Digimarc Corp (DMRC) 2002 Q4 法說會逐字稿

Good afternoon. My name is Stephanie and I will be your conference facilitator. At this time I would like to welcome everyone to the Digimarc quarter 4 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star then the number 1 on your telephone key pad. If you would like to withdraw your question, press star then the number 2 on your telephone key pad. Thank you Mr. Davis. You may now begin your conference.

I would like to welcome everyone to the conference call today. With me is E. K. Ranjit our C.F.O. and Paul Gifford, our President and Chief Operating Officer. We released fourth quarter and year-end financial results today. The purpose of this call is to provide you with a summary of our results and update on significant business developments during the quarter and financial guidance for Q1 03 in the full year 2003. We'll respond to your questions at the end of the call. E.K. will begin by reviewing and commenting on the financial information contained in our press release. E.K.?

Thank you, Bruce. Before we start our discussion on the financial results I'd like to go over a couple of items. First I would like to point out that during the course of this conference call we'll be making forward-looking statements which are subject to risks and uncertainties. These forward-looking statements, including our comments about our expectations for future results, growth areas, revenues and earnings per share, are based on information currently available to us. They are subject to change and actual results may differ materially from our expectations. For further information about these risks and uncertainties, I would like to refer you to the risk factors contained in our S.E.C. files including our form 10K filed on April 1, 2002 and our form 10Q for the third quarter filed November 14, 2002. Secondly, a replay of this conference call will be available for one week through webcast located on our investor relations web site at www.Digimarc.com, or www.streetevents.com. Now turning our discussion to the fourth quarter and full year 2002 financial results, first for a review of the income statement, revenues for the fourth quarter of 2002 were $20.8 million, up $16.9 million or 438%. Compared with the fourth quarter of 2001. And down $5.7 million or 22% from the previous quarter. The increase in revenues from last year is due to the acquisition of the I.D. Systems business. As noted in our last conference call third quarter revenues included certain one-time event driven international revenues of $5.1 million. The break from sequential revenue growth primarily resulted from this revenue not being repeated in this quarter. Combined with the lower-than-anticipated issuance volumes and add-on revenues in the domestic I.D. Systems business. Domestic programs accounted for $14.1 million of the $17.9 million in I.D. Systems revenues generated during this quarter. The lower-than-expected revenue from U.S. driver's license systems was due primarily to an earlier-than-anticipated defect of a change in volumes caused by lengthening of the terms of licenses issued by certain customers. Add-on revenues were limited by tight state budgets and deferral of recognition of certain add-on revenues under the current accounting rules. In other areas of our business, license revenues were strong and our federal government and banking activities performed as expected. Commercial solutions revenues continue to lag. In aggregate, fourth quarter total revenues of $20.8 million were below the range of guidance provided at our last earnings release call of $22 million to $22.5 million by $1.2 million or 6% of the low-end of our guidance. For the full year 2002, revenues were a record $86.6 million. Almost five times the $14.9 million reported in 2001. The dramatic year-over-year improvement in revenues is attributable to the acquisition of I.D. Systems in December of 2001. Gross margin for the quarter improved to 43%, consistent with our normal run rates, and up from the 35% reported in the third quarter. The unusually low margin in the third quarter was due to the even-driven revenues that I have referred to a moment ago. Fourth quarter gross margins reflect approximately $280,000 of additional inventory reserves taken in the quarter relating to field inventories. Gross margin for the full year 2002 was 