Digimarc Corp (DMRC) 2005 Q1 法說會逐字稿

Good morning, my name is Kimberly and I will be your conference facilitator. At this time I would like to welcome everyone to the Digimarc Corp. first quarter 2005 earnings 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. (OPERATOR INSTRUCTIONS). Thank you.

I would now like to turn the conference over to Bruce Davis, Chairman and CEO of Digimarc. Sir, you may proceed.

Good morning and welcome to our Q1 2005 financial results conference call. Mike McConnell, our CFO, is with me on the call. We are making the call from the AEA, the financial conference in Monterey. So I hope that the audio quality is okay for everyone.

We issued a press release yesterday announcing our Q1 '05 financial results. Effective with this call our summarized comment on our Q1 results, discussed measures we have taken to on -- taken to improve internal controls and the timeliness of our SEC filings; review significant business development and market conditions; and provide some visibility on our prospects and plans for the remainder of the year.

This webcast will be archived on the Investor Relations section of our website.

Before we proceed, I would like to remind everyone that during the course of this conference call we will be making forward-looking statements. These statements are based on our current expectations and are subject to certain assumptions, risks, uncertainties and changes of circumstances. Statements will include without limitation statements related to implications of the Company's first quarter earnings and subsequent periods and statements regarding management's opinions and expectations regarding any and all aspects of the business. 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 SEC including the MD&A section in our most recently filed Forms 10-Q and 10-K, our earnings release posted on our website, and our most recently filed form 8-K.

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.

Now we will proceed with the financial review. Mike.

Thank you Bruce. All references we make today to financial results for the first quarter of 2004 reflect the previously published restatements for the financial statements for that period.

Looking first at the income statement for the first quarter of 2005, revenues for the first quarter increased 700,000 or 3% to 24.4 million from 23.7 million in the same period a year ago. ID Systems revenue increased $500,000 or 2% reaching 21.4 million from 20.9 million for the first quarter of 2004.

This revenue improvement primarily reflects increases in service revenue related to new secure credential programs -- namely Florida, Ohio, Mexico and Latvia -- partially offset by a non-recurring sale of voter identification supply to a foreign customer during Q1 of 2004.

Digital watermarking revenues increased $235,000 or 9% to approximately $3 million from 2.7 million primarily from increased patent license revenues.

Looking at revenues geographically international revenues declined 1.6 million in the first quarter or 27% to 4.4 million from 6 million in the first quarter of 2004. While we experienced increased revenues from the Latvia and Mexico contracts referred to previously and from other international contracts, those increases were offset primarily by the non-recurring revenues associated with the voter identification supplies contract that occurred in the 2004 period.

U.S. revenues grew approximately 2.3 million to $20 million or 13% over the first quarter of 2004, largely from increased domestic issuance revenues, hardware sales during the quarter, and increased patent and technology license revenues.

Gross margins for the first quarter of 2005 are 36% -- comparable to margins realized in the first quarter of 2004.

Operating expenses totaled 14.1 million, an increase of 4.3 million or 45% above the 9.8 million incurred in the first quarter of 2004. Most of this increase was in the general and administrative cost area which increased 2.2 million or 45% over the prior period. The largest increases in the G&A area resulted from increased legal, consulting, accounting and audit-related costs of approximately $1.2 million, associated with our restatement efforts, our third quarter and fourth quarter financial statement preparation and our year-end audit.

Increased costs related to higher headcount approximated $300,000 -- an increased cost of approximately $100,000 each, related to bad debt expense, Sarbanes-Oxley compliance, a grant of restricted stock, and securities litigation.

Sales and marketing expenses were 3.8 million, up from 1.3 million in the first quarter of 2004, primarily due to additions of senior level employees, consulting resources and increased presence of trade shows and events sponsorships to drive increased demand and awareness of our products and services.

Research and development costs were 2.5 million -- up 800,000 over the prior year primarily from increased staffing -- both full-time employees and contractors -- and increased materials costs associated with tests and development processes associated with new products and service initiatives in our ID Systems businesses.

We anticipate that we will continue to invest at the current rate or more in the R&D area in the foreseeable future.

The increased operating expenses more than offset the contribution from increased revenues in the first quarter 2005 resulting in a net loss of 5.1 million compared to a net loss of $800,000 for 2004.

Regarding the balance sheet of March 31st, 2005, we had approximately 42 million in cash, cash equivalents, restricted cash and short-term investments and we had 43 million in working capital at the quarter end. These amounts compared to 52 million and 49 million, respectively, at December 31st, 2004. The decreases resulted from cash used to fund operating losses and from investments in significant new program implementations -- in particular, in Florida and Alabama where we are nearing completion of the installations. Both of these programs will continue to increase revenues for the balance of the year.

Cash used by operations totaled 4.1 million during the first quarter of 2005, compared to 2.8 million provided by operations in the first quarter of 2004. Cash used in operations for the three months ended March 31, 2005 resulted from a net loss of 5.2 million offset by non-cash items related to depreciation and amortization of 3.4 million, and negative changes in working capital components of 2.4 million.

The 2.8 million of cash provided by operations for the 3 months ended March 31st, 2004 was negatively impacted by the $800,000 net loss for the period off set by depreciation and amortization of 2.8 million and net positive changes in working capital components of $800,000.

Our backlog at the end of the first quarter remained strong at approximately 280 million down approximately 20 million compared to the balance at the end of 2004 due to the natural burn off of previously booked business. DSOs of 57 days in the first quarter of 2005 compares consistent with 58 days in the first quarter of 2004.

This concludes my prepared remarks on the first quarter financial results.

Now I would like to update you on the status of Sarbanes-Oxley Section 404 review of internal controls at December 31st, 2004.

