Digimarc Corp (DMRC) 2005 Q2 法說會逐字稿

Good afternoon I will be your conference facilitator. At this time I would like to welcome everyone to the Digimarc second quarter financial results conference call. [OPERATOR INSTRUCTIONS] Mr. Davis, you may begin your conference.

Thank you. Welcome to our Q2, 2005 financial results conference call. Mike McConnell, our CFO is with me on the call. We issued a press release today announcing our Q2, '05 results. The objections of this call are to summarize and comment on our Q2 results, discuss measures we have undertaken to improve internal controls, review significant business developments and market conditions and provide some visibility on our prospects and plans for the future. This Webcast will be archived in 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 risks, uncertainties and changes in circumstances. These statements will include without limitation statements related to the implications of the Company's second quarter earnings on 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 MDNA section in our recently filed Forms 10Q and 10K, our earnings release posted on our Website and our most recently filed Form 8K. Any guidance we offer represents the point in time estimates. We expressly disclaim any obligation to revise or update any guidance or other forward-looking statements to reflect events and circumstances that may arise after the date of this conference call.

Now, let's proceed with the financial review. As we transition of the troubled times of last year it is clear that the primary growth driver for our business is the quality of service that we provide to our customers and business partners. Throughout our formative years, we have demonstrated a great technical capabilities as pioneers in digital watermarking and a market leader in secured identification credential issuance systems. We are keenly aware that our financial performance is not satisfactory. That path to profitability and growth to us is clear. We've launched a massive quality drive across the Company that reaches far beyond improvements to internal controls and financial reporting.

From our beginnings as a technology driven Company, the unique value and improving quality technologies products and services had created customer loyalties that are delivering long term relationships and associated annuities. Today more than 95% of our revenues come from long term contracts with national and state government customers. Digital watermarking, the technology breakthrough around which we formed the Company, now provides benefits to customers in virtually all areas of our business. As a digital watermarking permeates our business and is combined with other technologies and various solutions, it is becoming less meaningful to characterize a digital watermarking as a business area our division as we have in previous periods.

Digital watermarking is better viewed as a proprietary ingredient akin to the Coca-Cola's secret formula as we build it into total solutions like the anti-counterfeiting system for currency. Integrated into our ID products as and IDMarc and our new ID validation suite. Develop and license technology development platforms like Digimarc Mobile and enables a wide range of solutions from our business partners through licensing of our extensive patent portfolio. Digital watermarking forms the foundation of our business potential banks. It is increasingly being adopted by the issuers of secure personal identification credentials as a unique solution to counterfeiting and tampering. A dozen states are issuing credentials protected by this technology today. And we expect this number to grow as states address the requirements of the Real ID Act and the risk that the legislation is targeting.

Digital watermarking use is proliferating in the media and entertainment industries. There is an ever increasing range of applications built upon the ability of our technology to provide persistent identification of media content. Supporting security and marketing objectives of the producers, distributors and consumers of such content. Photographers, stock photo agencies and marketing departments of commercial enterprises have enjoyed the use of digital watermarking to identify their works on the Internet since 1996. In recent years, our business partners had successfully propagated digital watermarking in music, movies, television and radio. Providing improved management of media assets and associated rights. Resulting in reduced piracy losses, improved marketing programs and more efficient and effective distributions of their valuable media content.

The majority of our revenues from media and entertainment customers comes from licensing our extensive patented portfolio, which recently reached the milestone 200 issued patents. We expect patent licensing to continue to contribute the lion's share of revenues of this area of our business. Like in government programs, our patent licensees are long term business partners. With this fresh perspective in mind we will now turn to Mike for a discussion of the Q2 financial results. Mike?

Thanks, Bruce. And good afternoon everyone. All references we make to financial results for the second quarter 2004 reflect the previously published restatements for the financial statements for that period. Looking first at the income statement for the second quarter of 2005, revenues for the second quarter increased $1.3 million or 5%, to 24.8 million from 23.5 million in the same period in 2004. This revenue improvement was driven by increased recurring service revenues originating from new secure ID contracts in Florida, Mexico, Ohio, Latvia and Alabama. These revenue increases were partially offset by lower product revenues of hardware and film based products that were recorded during Q2, 2004 and that occur from time to time.

Looking at revenues geographically, international revenues decreased $300,000 in the second quarter or 7%, to $4.5 million from 4.8 million in the same period last year. While secure ID issuance revenue increased from our now fully deployed Mexico and Latvia contracts, reduced product revenues from various sources contributed to this small overall decline. U.S. revenues grew approximately 1.6 million to $20.3 million, or 9% over the second quarter 2004, largely from increased domestic issuance revenues from Florida, Ohio, and Alabama. Gross margins for the second quarter of 2005 was 35%, down from 37% in the second quarter of 2004.