40%. Down 12% from 52% reported in 2001. The reduction in gross margin was due to the change in revenue mix that resulted from the acquisition of I.D. Systems. Almost all I.D. Systems revenues come from long-term state and international government programs which tend to have slightly lower margins than revenues from other areas of our business. Operating expenses for the fourth quarter of 2002 were $9.3 million, down $1.2 million or 11% from the previous quarter. The reduction in operating expenses is as a result of our continuing effort to responsibly manage costs while consolidating and streamlining operations to maximize our efficiencies. For full-year 2002, operating expenses increased from $32.4 million in 2001 to $44.4 million due to the acquisition of I.D. Systems. Operating expenses as a percentage of revenues, however, dropped from 218% to 51% as a result of growth in revenues, and various cost management measures, and more efficient processes implemented throughout this year. During the quarter, we recorded noncash expenses of approximately $450,000 related to deferred employee stock option compensation charges, which is in line with the charges taken in previous quarters. For the full year 2002, deferred compensation charges accounted for $1.8 million consistent with prior years' charges. Other income net of approximately $183,000 was in line with our expectations, but substantially down from the prior year due to lower interest rates on lower cash balances. For the full year 2002, other income dropped from $5.6 million in 2001 to just over a million as a result of the continued drop in interest rates throughout 2002, combined with lower cash balances due to cash used for acquisition of I.D. Systems and working capital provided for the first six months of 2002. The activities discussed about resulted in a net loss of $225,000 in the fourth quarter, which is $703,000 or 76% better than the $928,000 loss reported last quarter. Net loss per share for the quarter was at 1 cent based on $17.57 million weighted average shares, a substantial improvement from a loss of 5 cents reported in the previous quarter, and 2 cents below the low end of our street guidance of a profit of 1-3 cents. For the full year 2002, net loss was $8.7 million, an improvement of $10.5 million or 55% from the $19.2 million loss reported in 2001. We narrowed the net loss sequentially every quarter during this year from $4.2 million in the first quarter to just $225,000 in the fourth quarter of 2002. We have a cash flow positive in the third and fourth quarters. Net loss per share for the year was 50 cents compared to a loss of 1.15 per share in 2001. With regard to the balance sheet, our cash, cash equivalent and short-term investment balances were $53.2 million, up approximately $200,000 from last quarter. Accounts receivable decreased to $15.1 million from $16.1 million in the last quarter. Fourth quarter day sales outstanding, D.S.O., was approximately 68 days. Inventory net of results was $5.1 million, up $146,000 from the $4.9 million reported last quarter. During the quarter, we increased inventory results by $280,000 to a total of $330,000. Inventory includes materials to be used in manufacturing I.D. cards and consumable supplies that we sell to our customers. Long-term assets increased from $51.9 million in the last quarter to $56 million, primarily as a result of program asset additions and infrastructure build-out in I.D. Systems. Net of depreciation of assets already in use. Deferred revenue was $3.7 million. Up $700,000 from the $3 million reported last quarter. The increase came from continuing projects that we performed for our customers and will be recognized for the terms of the underlying contracts. In summary, although results fell a couple of cents short of our goal of achieving profitability in the fourth quarter, we continued to narrow the loss from operations, generated positive cash flow for the second consecutive quarter, improved efficiencies through the streamlining and consolidation of operations, and maintained timely receivables collections. All things considered, 2002 was a very positive year for Digimarc as we finished the year with record revenues, a strong balance sheet with $53 million in cash, and steady sequential improvement on the bottom line. Now I will turn the discussion back over to Bruce.