Section 404 requires that we file with the SEC a report on internal controls over financial reporting and related (indiscernible) station reports of our independent registered public accountants for 2004.

Due to the nature of the deficiencies identified during 2004 and the time necessary to fix them we have not effectively remediated several of the deficiencies as of December 31, 2004 -- the date of required assessment and internal controls.

The deficiencies were described in our Form 10-K for 2004. We have now completed our assessment of internal controls and filed a Form 8-K with a report on management assessment as of December 31st, 2004. Our assessment is not different materially from what we projected in Section 9A in our initial Form 10-K filed on April 7, 2005.

Our auditors are completing extensive documentation of their review. Within the next several days we expect they will complete their work and we will promptly file an amendment to the 2004 Form 10-KA which will include management's assessment and the auditors' attestation regarding the state of internal controls at the end of 2004.

As previously announced, we believe that our auditors will issue an adverse opinion. This adverse opinion is not expected to affect the auditors' opinion regarding the financial statements included in the Form 10-K. We and they employed extensive compensating procedures to give us and our auditors confidence that the financial statements for 2004 and the three months ended March 31, 2005 fairly reflect the financial performance of the Company -- despite the internal control weaknesses we identified.

As we recover from the extraordinary demands of the extensive financial reviews we conducted over the past (indiscernible) months we are prepared to offer some limited guidance regarding projected financial trends. Revenues, we expect those to be higher in quarter 2. From a cash burn viewpoint a number of very large programs have been completed or are expected to be completed within the next quarter or 2. Thus, the high rate of capital expenditures that began last year should abate, leading to improved cash flow.

Margins for the near-term are expected to continue in the range experienced in the last couple of quarters. Over the longer-term, the expansion and contraction of margins is a function of numerous factors outlining the risk factor section of our Form 10-Q. Some of these factors are within our control and some are not.

Operating expenses, we do not expect operating expenses to moderate. However, we will be investing above normal rates to continue to improve internal controls, achieve compliance with Sarbanes-Oxley, improve our accounting ID Systems, and make our enterprise accounting system far more effective and efficient. We do expect the EPS to improve in quarter 2 as well.

Now I'll turn the discussion back to Bruce to discuss significant business developments underlying our market decisions (ph) and trends and our plans.

Thanks, Mike. I've got one important correction to the summary and guidance that Mike just provided. It's early in the morning here. He said, "we do not expect OpEx to moderate." We mean to say, "we do expect it to moderate."

We will have investments above normal rates for a while longer here but we do expect the OpEx to improve.

Regarding the business review for the quarter, this is a time of unprecedented opportunities for our Company. It is important that the difficulties that afflicted the Company in 2004 and early 2005 do not leave investors to cast a blind eye to the value of these opportunities represent. I am pleased to report that we are making substantial progress in normalizing the financial operations over our business. The Q1 close began very late due to the late filing of the 10-K on April 7. Nevertheless we filed the 10-Q only a few days after the deadline within the generally allowed five-day extension period. We believe this will be our last late filing.

We have been diligently and aggressively discerning and addressing the root causes for the late filings and related financial issues that have depressed the perception of value of our Company. Major changes that we have been making in management, staffing, and business processes are making a difference, not only in improvement of internal controls but more broadly in better serving our customers and more efficiently and effectively managing our business.

Most notable among the change in management was the hiring of Bob Eckel (ph), a 15 year junior veteran of Raytheon Corp. that is President of our ID Systems business unit. Bob served as Vice President and General Manager of Raytheon's Air Traffic Management Systems business where he managed a portfolio of domestic and international contracts of more than 20 countries.

He brings much-needed discipline and a program management expertise toward our secure personal identification business.

Other significant restructuring of roles, responsibilities, and reporting relationships detailed in our last call that are intended to improve communication and strengthen internal controls are well underway and should expedite Company-wide quality initiatives.

As if the timing of our initiative strength of our management and infrastructure support for growth are gratuitous, a potential inflection point in our core market may be happening, driven by passage by Congress of signing into law the Real ID Act as part of Public Law 10913.

The new law explicitly recognizes the critical role that drivers' licenses play in homeland security and a wide range of financial and commercial activities. Among other things the Act establishes minimum standards for driver licenses, and other state issued IDs that are used for federal purposes such as boarding planes and entering federal facilities.

States may opt out but if they do their IDs will not be accepted for federal identification purchases. Secretary of the Department of Homeland Securities is charged with certifying state compliances. There are many specific requirements. Among other things the new state driver licenses are required to include information such as full legal name, date of birth, physical address, digital photograph, signature. They are also required to incorporate physical features to prevent counterfeiting or tampering and to include machine-readable technology.

It'll also set standards for documents used to verify an applicant's identity, which must include a digital photo, the applicant's full legal name and date of birth, proof of Social security number and proof of physical address.

The states are also required to certify an applicant's lawful status in the U.S. and temporary IDs must be issued to noncitizens with temporary status -- set to expire at the same time as their lawful stay in the US. The law further requires states to verify the authenticity of documents presented to approve an applicant's identity and requires the DMV's make and store additional copies of the documents. Validity periods for licenses are also capped at 8 years.

The law tells the states to ensure the physical security of DMVs initial (ph) facilities, run security checks on employees and provide them with security training. We expect these standards to motivate more states to a dropped and (indiscernible) security IP processes and technologies offered by Digimarc including improvements such as systems to capture fingerprint or facial images and use biometrics to deter fraud and identity theft in the application process.

Advanced security features such as digital watermarking, ultraviolet inks and kg (ph) that are authenticate documents to deter counterfeiting. New secured driver license production initials processes designed to deter collusion and fraud, and cross database of verification of applicant information to prevent fraud while protecting the citizen's privacy.