Operating expenses totaled 15.2 million, an increase of $5.3 million or 53% above the 10 million incurred in the second quarter of 2004. Operating expenses reflect increased investments in all areas of the business. In sales and marketing, where cost increased from 2.8 million to 3.9 million, we've continued to improve the mix of skills of our sales and account management teams as well as increased our investments in marketing and governmental activities. In research and development, where cost increase from 1.6 million to 3 million, we've enhanced existing products like our latest version of IDMarc and developed new products like our recently released IDDS as we ramp up to meet anticipated demand driven by the recently passed Real ID Act.

Other development projects underway to enhance the security of card materials, add new software security features and build new equipment for our driver's license and issuance systems. In G&A where costs increased from $5, to $7 million we've incurred additional legal, accounting and auditing costs. Including the hiring of additional finance staff in investing in IT to enhance our internal control infrastructure. We're experiencing a temporary increase in costs in our accounting and IT areas including the use of higher priced consultative labor, while we recruit to fill open positions. A majority of our increased G&A costs over the past quarters are associated with the restatement of our 2003, and 2004 financials and improvements in our internal control systems. Amortization of customer intangibles increased from $600,000 in the second quarter 2004 to $1.3 million in the second quarter 2005.

The increase reflects accelerated amortization of intangible balances based on current estimates of useful lives. Changes in contract status and customer relationships may lengthen or shorten the expected useful life or create an impairment of intangible assets. So variations in charges for intangibles will occur from time to time depending on a number of internal and external factors. Regarding the balance sheet at June 30, 2005. We had approximately 37 million in cash and cash equivalents, restricted cash and short-term investments and nearly $39 million in working capital. These amounts compared to 42 million and 43 million respectively at March 31, 2005. And reflect the results of our second quarter operations as well as capital investment in our secure ID programs. Cash used in operations totaled $600,000 for the quarter compared to 3.5 million provided by operations in the same quarter of 2004.

Cash used in operations for this quarter was significantly lower than the $4.2 million used in operations in the first quarter of this year. Total cash consumed during the quarter, including cash used in operations and capital expenditures, was $5.4 million compared to 9.6 million in the second quarter of 2004 and 9.5 million in the first quarter of 2005. Capital expenditures for the quarter were 3.8 million, compared to 13.9 million in Q2, '04 and 5.2 in Q1, 2005. The burnout rate we've experienced over the past two years has begun to decline as the installation of the large 2000 and '3 and 2004 contract wins have been completed or are in the final stages of deployment.

Our backlog, as defined in our SEC filings, at the end of the second quarter was approximately $229 million down approximately 13 million compared to the balance at the end of last quarter due primarily to the natural burn off of revenues previously booked. The decline in backlog largely reflects reduced bid closure activity in the domestic markets. DSO's were57 days in both the first and second quarter of 2005 and compare favorably with 64 days in the second quarter 2004. This concludes my prepared remarks for the second quarter financial results.

Next, I'd like to update you on the status of initiatives to improve internal controls over financial reporting and remedy the deficiencies noted in our Sarbanes-Oxley Section 404 review of internal controls as of December 31, 2004 as described in our amended Form 10K for 2004. Please keep in mind that the deficiencies noted in 2004 did not prevent us from issuing a reliable financial statements due to the employment of extensive compensating procedures that gave us and our auditors confidence in the financial statements for 2004 and the first half of 2005 fairly reflected the financial performance of the Company despite the reported weaknesses in internal controls. As we improve our internal controls over financial reporting we will continue to use such compensating procedures where necessary to deliver timely and accurate financial statements. We are making significant progress towards remediation of those reported witnesses. As part of these efforts we have enhanced our corporate finance and accounting staff.

Specifically, we've hired a Director of Global Tax Compliance, a Director of Compliance and Internal Controls and we've filled several financial management roles in our Burlington and Fort Wayne offices. And currently, we continue to improve internal controls associated with the implementation of our accounting system particularly with the manufacturing and inventory control systems areas. Now, I will turn the discussion back over to Bruce to discuss significant business developments, underlying market conditions and trends and our plans.

Thanks Mike. We're rebuilding our momentum amidst the strong growth prospects in our markets. Our financial statements were timely filed and accurate. Other aspects of operations are improving. Sales are growing, cash flow has improved significantly. And as we work diligently to improve our profitability as quickly as possible, the improvement will come from a combination of cost management, revenue growth and approved efficiency and effectiveness in serving our customers. Here is a broad outline of our action plan for the remainder of the year.

Profitable growth begins with our customers. Digimarc is an expert and leading innovator in drivers license issuance systems. We expect that this expertise will prove invaluable to our customers during the mandatory upgrade to Real ID compliance over the next three years. We are deeply involved with several customers in planning substantial improvements to their systems as we're ramping our marketing and development resources to provide total solutions support for our customers Real ID compliance needs. We believe that we have the most complete solution in the market and the experience and dedication to quality to satisfy the needs of driver's license issuance agencies in a timely, high-quality and cost-effective manner. Profitable growth in the media and entertainment area is dependent on the success of our patented technology licensees.

