Digimarc Corp (DMRC) 2004 Q2 法說會逐字稿

Good afternoon. My name is David and I will be your conference facilitator. At this time, I would like to welcome everyone to the Digimarc Corporation Q2 2004 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. If you would like to ask a question during this time simply press "*" then the number "1" on your telephone keypad; if you would like to withdraw your question press "*" then the number "2" on your telephone keypad. At this time, I will turn the call over to Mr. Bruce Davis, Chairman and CEO. Mr. Davis, you may begin your conference.

Thank you. Good afternoon and welcome to our second quarter financial results conference call. With me today is Mike McConnell, our CFO. Paul Gifford, our President and Chief Operating Officer, is joining us from Digimarc ID Systems headquarters in Burlington, Massachusetts. We released second quarter 2004 financial results earlier today. The purpose of this call is to provide a summary and explanation of these financial results and an update on significant business developments and market conditions and financial guidance for Q3 ’04. We'll respond to your questions at the end of the call. Mike will begin by reading the Safe Harbor statement and then reviewing and commenting on the financial information contained in our press release. Mike

Thank you, Bruce. During the course of this conference call we’ll be making forward-looking statements. These statements are based upon management’s current expectations and are subject to certain assumptions, risks, uncertainties, and changes in circumstances. Actual results may vary materially from those expressed or implied from such statements. For more detailed information about risk factors that may cause actual results to differ from expectations, please see the Company’s filings with the Securities & Exchange Commission, including the MD&A section in our most recently filed Form 10-Q and Digimarc's earnings release posted on the Company's website earlier today.

Any guidance we offer represents a point-in-time estimate. We expressly disclaim any obligation to revise or update any guidance or other forward-looking statements to reflect events or circumstances that may arise after the date of this conference call. Please note that the Company's earnings release located on the Company's website www.digimarc.com includes among other things a reconciliation of EBITDA amounts to the most comparable GAAP financial measures as well as certain additional information in connection with the use of non-GAAP financial measures. This webcast will be available for later listening at www.digimarc.com/investor/events.asp and www.streetevents.com for two weeks following the live call. Thereafter, the webcast will be archived and available at www.digimarc.com/investor/event.asp under the subcategory webcast archive.

Now let's proceed with the financial review. Q2 revenues of 23.7 million exceeded our guidance of 21.8-22.8 million finishing above expectations in both the watermarking and ID systems areas of our business. This represents a 5% increase over the 22.5 million reported in the comparable period for 2003 and a 1% sequential increase over our prior quarter, due primarily to a combination of lower than expected gross margins and certain inventory charges in our ID Systems business, we substantially missed our EPS guidance of 2-4 cents and recorded a loss of 10 cents per share.

The inventory charge is primarily related to changes in estimates of the value of our inventory and unanticipated manufacturing yield losses in the initial manufacturing of some new card materials. The inventory valuation estimate changes originated from a provision for excess and obsolete inventory related to our product life cycle processes and an impairment charge for spare parts on hand deemed to be in excess of currently projected usage needs. As a result we have overhauled our inventory management and control systems and procedures, including those doubling the usability and disposition of slow moving or excess inventory. The manufacturing yield losses were associated with the introduction and production ramp up of our new ExianDual Polycarbonate Card architecture. We expect yields to improve as the manufacturing process stabilizes and production volumes ramp up.

The lower than anticipated gross margin was primarily due to a combination of three factors -- first, an unfavorable revenue mix including approximately $2 million of low margin revenues including follow-on film sales into a foreign voter identification project in certain domestic equipment sales. Second cost over runs in implementing the New Jersey drivers' license issuance system that was completed during the quarter. And third, higher than anticipated freight costs and other expenses associated with the unusually high level of new programs that we are delivering. These new programs while indicative of our continuing marketing successes and a precursor to significant growth in revenues, stress the organization considerably during the quarter. Accordingly Q2 2004 gross margin was 33%, 8.5% lower than last quarter and below the low end of our guidance at 44-46%. Q2 2004 gross margin was 12.5% lower than the comparable period a year ago. The entire gross margin shortfall was at DIDS. The majority of the shortfall was due to inventory manufacturing charges noted above. The gross margin for watermarking revenues was up slightly from prior quarter to 69%.