Thanks, E.K. I'll briefly review Q4 operations and provide an overview of plans and expectations for 2003. E.K. will then provide detailed financial guidance for full year 2003. First regarding Q4, we were disappointed to come in short of the goal we had established at the end 2001 to become profitable by Q4 of 2002. We ended up a penny short of break even on $20.8 million dollars of revenues. Despite not achieving this goal, we made a lot of financial progress during 2002. The 1 cent loss if Q4 marked the fourth consecutive improvement in earnings per share. Notably Q4 was also the second consecutive quarter of positive cash flow. Q4 performance at I.D. Systems was mixed. Although we missed our revenue and profit targets, on the positive side, we implemented one of many facial recognition systems in Colorado with impressive results and began demonstrating visual watermark security enhancements to prospective customers. The facial recognition system which searches 10 million faces in 16 seconds has been successful in identifying fraudulent applicants and finding administrative errors. During the quarter we continued to streamline the organization toward optimum cost effectiveness to increase competitiveness in these challenging economic times. Financial performance in other areas of our business including financial systems, defense and intelligence, commercial solutions and licensing was generally consistent with our guidance. There were some notable events in licensing. For instance, [INAUDIBLE] Technologies who have been enjoined from marketing certain solutions in the US in a patent enfringement suit we filed, negotiated a license for us with some of the products and services. Continuing our policy of enforcing patents were necessary, we filed a lawsuite against SpectraSystems Corp. during the quarter. Alleging certain uses of digitalwater marking for document security infringe our patents. We have begun negotiations with the defendant company. The use of digital watermarking for broadcast monitoring got a boost in the quarter when, Teletrax using the Phillips Water Cast Watermarking System license under our patents on an NBC news channel was the first U.S. customer. NBC News Channel is the source for syndicated news content from NBC news. We also continue to see good progress by licenses in gaining adoption of forensic tracking water marking solutions by major record labels. The number of labels are actively using water marking to determine the source of leaks of previously released music, providing the music critics of radio stations onto peer to peer file sharing networks. The DVDCCA process for selecting a consensus watermark solution for D.V.D.copy prevention and play controls is continuing. The DVDCCA requested and we consented to an extension of the V.W.M. bid until May 1st. We are supporting the process as well as working on alternative paths to adoption including private company negotiations and privacy initiatives. Our initial property assets continue to increase. We now have 83 issued patents containing 1800 claims with more than 350 applications pending. As we enter 2003 we anticipate a profitable year on significantly higher revenues. And good growth prospects in all areas of our business. Our plan targets growth with improving bottom line results in what we anticipate will be another year of general economic malaise, war in Iraq and uncertainty over timing of economic recovery. Our plan is conservative. We intend to capitalize on past investments and secure personal identification, essential bank relationships, seed investments in developing the market for defense intelligence solutions, product development of investments in excalibur security class watermarking for authentication and tracking and global leadership in watermarking technology. The adoption of digital watermarking across a range of applications has shown acceleration in recent months supporting continuing investments in promising areas. We are not making any major shifts in overall strategy. The success of the plan for 2003 does not depend on any breakthroughs on industry-wide adoption of watermarking for copyright protection or federal mandates for protection of entertainment content copyrights. We expect the growth in I.D. Systems revenues will be driven by increased issuance volumes and continuing demand for improvements to security interoperability for driver's licenses. The ability to fund such improvements may be somewhat limited by budgetary concerns with many states. We intend to compete effectively and gain shares through quality of service, innovation and improving cost effectiveness. Our digital watermarking and biometric offerings will enhance competitive differentiation and provide important new security benefits to our customers. Digital watermarking provides a secure, covert, machine readable means to deter counterfeiting and forgery compatible with existing card designs. It enables cross jurisdictional objective authentication without changing the existing card designs, giving issuing authorities control of access to data and means for authentication for forensic analysis. Our one to many facial biometric system introduced in Colorado in Q4 will be marketed to other states to reduce fraud in the application process and provide new tools to law enforcement. Our long-term relationship with leading central banks that began more than five years ago is bearing fruit. Deployment is progressing well and the strategic benefits we foresaw in entering into the relationship are beginning to be realized. In anticipation of possible expansion of our work with essential banks to include new, related applications and new customers for related applications, we are increasing our attention on this area. We have formed a financial systems business unit to ensure that we give these opportunities proper focus. In defense and intelligence we continue to believe that our digital watermarking and secure personal identification technologies have broad relevance. We began generating revenues from defense and intelligence in 2002. Going forward we are working on increasing the size and duration of contracts, building relationships with established suppliers, and otherwise laying the foundation for multi-year licensing and services agreements, akin to our successful long-term relationship with central banks. As evidence of our commitment to this market, and to assist us in maximizing the opportunities there, I am pleased to announce the election of Jim Rob to the Digimarc Board of Directors. Jim is a retired corporate executive with over 40 years' experience in aerospace defense and related high-technology sectors. He remains very engaged in the industry, serving as a director on several defense and intelligence supplier boards and providing consulting services to a number of companies and government agencies. Jim retired in 1998 as President and C.E.O. of G.R.C. International, a New York Stock Exchange traded professional services company since acquired by AT&T which serves an array of government and private sector clients. The majority of revenues were from Department of Defense, military, space, and classified customers. Jim is a seasoned and successful executive. While he was President and C.E.O., G.R.C. increased client base and revenues and expanded the company's business into other sectors during an era of declining defense budgets resulting in a compound annual growth rate for the company's share price over his tenure at 60% per year. Jim's current consulting clients include Boeing where he participates on a senior review panel, G.R.C., S.R.C., and the federal government in classified areas. He holds current top secret clearances in connection with his consulting work. He's also a director of New York Stock Exchange listed Titan Corporation and E.D.O. Corporation. We are very fortunate to have the benefit of Jim's industry experience and leadership as we continue to develop our defense and intelligence business. In the commercial solutions area, Image is expected to continue to contribute moderate to moderate growth. We will continue market development initiatives for our Excalibur Authentication and Tracking Solutions for use in packaging, travel and securing personal identification documents and other document types. Building on our success in licensing for tracking and monitoring entertainment and news in 2002, we will continue to press the agenda for use of digital watermarking in other audio and video applications including copy prevention, play control. We also expect increased opportunities for licensing in connection with digital and print images and other documents. In summary, we are anticipating significant revenue growth in 2003. Fueled by continuing demand for secure personal identification document systems and solutions for enhanced protection of copyrights. And by expansion of our services to the U.S. and other national government customers. Our strategic blend of products, services and licensings to government and enterprise customers makes this growth possible despite continuing economic doledrums. Along with this growth we expect improvement in gross margins by continuing improvement in earnings per share. We are committing -- committed to delivering continuing growth and improving financial performance through diligent entrepreneurial efforts coupled with financial discipline. E.K. will provide us you with details of Q1 and the full year 2003 information.