They too will add maximum value to our shareholders when well supported by our technology and by our evangelism. To earn customer loyalty and we must have loyal and productive employees. To earn our employees' loyalty, we must help them be productive and build a tradition of success. As the troubles of last year showed, our internal business prophecies had not kept pace with our growth over the last eight years. To remedy this, we have implemented quality initiatives across our entire internal value chain including, R&D, manufacturing logistics program delivery and maintenance. Focused on improving cost effectiveness with the dual objectives of enhancing our responsiveness to customers and eliminating impediments to productivity and unnecessary costs. We are doing likewise in the key support functions of finance, legal and human resources.

Along with the quality initiatives referred to above, we are investing in products, marketing and delivering resources that will support all the customers needs. Giving DMV's and policy makers an expert resource and reliable supplier that they can count on to assess their needs, deliver the necessary solutions and stand behind those solutions. Along these lines, we have brought in new leadership in key positions in development, marketing, manufacturing and program management. Most of what we do to enhance driver license security can be applied more generally in secure personal identification systems for other governmental and commercial purposes. In parallel, we are examining means to reduce costs, expand margins, improve cash flow and expedite revenue growth throughout our business.

Let me explain how the focus on customer satisfaction translates into profits. The margins in our driver's license business are influenced by many factors beginning with purchase decision, that is typically phrased in terms of best value. Which in turn is the sum of the valuations on technology and price. These evaluations take place in the context of relationships, good or bad. In good relationships, customers are reluctant to switch suppliers because quality of service is so critical to their success. Vendor changes and complex system purchased pursuant to a multi-year contract carry significant inherent risks.

The expertise and reliability of the supplier thus has tremendous significance in purchase decisions. Influence whether the states engage in competitiveness and the weighting of various criteria in their requests for proposals when they do. We believe that our steadily improving customer service and other demonstrations of our market leadership, will make it clear to the driver license issuing agencies across America that Digimarc is the right choice to guard them through the major transformation of their businesses mandated by Real ID. Being a trusted supplier is more important than ever. Real ID represents a paradigm shift in driver license issuance.

It is a wise move benefiting all Americans not only in protecting homeland security but also in protecting citizens' economic security in light of rising threats of identity theft and fraud. And is enhancing heavy traffic safety by reducing the number of illegal drivers and by helping keep alcohol out of the hands of minors. The latest news on federal funding is that the Senate has passed a measure to provide $40 million of fiscal year '06 funding through the Department of Homeland Security for grants to help states to comply with Real ID. Whereas the House had previously appropriated $100 million. The matter has been delegated to a House Senate Conference Committee for resolution. We believe that a House-Senate Conference will take place after the August Congressional recess. In addition to the anticipated new grant funding from the Department of Homeland Security, we are seeing increasing interest from states and state funded security improvements involving increased funding of DMV's and/or increased fees passed on to citizens in order to help us address the rising identity theft and fraud issues and to otherwise help insure the safety of their citizens.

Delivering on these commitments to our customers, and to the market more generally in the context of strong demand, should drive revenue growth and improved margins. By improving our management and internal alignment we will serve our customers better. The allied improvements and operational effectiveness and efficiency should improve our return on invested capital.

Consider our basic business model. Driver license issuing authorities typically issue RFP's to enter into multi-year contracts, in which one supplier takes responsibility to provide a total solution to driver license applicant processing and driver's license issuance. The supplier generally provides the capital to develop and install the system. Putting those costs on the balance sheet, which is to be depreciated over the initial term of the contract. Revenues are recognized from cash received as driver licenses are issued at a fixed price per license. The issuing authority generally has an option to renew or extend the contract for additional years on similar terms. Most states have the option to continue to negotiate such additional terms as long as they believe doing so serves the best interest of their state.

A few states require periodic open, competitive bidding. Given this market model, margin improvement begins with demonstrating to existing customers that they have the best vendor, providing the best solution and the best service at fair and reasonable prices. This tends to obviate the perceived need for competitive bidding process. Such a trusted supplier relationship minimizes bid and proposal costs for both sides, providing the best solution at lowest total cost to both sides. The efficiency of this process should simultaneously deliver best value to the customer and reasonable margins to the supplier. Given that we typically operate pursuant to fixed-price contracts, the quality and timeliness of delivery has a big impact on margins.

Delivery and under budget, ahead of schedule, with high quality improved margins and speed revenue growth. Delivering late, over budget, and with low-quality does the opposite. We are focused on performing - - on improving performance on all of these dimensions. Our operating expenses are higher than they should be. We are working these expenses down as we transition from a period of unusually high legal accounting and consulting expenses. As we look forward into the remainder of the year we expect to be able to reduce many of the expenses. But some of these improvements will be offset by audit expenses that will be higher than usual due to the anticipated change in auditors and we expect to employ contractors to help us to continue our internal controls and achieve Sarbanes-Oxley compliance by year end.