Total operating expenses of $9.7 million for the second quarter 2004 were at the low end of our guidance of $9.7 million to $10.3 million, up 340,000 or 3% from the prior quarter and down 327,000 or 3% from the comparable quarter a year ago. Other income of approximately was in line with our expectations and up from prior year's comparable quarter due to higher average cash balances. Income tax expense of $222,000 reflects additional reserves and expenses associated with income taxes we expect to pay in foreign countries related to our international operations. No provision has been made for U.S. taxes due to offsetting loss carry forwards.

The activities discussed above resulted in a net loss of $1.9 million for the second quarter or a loss of 10 cents per share on 20.3 million weighted average shares outstanding. This compares to net income of $287,000 or basic and diluted EPS of 2 cents in the second quarter of 2003 and net income of $525,000 or basis and diluted EPS of 3 cents in the previous quarter. Earnings before interest, taxes, depreciation and amortization or EBITDA declined to $1.1 million in the second quarter from $3.3 million in the second quarter last year. EBITDA was $3.2 million in the preceding quarter. The decline was primary a result of lower net income.

With regards to our balance sheet, our aggregate cash balances including cash and cash equivalents, restricted cash and short term investments were $64.5 million, down $9.6 million from the prior quarter and up approximately $12.9 million from the same period a year ago. The net decrease in cash from prior quarter related primarily to investments in significant new program implementations including the Florida drivers' license system and the Mexico voter identification program that we're in excess of our positive cash flow from operations.

Account Receivable balance was $16 million at June 30, 2004 as compared to approximately $16.6 million from the prior quarter on higher sales. DSO was 62 days compared to 57 reported in the first quarter of 2004, reflecting higher average receivable balances during the second quarter as compared to those in the first quarter. Inventories were $5.2 million, down $900,000 from last quarter. Inventories include materials to be used in producing ID cards and consumable supplies that we sell directly to our customers.

Net long term asset increased from $69.2 million in the first quarter to $81.1 million in the second quarter, primarily the result of program asset additions associated with new program implementations such as the Florida and Mexico programs we mentioned above. Accounts payable balance at June 30 is $11.2 million, up 220,000 from the prior quarter primary as a result of sustained levels of activity associated with new program deployments discussed above.

Deferred revenue for the second quarter of 2004 increased to $4.2 million from $2.8 million reported in our prior quarter, primary as a result of new contract and prepayments from our customers. In the past 3 months, our backlog has grown significantly from about $255 million to an excess of $295 million, the primary contributors to this increase are contracts awards received from Alabama, Minnesota, Iowa and Ohio. We consider as backlog production volumes reasonably expected to be achieved under currently existing contractual terms, government orders that are firm but not yet funded and government contracts awarded but not yet signed.

In summary while Q2 earnings were substantially below our guidance and our cash balance declined as investment and significant new programs exceeded our cash generated from operations, revenues exceeded our forecast and our backlog grew substantially Before turning the presentation over to Bruce and Paul, I would like to make a few remarks considering my initial observations about our ongoing improvement in the Company's financial and business processes. I am pleased to inform that the Company has aggressive plans to significantly improve its ability to manage growth effectively. Upon joining Digimarc in June, I was encouraged to note the Company was nearing completion of an accounting overhaul that would provide more accurate and timely information to get our financial business decision making and financial reporting. A new and consolidated financial accounting system from Great Plains is largely in place. We believe that this is a good system and one that I have worked with for the past several years. We are now concentrating on the implementation of new functionality and tools in area of manufacturing and resource planning and the management of inventories throughout our supply chains associated with our ID business. In parallel, we have implemented a series of new procedures and controls within our operations group at ID Systems and have significant resources to document our processes to comply with Sarbanes-Oxley section 404 requirements. We are investing heavily to improve the financial management of our business. Now I would like to turn the call back over to Bruce.

Thank you, Mark. There was a convergence of improvements in Digimarc's financial leadership, information flow, and scrutiny of financial and business processes near the end of Q2 in conjunction with the hiring of our new CFO and other senior managers in the finance area, continuing implementation of our new accounting and planning system, and work on Sarbanes Oxley compliance. This led o a long and rigorous closing process in which we revised certain cost estimates and noted the need to improve the management of our business at ID systems.

This is the second time in the past three quarters that financial results at ID systems fell short of expectations. This clearly is not acceptable, and we are taking decisive remedial actions. In addition to beefing up our finance and IQ resources at corporate and at ID Systems, I have asked about Paul Gifford, Digimarc's President and Chief Operating Officer, to assume direct control and responsibility for the ID Systems business. Paul will commit himself full time to improving the efficiency, effectiveness and predictability of operations there and will lead the business unit, until we are satisfied that the operating issues that have led to these disappointments are fully resolved. During this period I will assume direct management responsibility for all other areas of our business.