For the first quarter 2003 we expect revenues to be in the range of $21.5 million to $22.5 million with earnings per share in the range of a loss of 1 cent to a profit of 1 cent. We expect our first quarter '03 D.S.O. to remain in the range of 60-70 days. For the full year 2003, we anticipate revenues to be in the range of $94 million to $100 million. Using the midpoint guidance that would represent the year-over-year growth of 12%. I.D. Systems revenues are expected to be in the range of $81 million to $85 million which is 9% growth using the midpoint of our guidance. Watermarking revenues are expected to be in the range of $13-15 million, representing year-over-year growth of 32%, using the midpoint of our guidance. Changes in our revenue mix should lead to improved gross margins approaching 45% for the year, representing a year-over-year gain of 5% percentage points. E.P.S. is expected to be in the range of 22 cents to 26 cents. Before we conclude, I would like to give an update on our coming investor relations activities in the first quarter of 2003. On February 20, we will be presenting at the D A Davidson Technology Conference at The Lodges at Deer Valley, Utah. We are meeting with current and prospective investors in San Diego, Las Angeles and San Francisco on February 24 - 26 and in New York City and Boston during March. This concluded our presentation, we now welcome your questoins.

Thank you. At this time I would like to remind everyone if you would like to ask a question, please press star then the number 1 on your telephone key pad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Bill Frerichs of D.A. Davidson and Company.

Good afternoon. I have a few questions. First of all, E.K., could you -- I'll give you all the questions and then you can take them. Would you go remind us what the one-time international business was last quarter that didn't come in this time? Secondly, could you go through the shortfall in I.D. Systems, perhaps more slowly and in laymen's terms? I imagine there's an artifact of contract accounting in there but I wasn't sure I understood it. Those are my initial questions.

Okay. Bill, the first one, the shortfall in revenues, the one-time revenue from last quarter relates to the $5.2 million of revenues we recorded from a one-time sale from Yemen. You'll recall that was a big profit in Q3. That revenue was not expected to repeat in Q4 and it did not. Recording the shortfall in sales, that resulted in about a $300,000 impact to our gross margin line and that was made up of lower-than-anticipated card issuance volumes because in certain states, they change the length of the contract. The license renewal period. That resulted in lower volumes this quarter. And secondly, there was budget constraints in certain states that limited our ability to book add-on revenues. Some of the added revenues that came in that we had to defer under the accounting rules we were not able to take that into this quarter's revenues.

Would you go through that once more slowly, that add-on revenues? What were those supposed to have been?

The add-on revenues, the nature of that depends on a number of different things, okay. If it is, for example, a sale of assets then we get to recognize that revenue up front. If it is a service contract, you recognize the revenues when the service is performed or if it is a continuation of the service obligation, then the revenue may get deferred over the life of the contract term. So you really don't have the ability on which category these will fit in when we do the forecast until you do the contracts.

Okay. I understand that. So you don't have perfect visibility on which bucket they are going to have to fall in.

That's correct. So that's probably what happened this quarter. So the combination of all this resulted in about a $700,000 shortfall in revenues which translated to about a $300,000 impact on the bottom line.

Okay. And one last question: When people extend the length of the contract, is that by negotiation with you or are they exercising some option that exists in the existing contract or what?

No. I think when E.K. was answering your question, he just had a verbal slip on the issue -- issuance volume shortfall, was a result of certain states changing the term of the licenses they issue, not the contract with us. In other words, if -- as Oregon has a five-year term on licenses, they could arbitrarily decide it should be seven years.

Okay.

Or three years.