We currently employ more than 150 contractors who are assisting in various areas of the business. Many of the contractors have been working on delivery of large programs such as Mexico, Florida and Alabama. Our Mexican factories are in full production. Florida is nearing completion. And Alabama should be finished before year end. There'll be a natural reduction in contract labor as these projects end. We're also using contractors in areas such as finance, where we had urgent staffing needs. These positions will transfer to employees as soon as possible.

Management has focused on reining in these costs. Eliminating what is not necessary and hiring employees to do the jobs that have enduring value. Our efforts to improve profitability are broad ranging. Including fueling growth to increase development and marketing and quality and service initiatives. Improving margins to bringing in executives and managers with skills that address historical weaknesses in key areas. And restructuring our existing management and operations to improve alignment, accountability and efficiencies and reducing cost to completing activities that gave rise to extraordinary legal, accounting and consulting expenses as soon as possible. By reducing reliance on contract labor in general and by improving the quality of program management, manufacturing and other functional areas of our business. Alongside of these efforts to improve profitability we are focused on cash flow by optimizing inventories and receivables and by managing our capital projects carefully.

In summary, we have a plan to improve financial performance and are aggressively executing on it. As we do this I am optimistic about the demand profiles in our markets. The key to profitable growth for us is not merely cutting costs, it is in getting maximum share of the uptick in our markets, while simultaneously improving our execution. We stumbled last year and learned a painful lesson. We know what we need to do now, we intend to do it. The strategy is sound. It's all about execution at this point.

Digimarc is very well-positioned to enter an era of prolonged profitable growth. We start with a strong base. With more than 95% of our revenues coming from long-term contracts of government customers for provision of critical infrastructure. Our key customers are state DMV's and central banks. We are the market leader in U.S. driver licenses and provide a competitively unique solutions for leading central banks to protect their bank notes. Given our market leadership we are fostering within Digimarc, a relentless focus on customer satisfaction that we believe should foster profitable growth with increased purchases, lower acquisition costs, better margins, reduced operating costs, strong referrals and increased trust in our recommendations regarding technology choices. We believe that you will see the competitive advantages of this customer first orientation and the resulting customer loyalty as the supplemental funding from Real ID and a wave of security upgrades by driver license issuing authorities across America hits our core market.

Real ID is an inflection point that will engender substantial concerns among our customers about the implications of the mandate on their budgets, Business process and quality of service standards. The confluence of these concerns and our heightened commitment to customer satisfaction, should lead to strong partnerships with our customers. Translating into mutual supportive learnings relationships that will support a mass customization approach to transitioning the market from highly fragmented state by state architectures to greater degrees of standardization and basic building blocks. While maintaining individual state identities and accommodating necessary variations in business prophecies and interfaces to other state systems. To build such trusted relationships we must deliver high-quality products and services at reasonable prices. And continue to evaluate and deliver a stream of technological innovations to our customers that are consistent with our market leadership. Most importantly, we must continuously earn the trust of our customers and the citizens they serve through secure reliable cost effective solutions to their needs. Our customers want to rest easy at night, it's our job to deliver this peace of mind.

Looking back on Q2, there were no announcements of significant contract wins or losses in our core market. We did receive a number of intents to award notices of contract wins. Such winds are subject to final contract negotiations. Our practice with respect to such developments is to defer announcements until the contracts are executed. In addition to the increased demand for products and services that will be driven by the Real ID federal legislation, we expect significant opportunities for competitive wins.

Illinois, the second largest issuer that is not already a Digimarc customer, recently issued a request for information, signaling that it is considering going to competitive bid. North Dakota another state served by competing supplier, has issued a request for proposals. Georgia, North Carolina, South Carolina may also go to market. Bids are in process for Digimarc customers Indiana, Virginia and Texas. Massachusetts, a Digimarc customer issued RFP's for biometric and document validation solutions recently. We responded in July and are awaiting the results of the bids.

Our response included the Digimarc ID validation suite, announced earlier this year. Several other states are expressing interest in our outlook and verification solutions that address these needs. We are synthesizing our outlook and verification solutions into a modular and comprehensive suite that includes biometric analyses, document authentication and data verification. That can be customized to meet the needs of customers regardless of the source of their overall systems. We're the largest supplier of facial and finger biometrics solutions for driver license issuance in America. We're moving aggressively to round out our leadership by providing the most comprehensive and effective document authentication platform. Our IDDS is supported by growing number of strategic partnership with Joicpoint(ph), SysCan, SureTech and IntelliChek, so far.