There are a number of potential sources of funding including federal grants, state budgets, and increased user fees. The law authorizes the federal government to issue grants to the states to improve ID security but does not go so far as to appropriate funds for this purpose at this time. States have 3 years to comply. Estimates of compliance costs vary widely ranging as high as $500 million during the first 5 years.

(indiscernible) context on judging its potential significant to Digimark note first that the total U.S. driver license market today is approximately $100 million; and the systems that we supply produce more than 2/3 of all licenses.

Widespread compliance would dramatically increase the scale of the market, our core market. Not all states will have to engage in massive upgrades. A number of our customers have recently undertaken comprehensive initiatives to upgrade the security of their IDs and have implemented many innovative technologies and processes that will satisfy certain of the requirements of the Act. And serve as models of best practices, processes, and deployment of technologies for the standard-setting process that DHS will administer.

We are well equipped to assist the Department of Homeland Security and state DMVs to make the required enhancements. The demonstrated expertise and responsive products and services Digimarc has ideally positioned as a trusted supplier to a majority of DMVs in the US. With the law less than 1 week old we are already hard at work, assessing our customers' needs for upgrades and developing programs to quickly and efficiently bring them into compliance with this very important homeland security imperative.

We are uniquely qualified to address the delicate balancing of security and privacy that will be necessary. The law does not call for establishment of the new nationwide database as feared by some privacy applicants. It does require states to share information with one another, which is already done by a number of states today. It also requires states to verify information against existing databases like the Social Security Administration which is also done by many of the states today.

The area in greatest need of improvement is post issuance verification. Today, most licenses are verified merely through digital inspection. Our ID mark security feature based on digital watermarking offers a cost-effective means to provide reliable machine verification of the authenticity of licenses without compromising personal privacy. We believe it directly addresses the need to implement new physical security features designed to prevent tampering, counterfeiting, and duplication as required by the new law.

Digital watermarking is machine-readable yet does not necessarily reveal anything about the card holder, does not require access to any database. It simply indicates whether the card is legitimate or has been tampered with, thereby warranting further inspection. A dozen states representing more than 20% of all driver licenses issued annually are already using ID Mark to improve the security of their credentials.

As you know prior to the passage of Real ID we had had in place a pilot program funded by the U.S. Department of Transportation to demonstrate how digital watermarking can enable law enforcement, retailers and DMVs to more effectively inspect and authenticate drivers' licenses. This pilot is underway in cooperation with the state of Nebraska and if successful should provide an excellent foundation full-scale roll out across the country, in support of the requirements of Real ID in the events with the use of proper licenses as a secured potential (indiscernible) more generally.

As we continue to innovate in using digital watermarking to make secured credentials more effective, we recently announced a new version of Digimarc -- IDMarc -- that can be used to enhance the security of passports and other international civil aviation organization-compliant travel documents. Digimarc will be presenting details of IDMarc to the International Civil Aviation organization's new technologies working group later this month.

The new version of IDMarc provides specific support for securing chip-based e-passports. The IDMarc security feature fuses multiple elements of identity documents into a coherent, secure ID structure. On passports IDMarc linked together printed text, artwork and a portrait with chip resident digital data including the facial image stored on the chip. The feature provides an important layer of counterfeit resistance for IKO-compliant travel documents by offering enhanced protection to both the document and chip against photo substitution, data alteration and attacks on the chip.

This release of IDMarc version 3.0 software has been successfully validated on many leading travel document printers, including the Toppan (ph) MP300 series digital passport printer used to produce the U.S. passport.

Digimarc provides software development kits to enable license vendors just to (indiscernible) securely incorporate this capability to decode the IDMarc feature in the reader device products, including suppliers like 3M Co., and Datastrip.

For decades, Digimarc has been a trusted supplier of critical infrastructure to state and national government. Building from this experience, Digimarc has the expertise to help states comply with a wide ranging number of new technology initiatives, datagathering rules, complex integration challenges and implementation of new processes and best practices required to comply with the real ID Act within the next three years.

These favorable market trends are not limited to North America. Countries around the world are evaluating their ID processes and systems in the wake of heightened terrorist threats and increasing level of identity theft and fraud. As the producer of over 60 million ID cards worldwide each year, Digimarc is well positioned to help the large emerging fragmented international market enhance and standardize it to secure personal identification processes to meet the challenges of the 21st century.

The excitement in Washington is not limited to driver licenses. You may also have noticed the widespread press reports recently about the courts' striking down the SEC mandated broadcast flag. This is another situation where we think we can help. We believe the entertainment industry and the distribution channels should recognize and build upon the effectiveness of digital watermarking as a means of identifying linkage from authorized distribution.

The increasingly popular forensic tracking use of digital watermarking minimizes the impact on authorized use and users while providing effective means to focus enforcement resources where they are most needed. Educating users about the risk of discovery of unauthorized uses, and consequences is a cost-effective means and nicely balances the interest of rights holders in relation to the convenience of fair use expectations of consumers.

Legally, there is increasing recognition of these opportunities in the entertainment and allied industries.

In parallel to the exciting developments in Washington, our watermark and solutions group is engaged in an ambitious product rollout. In addition to IDMarc 3.0 we issued an upgrade to our my fixture mark offering for creative professionals. That includes more robust covert digital watermarking, new digital watermarking, enhanced DRM tracking, and online image storage. More recently, we announced the launch of Image Bridge 2005 with new advanced image identification and search capabilities, delivering Digimarc enterprise customers dramatic improvement within tracking on the Internet.