Okay. So there's nothing in your contract that -- that makes you whole when that happens.

Generally speaking, it's not accommodated in either direction.

All right.

So if they shorten the term then more licenses get issued. If they lengthen the term, less licenses get issued. This is not -- what happened this quarter is not indicative of a trend as far as we can tell. There are conflicting views among the individual states as to whether they should issue licenses more or less frequently and a lot of it relates to budget versus security. More frequent is good for security, less frequent is better for the budget.

Got you. Thanks.

Your next question comes from Jennifer Jordan of Wells Fargo.

Bruce, I want to follow-up a little bit here or pursue a little further on this question that Bill's asking about the trend here. Clearly it is true that states are facing some dramatic budget constraint issues, and I would have thought the driver's license would be something that they would generally leave alone so I'm, a, surprised to see some states, especially in a heightened security period take an action of extending the license period, and also deferring new upgrades. When you are doing your forecast going forward, are you taking into account the idea that additional states could come up against these types of budgetary constraints and make similar decisions?

Yes. We do our best to try to anticipate where the sates will be going in their policies but it's not always possible to forecast perfectly. The other complication with respect to this, Jennifer, is that driver's license issuance is not exactly a cost burden for states because they charge the citizens for the license.

Right. That's why I'm surprised.

Well, but -- and there are a lot of states, and there is no uniform policy with respect to the use of funds from driver's license issuance so in some states, they will take the funds and use them for something other than driver's licenses. In fact, most states they do. And so you would think in hard times that actually might want to issue more driver's licenses.

Right.

But we had a couple of states in the last quarter who shut down some of their offices to try to save some money, and then they reopened them a month or two later after the outrage from their citizens. So there are a lot of of experiments going on in the states right now trying to deal with the difficulties they are having with budgets and some of them impact on our business in somewhat unpredictable ways. But again, it's not a long-term trend. It's more just 2002 as we close the year it was a challenging time for everyone in the U.S. here, and they are trying to sort out strategies for continuing with general downturn in the economy.

When you look at the revenue that comes under that type of fluctuation, do you have a way of looking at it in terms of oh, we think 5% is where there might be fluctuation or...

With well, we -- you know, there isn't any consistent answer with respect to the states. Different states have different views, and many of the views change, as I mentioned a couple things during Q4, where states shut down D.M.V. offices thinking they'd save money then the citizens rebelled and they opened them back up again. Other states actually shortened the term for their licenses, and they said they did it because it would improve security but it may also be a means of generating additional revenue.

Right. Okay. Then to just ask another question unrelated to that topic, to look for a minute at the digital watermarking business, I would have expected with the -- assumably some additional revenue starting to come through from your Phillips license and some other things that I would have seen digital watermarking make a slight quarter-over-quarter uptick here instead of ticking down and I'm curious about what happened there and what you expect going forward in terms of is there some lack of predictability in there either from defense contracts winding out or from the timing of the central bank contract?

The performance in that area was consistent with our guidance so there wasn't any unexpected downturn. There are some quarter-to-quarter fluctuations in the non I.D. Systems revenues relating to -- we had a little feedback here, I'm sorry. Relating to contracts that we have and services that we provide, and license income streams and so forth. So I don't think you should discern any trend other than an upward trend in general in that area. Jennifer, also, you should focus on the deferred revenue line.

You see continuous growth on the deferred revenue line, and a good portion of that is attributable to the licensing revenues. It gets recognized over a period of time.

One of the things that has been happening to all American businesses throughout the recent time is a very rigorous scrutiny of revenue recognition, and there are some situations, as E.K. described earlier, where the same basic product or service may be provided but in different ways having different implications on revenue recognition. So at times when we're forecasting, we will be properly forecasting what revenue we'll see but not necessarily what revenue we'll be able to recognize. It may go into the deferred line.

Okay.

And so deferred revenue did go up substantially in the quarter. Thank you.

You know, when we do the forecast, we put in whatever intelligence we have, and that's built into the forecast, but you know, we won't have complete visibility on how much is recognized immediately versus what is deferred.

Your next question comes from Philip Leigh of Raymond James.

I would also like to just ask a little about the deferred revenue there. As I understand it then, apparently some states unilaterally decided that my driver's license, which mine had to be renewed every three years, is now going to be every five years and that impacted the number of new -- you know, the volume that you produced in the four quarter, is that right?