We believe that the combination of these comprehensive and modular applicant verification solutions, with our market leading system integration skills and experience, should make Digimarc the clear choice to satisfy Real ID requirements for applicant verification. In other areas of our business there were many encouraging developments during the quarter. Our non-governmental revenues come mainly from patent license fees paid by business partners providing innovative media management solutions to customers in the media and entertainment industries. The foundation of those revenues is our high-quality patent portfolio, which recently surpassed the milestone of 200 issued patents.

During Q2, seven new patents issued as we continued building for the future by filing 26 new U.S. patent applications in the quarter. We have over 400 U.S. patent applications pending. Representing an enormous body of innovation regarding secure identity and media management technologies and process. There were good signs of growing enlightenment in the media and entertainment industries about the value of digital watermarketing and the management of media content. Among other things, in a recent announcement, the Digital Cinema Initiative, a joint venture of Disney, Fox, MGN, Paramount, Sony Pictures Entertainment, Universal and Warner Brothers formed in March 2002, issued a specification including the use of audio and video digital watermarks as an important element of security for digital cinema.

We anticipate that digital watermarking will be used as a forensic tool to help identify theater, location, production version and even the date and time that a film plays at a specific theater. Regarding awareness of recognition of digital watermarking as viable, cost-effective means to identify media entertainment concept to help curb copyright infringement got a boost last quarter in the US Supreme Court ruling in the landmark copyright infringement case of MGM versus Grokster. Coincidently, the day after the ruling, Digimarc gave a presentation together with the Motion Picture Association of America before the Congressional Entertainment Industry's Caucus in Washington D.C. on the benefits that the entertainment industry is reaping through content identification solutions like those enabled by digital watermarking. In the course of the June 27 ruling, digital watermarking was identified as one of the three technologies that could be used by race holders in peer to peer file sharing companies to deter piracy of copyrighted entertainment content.

This important ruling paves the way for content owners and P-to-P networks to consider digital watermarking as a solution for identifying and deterring piracy. We recently renewed and extended our multi-year licensing agreement with long time partner Activated Content an important provider of audio watermarking products and solutions. Activated Content's products are incorporated in more than 2 million audio tracks from record labels to identify and track leaks of promotional pre-released music on to the Internet. The expanded license field of use will permit Activated to extend its solutions to help the industry address privacy concerns surrounding business to consumer downloads and the use of music in games.

During Q2, Nielsen Media Research acquired Audio Audit. One of our licensees, which was using audio watermarks to provide advertisers and ad agencies with the capability to perform real-time broadcast performance management and tracking of television commercial schedules. We are in the process of signing the Audio Audit license to Nielsen. They have already begun making payments under the license to be assigned. Thompson, a major supplier to television and movie producers continues to acquire Digital watermarking capability. After acquiring MediaSec(ph) earlier this year they acquired NexTam(ph) a source of video watermarketing based technology for media management.

In summary, we are building on our market leadership and driver's license issuance systems and continuing technological innovation in serving government customers; with our Company well-positioned in the mid to a fast-growing market for secure identity and media management solutions. I believe there are good opportunities for margin expansion as we leverage a growing revenue base against a broader product portfolio, efficiency gains in operations and greater collaboration with customers and business partners. The operational aspects of our business are settling down and improving. At the time when SEC filings has returned to normal and we have made significant progress in improving internal controls. We are re-engaging full force of our resources on expanding our market leadership in secure media and identity solutions. The opportunities for our driver license business has never been greater. Real ID federal legislation will fuel demand for new, advanced identity management products and services among our existing customers who account for the substantial culture majority of the market targeted by the legislation.

In the media entertainment sector, we are encouraged by the continued success that our business partners, operating under licenses to our extensive patent portfolio, are having in propegating digital watermarking based applications across movies, music and television contents. Over the next 2 to 3 quarters we anticipate continued fluctuations in expenses from legal, accounting and consulting costs associated with defense of securities litigations filed last year, bringing new auditors up to speed, achieving Sarbanes Oxley compliance for 2005, completing the rollout of some large programs and transitioning certain responsibilities from contractors to employees. As these matters are resolved, we expect to see increasing leverage from growing revenues, careful management of expenses and cash flow, a broadening of our product portfolio and the likely influx of federal funding into our core market. Thank you. We will now take questions.

[OPERATOR INSTRUCTIONS ] The first question is from Rick Owens of the Robins Group.

Hi, guys. Can you hear me okay?

Yes.

Bruce, In the past year talked about your expectation or belief anyway that 2005 revenues could grow faster than we saw in 2004. And if I look at the first couple quarters of the year, and it seems to suggest a pretty good ramp up in the second half of the year if you still believe that statement to be the case. Can you talk a little bit about what your expectations are going into the second half of the year for the top line? And whether within that belief you see or believe you will start to see some benefit from Real ID towards the latter part of the year?