Stock photo, entertainment, and consumer brand companies publish and distribute valuable images extensively in their online marketing and sales efforts. Image Bridge 2005 provides new search services to track these image assets on the Web, enhance the price, security, and compliance of our programs.

In the mobile area we released a Digimarc Mobile -- Version 1.1 -- in Q1 2005 with an enhanced support for print to Web linking to applications running on the majority of the world's camera phones, shipping in 2005. Digimarc Mobile 1.1 includes a new release of the Digimarc global client SDK with support added for DOJA (ph) J2FD and Finnegan (ph) mobile phone system includes a release of the Digimarc Mobile and better with enhanced digital watermarking technology, specifically tuned for print-to-mobile Web connectivity as well as new embedded plug-ins for Windows and Macintosh for seamless integration in the prepress workflow.

Digimarc Mobile 1.1 is being deployed by Media Grid -- Digimarc's exclusive Japanese go to market partner. (indiscernible) greatest combining extensive experience with 3G wireless content and digital watermarking to deliver a quick fix wireless application the Japanese market 2005.

In notable licensing developments in Barrens, one of our licensees announced the joint offering of its conference media broadcast verification services with DG Systems. DG Systems provide digital and media exchange services for the advertising and broadcast industries. DG's extensive digital network is one of the largest in the advertising and broadcasting industries, reaching more than 5000 advertisers and agencies, over 3400 television cable and network broadcast destinations, and over 10,000 radio stations, delivering management solutions for both short and long form audio and video content.

The bundled service offering marries DG's longstanding market leadership in spot distribution and contra (ph) media's groundbreaking airplay verification and advertising campaign reconciliation services for the top 120 U.S. markets.

Utilizing each company's proprietary network in data management system, the DG come for media bundled service offering streamlines the workflow. Scheduling, watermarking, distribution, tracking, and airplay verification between advertisers and media outlets. On a real-time basis, national advertisers, agencies, and media outlets can access data online to help affect changes -- prior to airing and in-flight.

Post broadcasts, advertisers and agencies will be able to evaluate their media campaigns and buying strategies. Third party detection and verification services allow media schedules and traffic instructions to be reconciled to actual airflight.

France also announced during the first quarter they had licensed the Barrons content management system audio visual watermarking technology to Microsoft. Should Microsoft adopt the licensing technology, it would enable information to be embedded in copyrighted film and video content prior to the distribution. It identifies the content, describes the range of permitted uses, and persists throughout its useful life and can be read and understood by consumer computer devices. Universal Pictures -- a division of NBC Universal -- announced it will be deploying the Barrons watermark throughout its distribution channels including theatrical releases, home video product, pay-per-view, video-on-demand, free air television and other future distribution formats.

As to 2005 and beyond we note increasing interest and attention around media content and digital rights management. Homeland security and antitheft antifraud solutions. These trends are feeling increased demand for patented technologies and solutions and well-established expertise in large-scale secure production systems. We see robust demand in our core markets and expect that the good topline growth we witnessed in 2004 will accelerate in 2005.

Momentum behind the adoption of digital watermarking and increasing with new solutions and customers from our own watermarking solutions unit and the growing success of our licensees.

In ID Systems we should have a strong growth year, too. Our Mexican voter ID program just crossed the 10 million card mark and new customers like Florida, Alabama and Ohio will be reaching full production levels during 2005. We expect a bid on a number of exciting contract opportunities during the year as well. We also are encouraged by federal interest in promoting more secure driver licenses and the possibility of additional federal funding to support system upgrades by our state customers.

Our Company has an impressive range of improvements to offer our customers that bring our expertise to bear on complying with the new law and delivering more secure processes and credentials to improve traffic safety as well as homeland security, and to protect citizens from identity theft and fraud. We believe we can effectively meet these increasing market opportunities while demonstrating substantial progress in financial reporting and improvement of internal controls.

We will be updating investors on these and other matters at several upcoming conferences, including the AEA Microcap conference in Monterey, California today; Morgan Keegan Homeland Security Conference in New York on May 23rd at 1:30 PM; and the S. G. Cowen Annual Technology Conference also in New York on June 2nd at 3 PM.

Thank you, we will now take questions.

(OPERATOR INSTRUCTIONS)

Bob Stone of SG Cowen.

Bruce or Mike, a question on the level of extraordinary spending related to the audit etc. I thought, in your press release, the number was 2.2 million of the year on year increased; and then, Mike, I thought I heard you say 1.2. Can you first clarify that point? Then to what extent do you expect a drop-off in G&A in particular for the June quarter?

The 2.2 was a total G&A increase over the prior year. The 1.2 -- what those expenses specifically related to -- the restatement Q3 and Q4 numbers and the actual audit. The other expenses related to increased headcount on a permanent basis plus a sprinkling of other expenses. I think I mentioned bad debts and security litigation and a few other things -- at about $100,000 each. So that aggregate was 2.2 million increase over prior year.

So what does that lead us to conclude as far as potential decline sequentially in OpEx in this quarter?

We believe it will moderate somewhat in Q2. We are still putting forth a great deal of effort in finishing up the Sarbanes-Oxley this quarter -- obviously in the third quarter review but the extensive legal and accounting we experienced in Q1 is not expected to be continuing. I think it is going to be significantly reduced. I don't really have at my fingertips the true estimate for the quarter. But it will be down significantly.

So to put the question another way, when you get done with all of the unusual activities and get caught up, do you believe that you can reduce quarterly expenses by on the order of a million or some other figure is the right way to think about?

I'm not sure the million is the number. We really have gone to a great amount of detail in future projection but, clearly, we don't expect to spend 1.2 million on these types of things on a go-forward basis. It clearly could be in the low six figures but we're not going to give any more guidance than that.