Thats with one of the influences.

Right. Now, why does that increase deferred revenues?

It doesn't.

That has no impact on deferred revenue, Phil.

Jennifer was asking about non-driver's license revenue a moment ago.

Okay. So then your deferred revenue gains had nothing to do with the I.D. Systems business.

No. There is a component of I.D. Systems business that we call the add-on revenues. That will have some impact on the deferred revenue portion.

All right.

Okay. But it shouldn't have anything to do with the deferred revenue.

These add-on revenues, apparently you're being paid cash and sometimes you're able to recognize it as revenue, and sometimes you aren't.

That's correct.

So what are these add-on things?

There are many different kinds of products and services that are purchased in what we call the add-on category. It could be the upgrade of equipment. It might be the addition of a security feature. It might be the provision of some integration services. All of those things fall into the category that we refer to as add-on revenues.

Okay. So then some of the deferred revenue gain that you did, you're able to show on the balance sheet did, in fact, reflect I.D. Systems.

Correct.

Okay. That's correct.

Okay. It also appears to me that with respect to your guidance in '03, you're kind of changing the outlook for the watermarking business because you're showing very healthy growth there, and you're projecting something like a 500 basis point improvement for margins for the entire company. So am I making a correct interpretation here or not?

Yes. Yes, that's correct. We are projecting about a 30% year-over-year growth in the watermarking side, and we are projecting overall gross margin improvement of about 5%.

And that's largely due to the mix of business shifting towards the watermarking?

That's correct.

What gives you this enhanced confidence in the watermarking business?

We see opportunities for growth in all of the areas of that part of our business. We are particularly enthusiastic about the defense and intelligence and financial systems areas. We expect growth in all areas of the business, and on the licensing front, there's been an increase in commercialization efforts by other companies. Virtually all of whom are licensensees of ours and those who aren't we expect will be. As the world becomes more interested in watermarking, we will benefit.

Okay. Okay. So in other words, you just expect to get royalty income from various companies that start implementing watermarking technology. That's one source, right?

That's right. And as I mentioned in the prepared remarks, our plan doesn't assume any major breakthroughs. It just assumes the continuing incremental adoption of watermarking in a number of applications in a wide variety of areas.

Okay. But you did indicate, though, that one area that you're particularly optimistic about is the defense and also the financial. It's my recollection historically, you really can't -- or you haven't commented much about what those contracts are and what they entail. Is there any of this that you can talk about?

No, not really. It remains pretty much the same. All we can do is report the financial results for the most part.

So even in the financial sector you can't shed any light on what your new focus there might be?

No. All of the applications are security oriented, and thus, the customers' view, our discussion of the applications has an unnecessary risk to security.

Okay. Okay.

We do see -- we also see during '03 plenty of upside, though, but we don't believe that we need to change our investment model in order to be able to receive the full benefit of any upside that may occur. So the plan we described and the financial guidance we gave is based on just continuing the sort of incremental growth that we're observing now.

And this final question is this tracking then for the NBC News, I guess the broadcast tracking, is that kind of a breaking of the ice there? Is that kind of a reference type of account that's going to load to important new business or...

Yeah. That's a very nice development. The significance of it is that watermarking was introduced last year by Philipson and Teletracks and first customers was Reuters around the middle of the year. Then later in the year Reuters announced they were expanding the use of it. Then as we closed the year they got their first U.S. customer and a nice brand name at that in the same general field. So what it indicates is that a sophisticated customer tried it out and liked it, then a competitor saw it and thought they should grab it, too. So that's the kind of story you want to see unfolding with respect to the adoption of a new technology in an established field like that. Then we also learned just a week or so ago that Coca-Cola had signed up with Verance to use audio watermarking for tracking their advertisements and commercials. So we're starting to see what I think is the emergence of a trend toward the identification and content for monitoring and tracking using watermarking, video and audio.

The one thing that confuses me is I can't visualize how there's a big demand to steal NBC News programming.

Oh, there certainly is. It's not so much -- you're probably think of it in terms of Internet theft. That's not the problem. The problem is that when they provide a syndicated news feed, they have to audit where it ran and how often it ran so they can get paid properly.

Okay.

And so the television stations around the world will try to take down the feed and do whatever they may with it and create -- in the past logs, oftentimes handwritten logs indicating how much they should pay and you can imagine there might be a tendency to under state the amount of money.

Okay.