Yes. We still are targeting a higher growth rate in '05 and '04, which was higher than '03. And the domestic driver's license issuance business is seasonal and so we will see the third quarter typically be the highest quarter in revenues. And the fourth quarter we will experience a drop off in domestic issuance volumes. And those represent the majority of our total revenues. And so we would expect to see continuing growth with that seasonal element to it the second half of the year. What is uncertain about Q4 then is, potential impact from Real ID on that normally seasonal quarter. And we see a lot of interest among the states in developing plans to deal with the mandate of Real ID upgrades. And also independent and in parallel to that concern, concern about security of the driver's license for all of its uses. And so it's a very healthy demand environment in which we could see a substantial amount of business as early as fourth quarter, beginning to happen. Now, the Conference Committee has the funding initiative for its consideration when they return from recess. The federal fiscal year runs from October to September. And so if they act promptly to resolve their differences, and they then enable DHS to disburse funds pursuant to grant applications from the states, there could be funding made available in the fourth calendar quarter of this year, consistent with the '06 funding preparation. So there may be federal money as early as fourth quarter.

But it sounds like you consider that more upside to what your thinking is if that were to pass?

Well, I had said previously that I thought the impact of Real ID would most likely be felt in at '06 starting in the first half of '06. What I'm saying today is there some possibility that some of that uptick may begin earlier but we still are focusing in terms of likely timing in the marketplace on the first half of '06 for the beginning of a substantial flow of federal funding.

Perfect. Thanks.

Next question is from Eulia Julin of Morgan Keegan.

Can you hear me?

I can hear you fine.

I was wondering if you could talk a little bit more about R&D increasing going forward? It going to increase at the similar revisited at it did this quarter or how fast do you think it's going to accelerate?

R&D will fluctuate and it depends on a couple of major factors. One is the amount of programs that are underway and the selection of particular resources to work in them. In which case those R&D engineers would be capitalized. And on the other hand, our product development plans also influence R&D expenditures. So. at this point I wouldn't suggest that your make any linear assumptions about R&D. The more than it will fluctuate from quarter to quarter, depending on the mix of capitalized uses of that labor and expensed uses of that labor. and the relationship between in the market needs and our product strategy. And we are ramping up for Real ID, so we are investing and we're also winding down from some programs. But we are actively engaged in some bids. And so if we win some new business, then some of the R&D resources will be deployed in those bids and thus we will move to capitalized labor.

And your product development efforts, are they only going to be focused on Real ID opportunities or anything else?

The R&D runs across the organization at including the media and entertainment area. They'll work with central banks and with other government customers. Because of the skew of revenues in our business, the majority of those resources would be deployed on secure credential products and services.

Okay. You mentioned something about backlog. Could you repeat that I didn't really catch if you said where it's going or how much it was?

Sure. This is Mike. Our backlog at the end of the quarter was approximately 229 million and - - reduced from 242 million from the previous quarter is due primarily to natural burn off. We also referred to kind of a low activity quarter bringing bids to closure. As we closed bids as Bruce referred to, we're making some great progress working on contract stage that will then increase at backlog. But it dropped a little bit because of natural burn off.

So it's not 229 million?

That's correct.

In terms of your revenue this but, do you intend and providing the split between ID Systems and watermarking going forward for this quarter?

No, we're not going to do that anymore Eulia. Let me elaborate a little bit on that. We had maintained a distinction - - or tried to maintain a distinction between what was conceived of a few years back as the legacy business when we acquired the SS from Polaroid Corporation in December 2001, people sort of wanted to track what the old business was and what the new business was. Well, now about four years later, we're using watermarking in everything we do. And one of our important initiatives in our Company of simplification of our accounting processes. And so it would become debatable in future periods sort of how you valued watermarking in all the areas of the business because it's used everywhere. And I don't want to engage in those analyses because I think it's subject to disagreements and unnecessary expense. We provide watermarking in solutions, in technology platforms and in IP licensing. And so we mix watermarking with other technologies and the solutions and the technology platforms. And so it's not as simple as saying there's watermarking revenue and then there's other revenue. And we no longer have manage the Company along with those historical lines. So it has no management relevance and it's subject to debate in the terms of efforts to characterize it to the public. So we're not going to do it anymore.

And the last question about the cash burn it going forward, how fast do you think it will improve?

We're doing all we can to improve financial performance on all of the significant cash flow and P&L. And we prefer not to try and estimates the short term changes. We will just leave it at we're going to move in an expedited fashion but with good sense in regards to the significant market opportunities that face us. Unlike some companies who might want to cut expenses because their markets are weak, our markets are very strong. We've just gone through kind of a traumatic period in which we burdened ourself with lots of costs as we've dealt with an extraordinary situation. So we need to moderate those costs and back down but do it in a way that doesn't impede our ability to capitalize on the growth that's in front of us.