Digimarc ID Systems is in an enviable position as the leading supplier of one of the most important secured credentials in America. As we gain market share against competitors, whose business models and technologies we believe no longer adequately serve the needs of the governments and citizens for security and general effectiveness, we are becoming an increasingly important supplier of a critical element of our national security infrastructure. However it is imperative that we execute better. In doing so, we believe that we can and will build a great business of substantial value for our shareholders. Paul will now provide an update on ID systems. Paul.

Thank you, Bruce. As Bruce noted I'm now completely focused on our ID business and will remain that way until we are satisfied that the business is again being manage effectively. I have assume direct responsibility for managing the unit and have already become working closely with experienced management team at DIDS to more effectively implement our strategies for providing the more secure, reliable and cost effective enrollment and issuance solutions to DMV market to serve customers' needs to the best of our abilities and to continue to grow revenues and improve the predictability and profitability of our financial results.

In the area of domestic bid activity, four states have been in the competitive bid process thus far this year -- Minnesota, Ohio, Wisconsin and West Virginia. I am pleased to announce today that two of these processes have been completed with Digimarc the winner in both cases. The state of Minnesota has awarded Digimarc a 5-year contract for their new state-of-the-art issuance solutions. We understand that this award has been contested by competitor but have no further details at this point. We appreciate the confidence in Digimarc that this award signifies and look forward to continuing our long relationship as Minnesota's provider of DL issuance solutions.

I am also very pleased to announce that Ohio has notified us that we were selected as the successful bidder for a new 3-year contract to supply equipment, consumable and maintenance for their new DL system. Ohio is one of the largest issuers of drivers' licenses in the country. This is a significant competitive win for our team and we look forward to working with the State of Ohio to upgrade their DL system to our state-of-the-art solution.

During the quarter we responded to an RFP issued by the State of Wisconsin for a major upgrade to their DL system, which is currently operated by our competitor. Like Ohio, Wisconsin represents an opportunity for near-term incremental growth for Digimarc if we are awarded the contract. We are awaiting a decision on the Wisconsin bid. In the remitting open bid process, responses to the West Virginia request for proposals are due on August 25.

We learned recently of a purported agreement by the State of Georgia to partially reimburse a competitor for certain costs relating to 2002 procurement that is a subject to continuing litigation between our company and the state. In various public statements, the competitor has tried to create the impression that this action resolves our litigation. We have since received notice that the State has filed a motion to dismiss the case. We intend to repose the motion to dismiss. In our view, the purported settlement does not resolve the litigation. On the contrary, we believe that any such payment would complicate the thorny issue of whether a fair rebid process can be fashioned without disqualifying the competitor from participating. We are confident that the court will reach a just conclusion regarding the motion and other matters before concerning the case.

In the meantime, Digimarc will continue to provide service to the state of Georgia under its existing contract with the state. In our Q1 call, we also noted that the State of Hawaii had filed a motion to dismiss our protest, arguing that the protest was not timely filed. I'm happy to report that the State of Hawaii has since decided to resent their previous award of the new DL contract to a competitor and to extend their contract with us. While we expect the state to reassure an RFP in the near future, we are pleased to be able to continue the service date and look forward to this fresh opportunity to bid for the contracted supply and updated secured DL issuance solution to the statement citizens. In other news of extensions, we've recently entered into a long-terms expansion agreements with the State of Iowa.

Looking forward, we anticipate that Indiana, Texas, and California may go to bid by yearend, all our current Digimarc customers. With respect to these situations, please keep in mind that whether and when to take a program out to bid is generally after discussion of our customers and they may choose to delay or forego the opportunity to bid and continue to operate under existing contracts through extensions or sold source procurements. Our team is very busy with number of major new systems installations and upgrades. During the quarter we completed the installation of the new digital issuance program in New Jersey as well as new international programs in Latvia and Mexico.