I can add a couple of remarks in response to your question. As you see, we are experiencing good growth. We expect the growth to continue. Some of the increased spending is permanent, in R&D and in marketing where we are anticipating continuing growth and we are providing some fuel to keep it going.

In the G&A area, we are still quite inefficient as we've gotten over the tough times of last year. We will get more efficient; we haven't yet been able to model the steady-state reliably. But as we get more confidence in what we expect the run rate to be we will be letting everyone know about it. One of the unknowns here is Sarbanes-Oxley compliant cost of small cap companies in general. There are some additional guidance from the (indiscernible) and the SEC today. But for the time being it's kind of an open checkbook for auditors and that will evolve into some kind of reasonable expectation at some point in time. But right now it is a little hard to figure that one out.

A follow-on question on Real ID. Real ID given the three-year time horizon for compliance and the lack of any appropriation does far, on what kind of pays our your your state customers suggesting that they are going to move toward implementation?

We are just about a week past the finding of the loss so it is quite early in the process here. I don't think we have expectations from customers yet but I will give you my sense of things. It usually takes longer to get going on these things than outsiders think should be necessary so I would caution everybody. There won't be immediate uptick in the next several weeks or the next month or two. This is really going to take a while for them to assess their needs. We are going to do assessments of our customers and provide them with opportunities to upgrade to compliance in the structure fashion here.

The general initiatives of some of our customers and our leading ex systems are already in substantial compliance. There are others how ever that are quite far out of date and will require major overhauls. So I think the level of discrepancy between the status quo and the requirements will have quite an effect on the timing of upgrades. In other words the much longer, larger upgrades will take longer to go than the smaller upgrades. We should begin to see benefits fairly quickly. But the substantial growth will probably come in the next year and the year after.

Putting a rough timeline or sales cycle on this, it seems to me there should be three parts, a period of assessment while people figure out what they have to do to get into compliance and then a period for RFPs and the actual selling activity and then beyond set of implementation and revenue impact for the Digimarc and other suppliers. Is it fair to assume that at least a number of months, if not several quarters, would likely be consumed by the assessment and RFP process?

Yes, I think that is quite a reasonable paradigm. If you look at it in terms of the trends for our business, we had 9% growth in '04 where we've said -- a number of times -- we expect a higher growth rate in '05. You can just see this as turbocharging '06 and beyond. The nice growth trends that we've demonstrated should get positively impacted by the Act.

Brian Ruttenbur from Morgan.

A couple of quick questions on the Digi watermarking side of the business, just trying to understand the growth. You stated that 20% of the U.S. states currently have watermarking employed. That's how I understood it and, in the past, I know that a lot of different countries -- I won't say specifically which one or you won't say specifically which ones -- have the watermarking on the currency. I am just trying to gauge from you what the market size is on the government side and maybe we can talk a little bit about the commercial side because you are talking about Universal, Microsoft and all these other potentials.

Maybe you can give me the market size on the government? What you think it would produce for you if you got all the U.S. drivers' licenses or all the passports or something like that?

In terms of government use of digital watermarking, our Central Bank customers continue to represent the majority of our watermarking revenues and they have throughout our history. So they are quite large users and we can't really give a lot of detail on the relationship or composition of the revenues or any of those kinds of things. But in the past, I have described the general structure of that relationship.

The use of watermarking in identification documents is relatively new. We have been engaged in a multiyear development program that I articulated about two years ago. The plan is working very well. We are doing exactly what we said we were going to do and the market is unfolding in the way that we envisioned it. So the general program is to make watermarking embedding available to our issuers at a nominal cost in order to create data-driven application opportunities which we then license.

So we are going to produce some of those applications ourselves, some authentication software products.

We are also going to license others to use watermarking in all of the venues in which it can be used productively for authentication of identification documents. So the Department of Transportation pilot program in Nebraska has 4 classes of scenarios, and the purpose of the pilot study is to demonstrate the effectiveness of the watermarking in a variety of applications at retail, and at law enforcement and DMVs and so forth.

The plan of the Department of Transportation and ourselves and our partner in Nebraska is to engage in those pilot studies during 2005 and to go out in early 2006 and to describe the results more broadly to the market. And that one's going to do a road show. So if you look at the development of the market here, first, was to do the R&D to develop the technology. Second was to gain substantial market share on the embedding side, which we have done. Third is to demonstrate the applications; and fourth is to monetize the applications. So the monetization phase of this will begin in 2005 and really start to take hold substantially in 2006.

As we are doing that in the DMV market and the DL market, as again we said at the outset of the program -- once we began to demonstrate success in that market, we would roll it over into other credentials. And so we introduced the IDMarc 3.0 during Q1 which apply similar technology for use in passports and in particular the chip based passports that are specified by IKO. We are presenting to ARCO in a couple of weeks. We know that they are pretty favorably disposed to finding ways to use watermarking in specifications for international travel documents. So in terms of DL applications we expect that we are going to retrace substantial compliance across the U.S. market and DLs. Thin based on RKO (ph) and other large influencers in the travel documents market we hope that will be able to roll back application into broader travel markets.

In terms of sizing the market, we don't yet have solid basis for sizing the monitor session of the market because the machine verification of identification documents is in its early stage of development. As you know most driver license verification is manual, just a visual inspection almost all of them. In travel documents, frankly, a very small percentage of travel documents are machine verified today which is frightening, in light of concerns about international security. But there is a very strong impetus to improve that verification process and we think watermarking will be one of the key elements.

No one yet has, really, a grip on the size of the market for verification because it's a new market; but we expect that the sum total of revenues and income from the use of watermarking and the verification to secure potentials will be a significant contributor to our profitability.