Well, thank you.

Thanks.

Our next question is from Russ Silvestri with Veritai(ph) Capital.

You've given me lots o f qualitative assessments and round things. But when are we going to see some real numbers in terms of returns? You increase your sales and marketing by 2.5 million. Your talk about your efficiency improving in your press release. You don't give me any numbers to anything to measure it by. And you're kind of loosy goosy go through this in a rather obtuse manner. And I don't understand why can't put out a year target in terms of what you might to expect to do or your goal? You 150 contractors, I'm not exactly sure of what your total labor force that represents. But that seems exorbitant given the size of your Company. And you also talked about being more responsive to customers can you give me some kind of quantitative measure that actually demonstrates that other than you just saying it?

You raise a lot of points let me see if I can address them all. If I miss any let me know and I will follow up. We choose not to give forward detailed financial guidance because we consider it to have a bad return on investment. That is that our shareholders by and large are long term holders and - - who have a strong belief in the strategic value of the Company and our ability to move to a position of profitable growth and sustained it. And we actually are not very interested in having companies who are interested trading quarter to quarter in our shares as shareholders. And so that means the quarter to quarter guidance, unless it's used as a leading indicator as trends, is risky and distracting and has obviously proven a challenging for us in the past. There's a substrate of substantial predictability in our business but the quarter to quarter variations as you've seen if you look back in our history tend to move up and down in ways that don't indicate trends. So that you can view it as a little bit of randomness in the quarterly fluctuations. But we intend to demonstrate then you can already - - I think see in the long-term trends in annual and longer trends that we're heading in the direction of continuing growth. And except for the disruption of 2004 due to extraordinary circumstances heading in the right direction in terms of general financial performance.

I disagree with your characterization of what we've told you. We've spent a great deal of time in the 10Q and in the conference call describing our business model economic model great detail in great with great specificity. If you'd like to apply that to to historical numbers and published results I think you will find that it's quite elucidating. And we are carrying out quality initiatives across the Company. You mentioned one of being responsive to customers. We've been reorganizing our Company to have a greater and customer focus. As an example of that we just this week had our new Vice President of Programs start, was expert in program management, who is a focused on improving the quality of our deliveries to our customers and the timeliness of the deliveries, among other things. And so we already have had a number of customers complement us on the work we've done in the past several quarters on becoming more responsive. And we expect to do much better with Tom on board, our new VP in that area.

We've also moved Scott Carr(ph) who was the President of Watermarking Solutions into the position of Vice President of Marketing and Business Development and Product Development for our Government Customers. And taking advantage of his long standing senior executive experience here with the Company to move our business along in a rapid and effective manner; to establish ourselves clearly as the key supplier for Real ID compliance. Those I think our answers to most of which you said I don't think I missed anything.

Some of the customers' response, people are complimenting you but it's nice that they complement but are they going to pay for it and it - -?

Yes, they are. Without getting down to this specific account level. Yes, some of the customers that have been complimenting us have been telling us because of the expertise and the sensitivity and the dedication, the quality that we're demonstrating that they see us as their experts. Their business partners. The people who are going to help them move to move through the requirements of this mandate without any sacrifice in quality of service and with a reasonable budget and so forth. So yes, the customers have been translating those good feelings into money.

And my other question is; if a state is not complied with Real ID, what does it mean to that state? Are they going to lose federal funding is there any - -?

The legislation says that a non-compliant state's citizens will not able to use their drivers' licenses access to federal facilities. And they mentioned specifically as examples federal buildings and airplanes. So they haven't sort of fleshed it all out but I imagine when they do that if you think of federal facilities quite generally, if airplanes are federal facilities that means interstate commerce. And so I suspect that drivers' licenses wouldn't be terribly useful if it wasn't compliant a few years from now. And they give it till May of 2008 to gain compliance.

And I guess one of the last things to followup on that. In terms of the funding - - you said the Senate, I think had voted for a 100 - - or the House had voted for 100 and the Senate was 40. I think originally when I saw you last you talked about the cost to implement this thing around 500 million in that neighborhood as I recall. And I may be wrong but where is the shortfall get made up?

Your recollection is good, Russ. What we said last time when we spoke was that the National Council of State Legislatures have estimated $500 to $700 million of expenditure necessary in the five years or so. And so 100 million would actually be quite consistent with their estimate of 100 million per year it.

I see.

So the Senate right now is quite low in relation to those estimates. But I also have to say that the individual states have been developing estimates and some of them have been substantially higher than that number would indicate. And the choice of technologies hasn't been made yet and so there are also lots of opportunities for higher cost solutions to be recommended by DHS. So the budget aspects of this will get a clearer over time. But those are the early estimates. And we as we do our account plans with our customers will develop a pretty strong sense of what the costs are likely to be, that process won't be completed for a while.