This provides realtime relatively 100% accurate data on the use of the content.

Okay.

Back to the owner.

Okay. Thanks. That's helpful.

Your next question comes from Steve Lidburg of PacificCrest.

Hi, guys.

Hey, Steve.

First of all, E.K. can you tell me where the head count was, including contractors?

Yeah. We had at the end of December 400 employees and 50 contractors for a total of 450.

Okay. And as you look at your 2003 plan where would you anticipate head count to be at the end of '03?

Our head count is not anticipated to grow a lot. We will selectively do some hiring but that's a very small number.

So overall flat, probably not declining as well.

Yeah.

Okay.

On the I.D. Systems business, Bruce, can you talk a little bit about the competitive environment, you know, first of all I guess how is the contract with Florida rolling out? Is it on schedule for the back half of '03 as far as turning the system on and then secondly, we've also seen your competitor in this arena announce a couple of states. Can you provide some color as to why are they waiting business, what your plans are to address that? Thanks.

Okay. Let me take the Florida question first and then provide a more elaborate question to your -- answer to your question about the competition and driver's licenses. Our understanding is that Florida continues to move toward contract. They have to go through various approval processes with the legislature, and we anticipate beginning work with them later in the year. So I don't think there's any change in our projections regarding Florida. With respect to competition in driver's licenses, the states at this point in time are very sensitive to pricing. In prior years, they seem to have more of an interest in quality products and adequate security, and certainly we always want to get the best price but it looks like the tables are turned a bit for the near term here, and they are really feeling the squeeze on their budgets. And thus, we had a situation with the State of Georgia last quarter which was a customer of ours that announced an intention to award their contract to a competitor, and the decision was heavily influenced by price. As you know, and we've said to everyone since the acquisition of I.D. Systems a little over a year ago, we've been working hard to improve operations there and to make I.D. Systems leaner, more efficient and world-class market leader in the driver's license and I.D. Systems area, we've made a lot of progress during the year. But I think in Georgia that we should have perhaps bid more competitively than we did. We thought that the state would be more influenced by the quality of the product and service than our market leadership than it turned out we were. We learned a lesson there. We're not going to let that happen again and so we believe that we can compete effectively with anyone, and do it on a combination of quality and price that will allow us to grow the business and deliver satisfactory margins for our financial expectation. We're getting to be a better competitor quarter after quarter, and the Georgia loss was one we regret.

Bruce, can you give us an update as far as what you see out there with regards to any type of pipeline as far as states making decisions about upcoming driver's license contracts?

State of New Jersey's out to bid, and so we're working on that. I don't know if E.K. has...

Yes, Steve. It's Vermont, New Jersey, and Hawaii.

So it's three. Great. And lastly, Bruce, with regards to watermarking, a lot of your licensing, I guess partners have come as a result of litigation. Obviously, we're starting -- it appears that water's building up behind the dam as far as the adoption of watermarking, you know, some that you're getting paid for, some that you may not be getting paid for. As you initiate discussions with potential licensees, has the tone changed at all or is litigation going to continue to be kind of a primary road that you're going to have to travel down?

All licensing companies find the need to occasionally resort to litigation. It's more common in the early stages of development of a licensing program than in the later stages. I might differ with you on the characterization of how we establish our licensee partnerships by saying that none of the large companies have chosen to litigate with us, and virtually all of them have entered into license relationships with us. It's more the small companies where perhaps they don't have the same level of sophistication on intellectual property or maybe they are just scrappy entrepreneurial sorts. So our litigation tends to be against private companies and our partnerships are against the large intellectual property saavy companies. So it's a mix where we believe most licenses and most often the licenses larger companies will not require litigation, but in the case where someone is infringing our patents, it's necessary to the development of an effective licensing program that we not tolerate any situations like that. So we'll litigate where necessary. Our last litigation here that we filed during Q4 was against another private company, relatively small private company, and we have already begun discussions with them to see if we can resolve it without having to continue with the court. I'm reasonably optimistic we'll find a way to avoid having to go to further litigation with them.

Great. Thanks.

For any additional questions please press star 1 on your telephone key pad at this time. Your next question comes from Andrew Weiner of Burham Asset Management.

Hi, Bruce, E.K.

Hi.

I just wanted to get some clarity on -- not to beat a dead horse but here in New York we get our expiration date on a license when it's issued so that I would have expected that any, you know, change in policy would affect you more in the out years as cards that are issued today don't come up for renewal in the normal course that you had expected. Is that differ in other states?