I guess the last question I have -- just real quick. Quarterly revenue to breakeven, what you see that you need right now with Sarbanes-Oxley and all your additional expenses. I don't think that all the Sarbanes-Oxley costs as I understand the Congress and call is going to go away. That's my first question, the second question is -- what is your goal a year or so out on watermarking? You are doing about 3 million a quarter now. Is your goal to be at 4 million a quarter or is it 10 million a quarter? I mean, what is the near-term realistic goal for that division?

Let me take the second question first because you got the number wrong there. Watermarking revenues for 2004 were 11.5 million.

Yes. I meant 3 million per quarter.

Oh, per quarter, I'm sorry. The watermarking revenues should continue to demonstrate the growth but we'll occasionally have set functions in the nature of early market development for the technology with broad application like watermarking. So you shouldn't expect it to be linear or exponential. You should expect it to show good growth accompanied by set functions. That's what we are expecting.

So when I look at trends that in the future range from good to extraordinary, the good side would be it continues to grow at a healthy rate -- a healthy double-digit rate. The extraordinary is that the step functions occur and it jumps up really big. I can't predict the timing of the step functions nor the magnitude but over the years I have described many ways in which those can occur. And we do expect them to happen.

We are seeing a very nice spreading of recognition of value across the relative market. Entertainment industries getting it now and using watermarking increasingly so we are benefiting from (indiscernible) licensing program. We are seeing increased interest in our image management software application by picture market and image bridge. And we are moving here now to the application phase on the secure credentials, Central Bank business continues the pace.

So we are getting there. I'm pretty pleased about the way in which the general market awareness and the embracing of watermarking is occurring. The revenues naturally trail after the adoption of that, unless there are these big events where we get a large-scale adoption in new distribution and lots of opportunities for those.

As to breakeven, we have just come off of a difficult period with our financial systems and this overwhelming review of our business and regulatory imposition. So I would like us to settle down for a quarter or two before we get more refined in our guidance and in our estimation of how and when we get to our breakeven and profitability. You can see in the composition of the change in expenditures year-over-year here that some of the spending looks like it is going to stay with us, stay in R&D and marketing. And then in G&A, where we clearly will become more efficient and we won't have many of the extraordinary costs we've been bearing. So there should be some moderation in OpEx. But we are not getting more specific on that at this point in time. We will in the not too distant future but you just need to be patient with us for a little bit.

Nick Andrews with Janney Montgomery Scott.

Could you spend a little more time on gross margins, what you expect?

Actually on gross margins, what I would recommend to you, Nick, is to go to the risk factors of the Q we list about a dozen factors affecting gross margins and you can see in those factors that while we should be able to manage our margins to improve them in certain ways and then we carry risks and uncertainties. So our business has I think an unusually complex algorithm for gross margins and double go up and down from time to time for various reasons and yet if you look back on the past year or so they've been pretty steady.

Okay but could you talk a little bit about what you're seeing right now in the marketplace? Competitive pressure, pricing pressure?

We are not seeing much change in that in the past three years. I don't see any trend yet. There aren't that many (indiscernible) to develop a trend out of what you I hope have come to appreciate.

There's far less bidding than theoretically possible and so many of the customers are just sticking with what they've got and doing upgrades and renewals and extensions. So there isn't any price competition in the majority of the business.

When a contract comes up for bid, the customers make their assessment of the relative proportion of technology vs. price and they make a judgment about whether they want to go to a high-quality system or a low-cost system and there is a disconnect there, which is expected and normal in all product and service offerings.

In light of Real ID, I would expect it to be a really bad judgment for states to focus on the lowest cost offering. We saw a couple of years ago some excellent judgment exercised by the state of Florida where they went from a $0.65 cost structure to $1.57 because they wanted to have secure professionals in their state and they went with us as their supplier.

So I think that we have the best offerings in market. We have the most cost-effective solutions and it's not a time for pinching pennies. It is a time for the states to pay attention to the security risks associated with their credentials and the growing value that everyone puts on them.

I think there should be healthy trends within the market but, obviously, other suppliers will do whatever they want to do in terms of bidding for business and we will always be competitive.

Can you talk a little bit about what you think Real ID will do to the gross margins of the Company?

Real ID should have a positive impact on revenues and markets. I was just pointing out the things they really need to care about security that runs throughout the entire process. Not just a better document, but it's a better document and a better process. There is a great need across the market in general for improvements in the overall architecture of issuance. We have been beating the drum on this for the past few years. We've been building products and spending our expertise in these areas because we saw coming with the Real ID Act embodies and that is that driver license is not just a credential indicating someone's passed a road test. It's a very significant broad-ranging personal credential that needs to be as secure as the states can afford to make it.

Now the Feds in the Real ID Act do expressly say that the HS can provide grants for upgrades; they just didn't earmark a specific amount of funding yet. So I expect there will probably be federal funding. States can increase user fees which is what a number of our customers have done to fund enhancements. And then the states to the extent that they don't do one or the other those, we will have to increase their budget. So there will be more products, more of the products will be software, and our expertise and our product offering range, I think, should have a healthy impact on the margins as well as revenues.

So if the Feds will give funding, can you think of that as the gross margins will likely go up then? More so than if the state has to (MULTIPLE SPEAKERS)

Yes I would think so. I would think that there wouldn't be as much pressure as some of the states feel to reach a particular price point, if you like, within their budget or maintain a certain budget because the Federal money will be earmarked for specific kinds of improvements that are identified in the Act. So I would expect the Federal government to be reasonable about allowing customary margins for the delivery of products and services in meeting this national security need.

Steve Lidberg with Pacific Crest Securities.