And what's the total headcount at the Company excluding the contractors?

Excluding the contractors around 425.

425?

Actually Russ, thank you for bringing that up because I forgot to address that part of your question. On the contractor piece, we have contractors across the Company right now in lots of functions. And there was some tradition in using contractors in programs. And there are some requirements occasionally for using contractors in programs in order to satisfy state laws. But we did also in dealing with the issues that we had last year bring on a substantial amount of contract labor to fill urgent needs. And that's the point that we made in our script is that as those needs become satisfied, that part of the consulting and contract labor will go away. In other cases the contractors will be converted into employees. And then at the end of the day there will still be some left that will be appropriate to the way in which we conduct our business. But overall you should see a substantial reduction in that area over the coming quarters.

Thank you.

[OPERATOR INSTRUCTIONS] Our next question is from Kevin Enrehan(ph) of Harold Brown.

Hi Bruce, hi Mike. I guess I should congratulate you on getting a quarter out on schedule.

Thank you.

Yes. I hope that's purely incidental in the future should there be anything else you might want to congratulate us on.

So like in October and in future quarters we should expect you to be on schedule? You think most of the problems in the past are behind you?

Yes. I don't expect this to be an issue going forward.

Okay. That sounds good. I know you were presenting at some investor meetings yesterday and some tomorrow, Bruce. Will either of those presentations be available on the Website for all investors to look at?

The two meetings that were held yesterday were the Pacific Crest Conference in Vail and then AEA Investor Tour here in Oregon where investors came over to the Company. And the Pacific Crest press conference I believe is a Webcast. I was told it was. And our local conference I don't know of offhand, I believe that is was being Webcast but I'm not certain of that. And then tomorrow I'm presenting at the Unterberg Conference in San Francisco and that I believe will be Webcast as well.

The TechFest?

The TechFest, yes.

I will look for that in the Webcast. that sounds good. I was looking through the proxy from this year, and I see that Mesama(ph) as well as Lecop(ph) have an exception, if you would, they can own more than 15%, which is your rights agreement commonly known as a poison pill. If another entity bought out Mesama's stake, tried to go hostile on you at these low valuations would the pill automatically kick in? In other words the exception is only for those entities stated?

It is only for those entities stated. There were grandfathered into the policy given their holdings at the time that we implemented it. But it's a personal to those investors.

Can those investors increase their stake or do they have limits as well?

We gave them a little bit of room to increase consistent with portfolio management.

Okay. And lastly, and don't take this the wrong way, there's a lot of M&A activity out there and obviously the value of Digimarc has come down. I think it's a bargain, given the problems that you've had. And you said you didn't like to have short-term shareholders and the Sarb-Ox costs, the costs to comply with the Sarb-Ox and the other regulations, would consider taking the Company private so you no longer had to file and comply with Sarb-Ox?

Well, I work for our shareholders I want to do what's best to increase their shareholder value. At this point in time we think what's best is to serve our customers well and to improve our financial performance and to grow with a significant rate. We're facing robust markets. We think we are getting over the hump here. We know what we want to do. We believe we're capable of delivering it. And so we're driving hard to achieve those objectives for our shareholders. So I don't think we need to make a fundamental change in the ownership of the Company in order to deliver good results. I think we as management need to do our jobs and deliver well to our customers. And as I explained, if you run through our model, good execution runs through every aspect of the financial statements. It's not merely a cost issue in terms OpEx or gross margin but everything gets better we things well. So we are absolutely intent on doing that.

And can you give us an update on the audit committee, are they still searching for an independent auditor?

We are in the process of interviewing and audit firms to replace KPMG. KPMG will be resigning shortly, as we had announced previously, now that the second quarter is completed.

Okay. And you brought on three new Directors this year. Is that correct, Bruce?

We did very high-quality, experienced gentlemen. And they are all experience in managing public companies and in serving on public Company boards. And they are experienced in those areas in companies of the scale that we aspire to meet. So they can help guide into the future as we continue to grow and deal with the requirements of increasing scale as a public Company.

And do you think they will be able to help you alleviate some of the issues you had before including the Sarbanes Oxley compliance in the accounting and auditing?

Yes. I think they're going to serve the shareholders well in the traditional functions of Directors in terms of oversite and advice. And they have already been very helpful in offering advice to us and in sharing their observations about how to best deal with the circumstances that we have. So I'm very excited about these new Directors and the contributions I expect they will be making.

Good luck. Thanks.

There are no more questions at this time.

I would like to thank everyone for joining us on the call today and look forward to speaking to you again from time to time between now and the next call. And I just want to reassure you all, we're doing all we can. And we think we have a good plan and we have excellent prospects in our markets. And so we're very excited about the future and very pleased to be done with the distractions of last year. So, thanks to everyone and I'll look forward to talking to you again soon.

Thank you for participating in today's conference call. You may now disconnect.