Meanwhile, the work load remains heavy, as there are several other domestic program installations and upgrades underway in places such as Alabama, Colorado, Florida, Kansas, Michigan, Minnesota, and Wyoming. In the largest of these programs in Florida, we began generating revenues in Q2 and intend to substantially complete the roll out in installation of the system later this year. Our commitments with drivers license market is reflected in our high level of product development activities where we are designing and building a number of enhancements for our drivers license systems including the software application system that we discussed in our last call. SBS through an exclusive partnership with ChoicePoint provides a real time means for verifying the demographic information provided by an applicant during the enrollment process prior to issuing a new license.

We also have under development a credential verification solution, which is intended to authenticate an existing drivers license as well as other source documents used during this enrollment process, in order to obtain a new or reissued drivers license. One of the largest sources of identity theft in a fraud is a use of false source documents to establish identity during the application process for a drivers license. Our new CVS solution will support all existing drivers licenses issued in the United States and will for the first time incorporate support for machine readable digital watermarks that can be used to authenticate that a drivers license has not been altered or tampered with. SBS and CVS along with our industry leading facial recognition solutions for detecting whether new applicants have been issued licenses under other identities combined to provide the most powerful speed of applications available today. It enables an issuing authority to authenticate an applicant's identity data and sourced documents before the documents are issued, thus helping to close a major loop hole in the most current secured identification document issuance processes. We believe we are the only supplier addressing these significant needs in a meaningful way.

As we have discussed in prior calls we are developing a new sales channels in the domestic and foreign markets for certain components and subsystems of our domestic driver license solutions. We've substantially strengthen these initiatives during the quarter with the addition of a new channel sales VP, Drover Steward (phonetic) who had seasoned and experienced professionals management skills to our team. We believe these new channels will contribute significantly to our future results as Digimarc products get placed into programs and start generating reoccurring revenue streams. However, given that this is an emerging area of our business, involving the development of new products and distributional relationships, there are ongoing risks that the channels will not develop in a manner or a longer timeline that we are projecting. With this said, international business in general during Q2 was strong, with $2.6 million of new bookings added for a total of $19.8 million of 2004 so far.

In summary, as we make necessary improvements in our internal business and financial processes, we intend to continue to increase our issuance volumes in the US market, win market share through confederated bids for new contracts, introducing important new products and significantly grow revenues with the addition of new state program such as in Alabama, Florida, and Ohio, and aid major upgrades for systems at existing customers such as Minnesota, Kansa, Iowa, and Michigan. We are driving the market force with major new software applications that will enable issuing authorities to detect and deter identify theft and fraud and with new car materials and architectures that being -- bring unprecedented durability and security to documents produced by our systems. We have many positive things going for us.

I'll now turn the presentation back over to Bruce.

Thank you Paul. In other areas of our business, second quarter digital watermarking results continue to attract a good growth year. Year-to-date revenues are up almost 20% over the same period in 2003, during the same period gross margin improved by 10% from 58% to 68%. We expect this strong growth to continue with revenues for our activities other than with Central Banks, forecasted to grow at significantly higher rates than the aggregate growth rate for watermarking revenues. Digital marketplace is to play a major role in preventing identify theft with ID mark, more than 30% of US drivers license issuance volume is already under contract to include ID mark and drivers license for costlier [fictional] authentication, aimed directly this multi-billion dollar international problem.

As governments around the world address concerns about identify theft, digital watermarking is becoming more visible in the standards community as a potential standard security feature of a broad range of identification documents. It already appears in the American Association of Motor Vehicle agencies drivers license classification in the United States and is under consideration in the European Union and other venues with a key machine readable security feature. During the quarter the Latvian drivers license went into production with IDMarc, as our first international program deployment.

In the US we sold our first forensic inspection tools to law enforcement, providing the means to analysis suspect documents in the drive to deter identity test. We anticipate that our next steps in building solutions states on the broadening deployment of IDMarc will be in the areas of law enforcement and fraud reductions in the drivers license application process.

In our digital imaging product line we've released a new version of the ImageBridge enterprise providing a technology update tuned for using integration with corporate assets management work flows. ImageBridge enterprise 2.0 provide server based tools at digital watermarks image outlets and improved internet tracking and reporting services. We are seeing times of early traction with major retailing consumer brands, each looking to extend their asset management capabilities out side the corporate firewalls.

