procedures and to extend our internal control
over financial reporting to our newly acquired German operations. These two
private German companies previously had accounted only to their six shareholders
who were also Managing Directors and to German tax authorities. Other than in
connection with their acquisition by the Company, these companies had not
previously prepared financial statements in accordance with accounting
principles generally accepted in the United States of America. As a result, we
have added an experienced Controller and we have instituted disclosure controls
and internal control procedures in an environment where few existed previously
and in which the existing personnel have no experience in operating a business
using the newly instituted controls and procedures. Therefore, the disclosure
controls and procedures used in our German operations are tailored to their
business circumstances and we anticipate that it will take several months until
they are strengthened and made more robust in order to be comparable to those
used in our U. S. operations. The Company's principal executive officers and
principal financial officer have evaluated the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) as of the
end of the period covered by this Form 10-Q and have determined that they are
reasonable taking into account the totality of the circumstances, including
those described as to our German operations.

        CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. As described
above, the Company is in the process of extending its internal controls from the
U.S. to its newly acquired German operations. Otherwise, there were no
significant changes in the Company's internal control over financial reporting
that occurred during the period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, such control.

PART II.  OTHER INFORMATION

Item 1. - Legal Proceedings

None

Item 2. - Changes in Securities and Use of Proceeds

        None


                                       31
<PAGE>

Item 3. - Defaults Upon Senior Securities

        None

Item 4. - Submission of Matters to a Vote of Security Holders

        None

Item 5. - Other Information

        None

Item 6. - Exhibits and Reports on Form 8-K

        (a)    Exhibit No.     Exhibit Description
               -----------     -------------------

               3.1             Amended and Restated By-Laws

               31.1            Rule 13a-14(a) Certification of Christopher J.
                               Dyball, co-principal executive officer

               31.2            Rule 13a-14(a) Certification of Richard M.
                               Haddock, co-principal executive officer

               31.3            Rule 13a-14(a) Certification of Steven G. Larson,
                               principal financial officer

               32.1            Section 1350 Certification of Christopher J.
                               Dyball and Richard M. Haddock, co-chief executive
                               officers

               32.2            Section 1350 Certification of Steven G. Larson,
                               chief financial officer

        The above-listed exhibits are filed herewith. No other exhibits are
included in this report as the contents of the required exhibits are either not
applicable to Registrant, to be provided only if Registrant desires, or
contained elsewhere in this report.

        (b)    Reports on Form 8-K

        On April 15, 2004, the Company filed a Report on Form 8-K dated March
31, 2004, which reported under Item 2 completion of the acquisition of two
related German card companies, Challenge Card Design Plastikkarten GmbH of
Rastede, Germany, and cards & more GmbH of Ratingen, Germany.

        On June 18, 2004, the Company filed a Report on Form 8-K dated June 14,
2004, which reported under Item 12 the issuance of a press release containing
financial results for the fiscal year ended March 31, 2004.


                                       32
<PAGE>

SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized:

DREXLER TECHNOLOGY CORPORATION
(Registrant)

<TABLE>
<CAPTION>

        Signature                                Title                               Date
        ---------                                -----                               ----
<S>                                                                             <C>
/s/ Christopher J. Dyball           Co-Chief Executive Officer                  August 11, 2004
-----------------------------       (Co-Principal Executive Officer)
Christopher J. Dyball

/s/ Richard M. Haddock              Co-Chief Executive Officer                  August 11, 2004
-----------------------------       (Co-Principal Executive Officer)
Richard M. Haddock

/s/ Steven G. Larson                Vice President of Finance and Treasurer     August 11, 2004
-----------------------------       (Principal Financial Officer and
Steven G. Larson                    Principal Accounting Officer)
</TABLE>


                                       33
<PAGE>

                                INDEX TO EXHIBITS

                                  [ITEM 14(c)]
Exhibit
Number      Description
------      -----------

  3.2       Amended and Restated By-Laws

 31.1       Rule 13a-14(a) Certification of Christopher J. Dyball, co-principal
            executive officer

 31.2       Rule 13a-14(a) Certification of Richard M. Haddock, co-principal
            executive officer

 31.3       Rule 13a-14(a) Certification of Steven G. Larson, principal
            financial officer

 32.1       Section 1350 Certification of Christopher J. Dyball and Richard M.
            Haddock, co-chief executive officers

 32.2       Section 1350 Certification of Steven G. Larson, chief financial
            officer


                                       34