With regards to the ramp up of Florida as well as Alabama, where are we in that process? And how should we think about cost potentially moderating, related to those ramp up expenses?

Florida is in the later stages of deployment. We should be done around the middle of the year in Alabama, around the same time, maybe a little bit later. Florida is producing revenues already. Alabama is not yet producing revenues. So both of them should be in full production by the second half of the year.

Bruce, is there a percentage that you can give us? Is it two-thirds of what you would expect kind of a quarterly run rate to be or annual run rate to be? Or is it 50%?

Are you talking about issuance volume generally or (MULTIPLE SPEAKERS)?

Yes. The issuance volume and the revenue associated with that.

Mike, I think --

I think we exited the Q1 at probably 40% or so of revenue volume on Florida and we will obviously begin Alabama. We also exited the quarter pretty well fully deployed on Ohio, which was a new contract that we obtained last year.

Deployed in terms of the infrastructure but not yet in terms of revenue?

Actually issuance revenue was pretty well fully deployed by the end of the quarter.

I guess just on the cost side, are there extraordinary costs that you are incurring as a result of the ramp up of these projects? And should we think about those moderating? I would imagine they are hitting cost of goods. Yes or no?

The way the costs are allocated is during the deployment and all the development, those costs are all capitalized which is (indiscernible) capital expenditures during the past four or five quarters. As they move into production real-time, then we do a ProWrite allocation of the cost that had been previously capitalized. So it should be relatively steady on a going out basis. Sure, there is going to be some inefficiencies as people move operations in the first quarter or so; but we think that will moderate over the coming quarters and not be a significant factor.

I guess relative to the ramp up -- the cash ramp up expenses you are absorbing, where does cash bottom for you? As you look out the next quarter or two?

Clearly, we're through the biggest burn rate of cash and we expect it to come down quite a bit this quarter. Haven't really completed the modeling on when that bottoms out and turns positive but it's that plus the entire business model to profitability that we are beginning to focus on at this point. Clearly if you've seen what we've spent over the last 5 or 6 quarters it's about $45 million in total capital investment in most most of the programs.

Clearly we threw the biggest burn rate of cash and we expected to come down quite a bit this quarter. I haven't really completed the modeling on when that bottoms out and turns positive. But it's that plus the entire business model probability that we beginning to turn focus on at this point. But clearly if you have saved what we spent over the last 5 or 6 quarters its about $45 million in total. Capital investment in most other programs.

I guess lastly looking at the states revenue the revenue growth your senior appears to be in the low double digits, low teens type of growth rates of setting that is -- I guess that comparison with regards to international market. What is happening international, with easy in terms of activity there?

The international markets are very large but difficult to predict outside of the mainstream business that we have. Our largest overseas customers are Mexico, UK and Russia. And those provide a solid foundation to the international revenues. Layered on top of that are lots of opportunities. Some of them are sporadic like the voter identification program in Q1 '04 and others of them are steady business like Latvia, which we expected to behave like a domestic issuance customer -- that is, to be a customer for life and provide a steady source of income to us.

So as we look out on the marketplace, we will take the sporadic business when it comes, when it makes economic or strategic sense. But we really would like to continue to develop more customers like Mexico, UK, Russia and Latvia that provide more predictable international revenues. So there will be a little bit of lumpiness mostly on the upside and when those non-recurring opportunities come in we will identify them as such so you guys and your modeling can take that into account. How you account for them will be a matter of preparing individual judgment. You'll view it as normal or abnormal. There are arguments for both but it's in the nature of the business.

And the general trend internationally should be up. Last year was very big growth in national 40-some% of the -- if that's original basis for projection are not that it was a very good year in 2004. We just made a good year in 2005 as well.

One additional question. What RFP do you see standing standing in the U.S. and has there been any change in that over the last quarter?

I'm sorry, Steve, what was that question?

What are pleased to see on marketplace with regard to bids in the U.S. marketplace and has there been any change with states going out?

Are you talking about bids?

Yes.

Indiana has been out for almost a year now and I don't know when and how and if they will reach the conclusion but they put out an RPE and got responses and they have been evaluating them for quite a long time. Texas is in the evaluation stage as well. All the bids have been entered. And on Friday of last week, Virginia issued an RFP. That's it for RFPs; so it's really a small number with two of them having been out for some time now and one just recently issued.

Sam Bergman with Bayberry capital.

Several questions. First of all -- how large is the Florida contract in total?

How large?

Yes.

Florida estimated at $10 million a year and it is a 5 plus 5 contract so it's a 5-year based terms with 5-year extension.

And would that include the service component of the contract?

We charged them on a per license issued basis so essentially it's their estimate of issuance volume times $1.57.

Can you tell me in the R&D spending which is up about $750,000 for the quarter, what programs are in that extra spending there?

We have a number of new product initiatives involving a range of hardware, software, and materials. So for instance, we have a new capture station that we've been working on we are readying for distribution. We have a number of new card structures that are more secure and higher performance in other respects and we have several software products that we are working on. So it is actually a range of products.

Any of them ready to be released?

Pretty close. We will be making the announcement as we get ready for introduction but we have indicated in our materials, the general nature of some of the offerings in the Axion Dual (ph) card line and the Capture Station has been demonstrated at trade shows and described it as not yet shipping.

So in other words the $2.5 million of R&D. Is that expected to continue on a quarterly basis or when do you expect R&D to come down a little bit?

The R&D expenses are a function of our assessment of the marketplace so they may vary from time to time. They could go up or down. We don't see any reason for significantly reducing them in the foreseeable future. That's why Mike said they are likely to stay at the rate they're at. They could go up depending on our assessment of the market.

Have you hired people for the extra R&D?