During the quarter we also announced that Digimarc mobile initiative and our first go-to market partner in the mobile print internet market. MediaGrid based in Japan with roots on online catalog sales and digital watermarking, licensed our digital watermarking platforms build and deployed mobile applications. With exclusive rights to our reference implementation in the Japanese market MediaGrid is expected to deploy applications on camera phones to provide one-click navigation from catalog, magazines and other printed materials to e-commerce and streaming content. We anticipate that our reference design will be available for integration and leaving mobile operation systems by the end of the year. As MediaGrid enters the Japanese market, we are working to identify and sign regional go-to market partners in other key early adopted geographies. In the licensing area, our patent portfolio continues to expand. At the end of the quarter we have 157 US patents, our current total was 168. We have over 3000 claims in our issued patents and more than 350 patent applications pending in digital watermarking personal identification systems and related technologies. We had a good quarter in licensing with strong revenue growth. They're an increasing number of watermarking based solutions being offer to the entertainment community and many new enquiries about licensing terms.

During the quarter we signed a multi-year license put biometrics, a digital rights management security systems provider that is incorporating digital watermarking into video contents solutions. Based on San Diego, Biometrics is expected to use digital watermarking as forensic tracking capability within the DRM solutions that offers to the paper view and video on demand providers in telecommunications hospitality and government markets. Digitally watermark video content can be track to monitor as it is distributed electronically along content owners to unidentified unauthorized used monitor compliance and marketing programs and better manage to delivery of video content to channel partners.

To understand, the Biometric is also exploring the use digital watermarking to protect against unauthorized coping of commercially released video content. The Biometrics solutions are good examples of the complementary use of digital watermarking with common DRM technologies. We also license certain DRM related patents in our portfolio to Philips Electronics. The agreement provides the paid up license for used by Philips in their product and services, and ongoing royalties would guarantee minimum with respect to licensing the IP to third parties. We continue to see good growth in watermarking forefront, attracting and pre-released movies and music and broadcast monitoring of advertisings, news and programming. There is continuing interest in the benefits of watermarking for using DRM and other content protection architectures. Michael will now provide financial guidance for Q3 2004 and the remainder of 2004. Mike?

Thank you Bruce. The following statements concerning projections of future financial performance are based on current expectations. These statements are forward-looking subject to risks and uncertainties and actual results may differ materially. These statements do not include the potential impact of any investment outside the ordinary course of business or mergers and acquisitions.

Our estimates for the third quarter of 2004 are for total revenues in the range of 22-23 million. Gross margins in the range of 40-42%, total operating expenses in the range of $10.5-11 million, other income consisting mainly of interest income of approximately 145,000, and provision for income taxes of approximately $50,000.

Based on the above assumptions, we estimated loss per share for the third quarter of 2004 in the range of 3-6% -- I'm sorry, in the range of 3-6 cents based on approximately 20.4 million weighted average shares. Also we expect EBITDA in the range of $1.5-2.5 million. For the full year of 2004, we are maintaining our previous revenue guidance of 94-97 million. However, we are not currently offering full year EPS guidance.

Bruce now has some closing remarks.

The recent operational problems at ID Systems are disappointing. It should not overshadow the bright prospects for profitable growth at Digimarc. It is especially disappointed to deliver these financial results in the context of so many positive signs surrounding our business including major new competitive secure identification system and contract limits and deployments, significant new patent licensing, and a backlog of overall business now approaching $300 million. We are aggressively addressing the route causes of these problems. We are enduring some pain along the way. I'm confident that the problems that have affected us recently will be resolved. We have outlined many of the measures that we are taking. Through these significant changes in management, systems, and processes, we are improving our ability to manage our growth and deliver the rewards that our shareholders deserve from the great opportunities they are positioned to profit from. This concludes our presentation. We'll now welcome your question.

Ladies and gentlemen, at this time, I would like to remind everyone if you would like to ask a question press "*" then the number "1" on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from Brian Ruttenbur from Morgan Keegan.

I just have a -- I am really confused on the gross margin and I was wondering if you could go through this kind of slowly and a very simple terms why the gross margins were out of the whack, as I understand let me read it back to you so that I -- and maybe you can tell me where I am out of whack. It looks like a gross margins were out of whack because of inventory management issues that you issued a new kind of card and you had to write-down the inventory that hits you on the gross line, there was a revenue mix issue, there was the New Jersey cost issue and then you spend a lot money on shipping freight. Maybe you can go through each one of those and how that negatively impacted you and may be a percentage on how and how much?