No. It's a little bit complicated. It might make sense for us to -- depends upon the level you're interested to take T take it off line but we have to estimate the effect of changes in the term of licenses against demographic trends and seasonality trends, and so it's not that a state decided in October they were changing the term of the license and that affected Q4. It's that we know of changes in terms and we try to match them up in our model against those other factors, and it's a little bit hard to see exactly when the effect begins, and so the effect occurred earlier than we had projected in that -- in the fourth quarter.

Okay.

It's really -- it's an actuarial model. We have to take a bunch and estimate them together, and we didn't estimate properly.

Okay. I'll talk to you more about that off line.

We can go through it in detail with you if you're interested.

That would be terrific. Second question I had was, you said that some of the add-on I.D. business that you had expected, you didn't get due to budget constraints. Were those cases where your product or the add-on products were actually selected, and then when it came time for funding, the budgets weren't there, or rather, that the states that seemed likely to maybe adopt technologies but never got to the decision process because they didn't think the budgets would be there for them? I guess it's a subtle difference but I was curious.

I don't know. E.K.?

Andrew, we're typically in the add-on type of revenues. We're not competing with another vendor. Typically with our existing customers, they want to -- they are coming back from enhanced services of products. So without competing with anybody in that regard, the states decided to put it off for a while because of budget constraints.

So it's a timing issue essentially I guess it would be the kind of situation, Andrew, where a customer has said I'd like to buy something from you, x sort of improvement, and the salesperson thinks they can make the sale in Q4 and then sometime during the period, the customer comes back and says I thought I could do it but my budget's just been crunched a bit. So it looks more -- it's more akin to traditional sort of sale where a customer might move it if they are feeling really tight.

So you, in theory, if you had, quote unquote, a pipeline of sales activity, would view it as something that's still very much in the pipeline but just hasn't closed?

That's correct.

Yep.

I guess the third sort of a more broader question, you've talked in the past about the I.D. business or the -- you know, the market for I.D. Systems having a 15%-ish type growth rate. Obviously, as what you've -- you know, the things you've seen in this last quarter or so, have you rethinking the longer term growth rate to this market?

No, not at all. If you we project 9% in the midpoint which means there's some range of the guidance that we gave for '03 so we're not far south of 15 at the higher end of that range, but if you -- if you discount the Q3 sale that E.K. referred to.

The $5 million.

Take that out of your number and you're on the growth track that we've talked about for the past year. That was an unusual event, had to do with a large program and they needed some supplies, and we provided it largely as a measure of strategic benefit, hoping to get some future business from the customer. But if you knock that off the '02 figure, you'll end up with a better comparison.

Now, I guess my last question was in the financial area, you know, you talked about expanding that group and expanding beyond perhaps the central banks. I know you can't talk about the specific applications but I guess one, do we have any nonCentral Bank revenue generating customers, and two, is that still in the development or is it in the deployment stage with those customers, if there are any?

That's a good question. Let me tell you what I can. We have generated some revenues outside of the project that we have had for many years. I can't tell you with who. And so there have been some revenues generated. I would characterize where we are as the beginning of a process similar to what gave rise to that long-term relationship with the central banks on deterring the production of counterfeits. We also believe there are expansion opportunities into the commercial banking and financial services sector. So we formed the business unit so that it can address not only more opportunities with central banks and other government institutions but also with the commercial sector of financial services.

Are the parties you're working with now -- is it similar in nature to the central bank arrangement such that you're trying to establish a standard in a tangential market to the central bank such that there will be royalty generating or are these potentially royalty generating customers?

They are potentially royalty generating customers. We made the concession to the Central Banks to have a nonvolume oriented license agreement with them because we were -- had 25 employees at the time and needed to get get the business jump started. We are obviously not inclined to do those kinds of deals going forward.

Terrific. Thank you.

You're welcome.

At this time you do have a followup question from Philip Leigh with Raymond James.

On your guidance are you computing the tax right?

No. We won't be paying any taxes next year or in a few years to come, so there is no tax in this built in.

Okay. Thanks.

At this time I would like to remind everyone that in order to ask a question please press star then the number 1 on your telephone key pad at this time. At this time, sir, there are no further questions.

Thank you, everyone.

Thanks a lot. Good-bye.

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