We have both employees and contractors that are in R&D and we also have materials cost.

The other question I want to ask you is it seems to me that your infrastructure last year was mature enough for the amount of revenue you were doing. Yet you've added so much on on the G&A and sales and marketing expense. I was just wondering why did that happen? Besides the fact the you had an accounting issue.

Let me address that in a number of ways here. First with respect to marketing and R&D. We had investors and analysts have differences of opinions about whether we have invested adequately in those areas. I think you would probably find plenty of people who felt we should have invested more. We invest in R&D and marketing based on our assessment of the marketplace. So when we see significant opportunity we invest more when when we see things stagnating a bit we may invest less. So that's a judgment that we will make that will vary from time to time. That is based on market assessment. So when you see us engaged in robust investment in those areas it means that we are enthusiastic about the marketplace and we see opportunities for good return on that investment.

With respect to G&A, 2004 was an extraordinary year and in early 2005, we are recovering from that extraordinary year. So we have made a lot of changes to infrastructure. We will continue to do that. We need to become not only more effective, which is really the theme of Sarbanes-Oxley compliance requirements, but more efficient. Now in order to get effective really fast which is what the Act requires and what all of the rigamarole in 2004 related to, we have to spend in an inefficient manner. so we are essentially brute forcing the changes to get them done fast and then we will make them more efficient. So as you look at G&A that is what Mike was trying to say earlier. We expect it to moderate but it's not as if the lawyers and the accountants fees go down and if everything is done. We have to become more efficient. What is our optimal run right at that efficient level? We haven't been able to model that yet. It should be significantly better than where we are but I don't know where it is.

We are going to get there as fast as we can get; but the most important thing is to provide reliable and timely financial statements and good data to management to make the decisions. And we are paying a premium right now to achieve those things. A premium we don't expect to endure.

On the R&D expenses and the high expenses for the quarter, what type of revenue would you expect to see long-term from the extra R&D expenses? Where would you be happy with a certain number of topline dollars on the amount of extra revenue that you spent -- extra R&D dollars you're spending? It must have some kind of payback that you're looking for over time.

Yes I can't give you a specific answer on that, Sam. Let me give you an answer, however, in response to your question. Our new card materials that we have been working on are not something that we engage in every year. A number of new cards per year. In fact the last new card was five years ago. So the work that we're doing there is our effort to provide a substantially improved product to our marketplace, not only to gain competitive advantage and hopefully to improve margins but to improve our credibility and opportunities in the global market.

So will we do more such R&D in the future? It depends. It depends on the effectiveness of the R&D we have done thus far. On the financial return that we get from it; and the financial terms broadly defines the terms of increased competitiveness, increased share, increased margins and increased revenues. So it's not as simple as your question might imply, that we will get $10 million additional revenue for the $2 million of R&D. It's really a more complex sort of ROI calculation.

Last question is in terms of your book value is $6.85 right now. You think the board will consider any type of buyback once all the issues are taken care of in the accounting phase?

The question of a buyback is something that we have considered and we don't feel it is appropriate because we -- I and I would say all of us believe that there is a disconnect right now between share price and intrinsic value of the Company that is driven by credibility issues. We need to get off of the problems that plagued us during the second half of 2004 and re-establish credibility; then we think the value will be fairly recognized.

When all of that is done, we will still have half the number of shares outstanding of what we considered to be peer companies for our own valuation analyses. So buying back shares actually aggravates the -- I'll call it the normal problems that we have, which is too few shares outstanding which makes it difficult for investors to accumulate positions.

So although it might be something that we could do in the short-term that might have some positive effect and we do think it would be a good investment for us to make, it would actually aggravate certain long-standing innovations on investments that we have had. So we don't want to do it.

Are you expect the e (ph) to come off the stock in the next couple weeks?

That's up to NASDAQ and they have been understanding and supportive within their own regulatory framework. They are wrestling around with changes in the marketplace. There are a lot of companies that are not compliant with Sarbanes that are late with financial statements because of these kinds of issues. I don't know that I would want to predict what they will do with respect to these issues because I think they are wrestling around with pretty much matters of first impression here. And they've got to reach a good judgment.

Now we think we have told the investment community everything of substance. We have been very forthright and we have tried to provide as much information as we can at all times about what we're doing. We've given our assessment of internal controls but our auditors have not completed their attestation of controls at 12/31/04. So we are not in technical compliance with the Section 404 requirement. So we don't know what NASDAQ will do about that.

The items are supposed to be back -- what? In the next week with their assessment?

We've estimated that it's a number of days. It's beyond our control. We believe that we are done with our work. They have to do their documentation as required by the Act to provide their attestation which we believe will result in an adverse opinion. So we are not -- there is nothing that we are arguing with them about in terms of trying to say anything other than what we have said twice in the 10-K and 8-K that the controls were deficient at 12 '04 and that we are focused on improving our controls, and on achieving a favorable opinion on internal controls for 2005.

Do they have any opinion on internal controls for the first quarter of '05 (MULTIPLE SPEAKERS)?

They don't express opinions in that way. They provide an attestation at year end at each year under Section 404.

There are no further questions at this time. Do you have any closing comments?

I want to thank everyone and just know that we have made substantial progress in the financial infrastructure and we will do all we can to manage the cost on an ongoing basis and as we look out on our marketplace, it is a very exciting time. There are lots of great opportunities for our Company; we're in a good position in our product offerings and service offerings and our general view of the marketplace here.

So it should be quite a good trend going forward in every respect and we should be recovering from the difficulties of the past few years in good fashion over the course of the next several quarters.

I thank everyone for participating this morning and look forward to talking to you again in the quarter.

Ladies and gentlemen, this concludes today's conference.