So Brian, this is Mike, I'll take the little time here and talk in to try if I miss something here. First of all the inventory and manufacturing areas where we took the charges for the quarter, those charges totaled $1.4 million and that relates to about 3 factors, one is as we evaluate our product life cycles meeting end of contracts, extensions, new technology being implemented, we looked at some of our inventory that we had on hand and took a look at can we use it what was our estimates of the excess and obsolete inventories in previous period and based on our current product plan we took a pretty large charge for that. In addition, as part of 1.4 million there were spare parts that we used to support existing installations that we have around the country, and as we look at how often those parts fail, we are having a very low failure rate, so I had an excess quantity on hand, and I took some charges there as well. And finally, as we produced this new card, we had some unexpected yield losses in the early productions, you know, can start or stop process that has subsided to considerably, since, say the first few months of implementation.

So, all these charges that were buried in the gross margin line is that correct?

They all were buried in the gross margin. That was about a 1.4 million. In addition there were mix issues, we have talked about a couple of million dollars of low margin sales on to New Jersey hardware, and on some film sales in some foreign markets and then some mix of product sales also had a negative impact on margins.

Yeah. So, if I understand, then your gross profit should have been 9.2 million instead of 7.8 million or 7.847. Right, is that correct?

You -- If you would take the 1.4 million, and add it, yes, you would arrive at that amount.

Okay.

Then on top of that we did have some other operational issues as we are deploying these programs, initial cost greater than we expected and again some other mix issues where we expected some larger margin sales, and we had some lower margin sales.

Is it correct to say though, if you back this out, you would had about 39% gross margin at the inventory. And then these other factors contribute to the downward pressure in the gross margin here?

I think, yeah, the inventory issues and the 1.4 million would have brought it, into that 39-40% and then the other items are pretty on the marginal or bit more.

Okay, great. I understand things a lot better now, thank you. The other question on the cash, you burned $9.6 million in the period -- Florida and Mexico being, I guess two of the main reasons, where this cash go to next quarter -- how much does the balance sheet go down and before it starts rising?

Okay we are projecting a little bit north to $9.6 million if you look at the cash flow we saw that in the release, I think we capitalize about $14.4 million or 14.7 it was for projects that we are -- will rolling our revenue in the future periods. We are finishing some of the larger ones this quarter and it will be another $12 million to $15 million of capitalize item that will utilize cash, so we will -- and in that net of the cash flow that we expect we will probably be somewhere in the $10million -$12 million range of total cash, Brian.

Okay, that’s third and then fourth quarter it should be lot less, things should start to be stabilized in the couple of million then in the quarter?

It would be a lot less, we aren't giving any detail projections of fourth quarter but as we finished couple of these programs this quarter, obviously Q4 will be down. On the positive side should we gain some other contracts that require us to build systems that will gain more capital -- capital expenditure, that’s the kind of good side we have capital expenditure because it is a precursor to revenue increase in later quarters

How long before you recoup this -- 9.6 this period and 10 or 11 next period, is it what a year or two?

The -- in general Brian the investments upfront on our contract run about 20% or so the total contract value and that’s out of 5 year contract you would recover the cash in the predictable fashion during that somewhat [tidy] issuance over the five-year period.

That you would recover the cash, wouldn’t you recover I guess, I will always look at you as you recover that investment and then you start making money. So it take two, two and half years over five year period to recover the cash investment than every thing else is kind of true profit after that, is that the right way to think about it or not?

Well, in terms of what you are talking about is GAAP income or cash flow?

I was talking about cash flow.

On the cash flow, we took the money out upfront and then we recover the cash in relation to the net cash margin over the consumables cost and support cost for the system.

Okay, and then can you also give us a mix that sales and marketing, let's say first quarter, I believe that you hadn’t broke down sales and marketing and G&A separately. Can you tell us what that number is, you reported I think SG&A all together. And I was wondering if you could give us little break up between what sales and marketing and what's G&A?

I do -- actually have broken down just between the R&D and the SG&A. I haven’t got that information available; I thought we only produced in prior the groupings of the two. I mean just look a bit further here, and through some of my notes. R&D is about 5% of revenues, sales and marketing combine about 12 and G&A about 24%.

Great. And then last question, when do you anticipate getting back to positive EPS, not positive cash flow but positive EPS? Is that any time that you can see in the near future?

Well, obviously, [inaudible] about to Q3 but since we are not giving Q4 or '05 guidance at this time, we are not going to provide any more granularity there. I think Paul is going to be staying a great deal of time and effort at ID systems to make sure that we're moving in the right direction and so we'll have to wait till next quarter to give maybe more clearer granularity on profitability picture.

Thank you very much.

Your next question comes from Rob Stone of SG Cowen and Company.

Hi, a couple questions regarding granularity in Q3 in terms of your guidance, would you expect watermarking revenues to be up sequentially, and if that's the case how much of a rebound do you have to get to in margins for the DIDS segment in order to hit your 40-42%?

Rob, on the -- this is Bruce, on the guidance for Q3 looking back, we haven't given a breakdown of the split between watermarking and ID systems for Q3 at this point. So I made a statement earlier in the presentation about the annualized growth rate for watermarking. I think you have thus far some growth at this point.

I'm asking for a specific number, but in terms of the recovery in margins, I am trying to understand if -- that the overall revenues are going to be fairly similar to what you just reported and actually a little bit smaller, I'm trying to understand either the mix implication or a recovery in the problems that you have seen any ID Systems business?

Yeah, ID Systems is where all of the margin question regards. The margins in watermarking are steady.

I understand that and I'm just trying to get behind the -- without getting in to specific numbers to get to the gross margin guidance that you have for Q3, does that assume a mix shift as a percentage of revenues towards the higher margin licensing segment or is it all based on taking care of these issues in the ID business?

Rob, this is Mike. The majority of that recovery really comes from not expecting any large charges on inventory in the coming quarter. I think we've done a very thorough and rigorous analysis of our future technologies, what inventory items may or may not have risks and we've provided for those adequately in our estimates and reserves this quarter. So we are not expecting significant charges in that area in Q3, so the majority, again, the recovery would come from elimination of most of those charges.

Okay. I guess it's probably premature to ask whether, in your review of all the systems and practices in the ID business, do you have any thoughts on a target margin for that segment as opposed to where it is now?

Rob, I think it would be a little early. We are certainly digging in here this week and I'll be doing the same for weeks to come to better understand the major trends in the business, but I can say that during Q3, where we've given guidance that the revenue mix will be a little bit more favorable and that we don't expect to have as much low margin revenues we saw in Q3. But at the same time we are in a very, very heavy deployment and delivery phase here, and it is not only consuming the organization, but it's also leading to a little bit of a dent in margins here that we saw in the prior quarter, and I think that'll continue into Q3.

Thanks very much.

The next question comes from Julia Holland of DA Davidson & Co.

I was just wondering if you could let me now when the deployment of Minnesota and Ohio are expected, when do you expect to see revenues and how do you see them ramped?

Paul do you want to take those?

Yeah, Julia this is Paul. Minnesota is a current customer, so we will expect to see a fair degree of continuity in the revenues from that program. We are under a pretty tight schedule to implement a new system in Minnesota, so sometime late this year or early next we will be cutting over most of the issuance to the new high security drivers' license that we will be producing for the state. Ohio actually has just given us the intent award late last week, and we are in negotiations with them this week on the fine points of what it is actually they want to see in their new card and so forth, but again it's a type of program that will be really becoming active late this year or next.

Okay. And with the Minnesota, are you going to see any incremental revenue with the upgrades?

I would expect to see a consistency in the program revenues from the state of Minnesota.

Okay thank you.

Your next question comes from Christopher Swan (phonetic) of GMT Capital

Yeah hi. I have a question about the Georgia contract, with the recent announcement from Viisage, and I was wondering if you could give any more comments or go into that contract?

The facts are, as we stated them in the prepared remarks, Viisage has joined in the litigation by the State of Georgia; our litigation, our suit is with Georgia. The characterization of the litigation being resolved by some action between Georgia and Viisage is not correct in our view, and so we are opposing the motion to dismiss and we believe that the court will come out with the best result that will service the citizens of Georgia, and result in us retaining the contract there. So the litigation is continuing.

Okay. And I apologize; I joined the conference a little bit late. In regards to other areas where you have competitive situation with them, may be you could just quickly outline some of the key areas where you think you might have competitive advantages.

Well the fact that two third of the market chooses us as a supplier, I think indicates the superiority of every aspect of our business. We are technology leaders, we have the most comprehensive solution, we're more forced on the market, our competition and all of our competitors have said they sort of use drivers licenses as a minor part of their business, their focus is elsewhere, ours is directly in serving the drivers license issuing authorities and the citizens that use the documents, and we have excellent customer service and we intend to continue to enhance the security, the cost effectiveness and the reliability of the drivers license issuance systems as the drivers license becomes an even more important credential in every aspect of the daily lives of Americans and the citizens of the foreign jurisdictions that we serve.

And just one final question. How important in your mind is integration of facial recognition technology into the document -- in secure credential marketplace?

Facial recognition is a useful tool for reducing the risk that applicants will apply for more than one license within the system; that's the extents of its use within most secure credential systems and the drivers' licenses, in particular. And so we have abut a half of those in states that employee facial recognition, another handful that use finger prints as a means of combating fraud in enrollment. We are wrapping facial recognition in with a number of other means of mitigating fraud, including verification of documents and verification of identification information provided by applicants in order to provide a more comprehensive solution to the problem of fraud and enrollment. Given the extraordinary security provided by our state-of-the-art card materials and digital technologies, we think the document itself is very secured. And so in the systems that we serve, we think it's most likely that criminals and others trying to take advantage of the system will gravitate toward the enrollment process in their efforts to get driver license, in essence getting a legitimate credential illegitimately rather then trying to counterfeit. And so it's very important that we continue to develop and deploy this suite of applications at the enrollment area to reduce the risk of fraud in these issuance systems, so facial rec is a piece of the solution.

Okay. Thank you.

Your next question comes from Jennifer Jordan of Wells Fargo.

From Jennifer's line, just taking back to the gross margin issue. you were guiding the growth margin in Q3 back to the 40-42% net [inaudible] where you were in Q1, and in fact then on the other hand you mentioned that you have Paul Gifford to lead this unit until you are satisfied with the operation issues yourselves. It sounds like you have some kind of -- there on that you are looking out and try to fix, and can you help me understand why you think that you going to achieve the gross margin back to the Q1 level?

I think there were two questions there. Let me see if I can both of them for you. First, on the management of ID systems, we have disappointed our shareholders two of the last three quarters in not meaning expectations, and that calls for a change in the way in which we are managing the business. So that’s why Paul is there. Paul is our best operations executive. He is taking responsibilities for the business directly. He is going to make sure it's running well. We are in the midst of a transition to a very nice growth business here. And I have said for the last year or so that we had thought that we had laid down the infrastructure sufficiently that it can support growth, and we are then going to be growing the business. Well it's obvious now to me that we were a little optimistic in that view. However, it's clear that the growth is available and we are going to be taking advantage of it so we need to have an organization that can respond to it effectively and profitably and predictably, and that's where we have looked at expectations recently and what Paul's focusing on.

The gross margin is our one element in that overall mix of successful operation of the business, so Paul's not there to fix the gross margin per say, he is there to help the management to improve the operating effectiveness and predictability of the financial results that we produced at ID Systems As Mike outlined a moment ago on response to a question from Brian Ruttenbur, there are a lot of elements of the business that are implicated in the gross margin, and so as we run the business better in many aspects of operations that will have a beneficial impact on margins, and so there is kind of an indirect relationship between the two questions I heard you asking. in terms of the gross margin and recovery we are only giving guidance in terms of margin and EPS for Q3, because we want to give Paul time to really dig in at ID systems and to make judgments about how to improve operations, and then after he has had sometime there, we will give you all our best estimates of the impact of the changes he is able to make on the operating and financial performance of business

I see so -- so you don’t have any -- like do you have targets of getting back to the mid 40 range that you were getting last year this time yet?

Sure, this is Mike. We are targeting to return into 40s this coming quarter of Q3 and that's reviewing the backlog what's going to roll into revenues this quarter with cost and also with given the revenues that we expect to generate. So this -- again we are not expecting to have the large charges that we had in Q2 to repeat themselves in Q3, so we will recover substantial margin degradation here in the coming quarter.

Okay, thanks so much.

Once again, I would like to remind everyone, if you would like to ask a question press "*" then the number "1" on your telephone keypad. We will pause for one more moment to compile the Q&A roster. At this time, there are no further questions, do you have any closing comments.

I want to thank everyone for participating in the call today. We are doing our very best to improve our predictability of our financial results, and I hope you appreciate the measures that we've outlined today, which are comprehensive and aggressive and intended to put to rest these issues that have troubled us in the last few quarters. So, I appreciate your participation and your patience, and we are going to make this business work well for you. Good bye.

Ladies and gentlemen, this concludes today's Digimarc Q2, 2004 Earnings Conference Call. You may now disconnect.