Digimarc Corp (DMRC) 2005 Q3 法說會逐字稿

My name is Miles, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Digimarc Corporation Third Quarter 2005 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a Q&A session. [OPERATOR INSTRUCTIONS.]

Mr. Davis, you may begin your conference.

Thank you. Good morning, ladies and gentlemen. Mike and I are in San Diego at the AA Financial Conference, since I hope the quality of the call audio is good. I want to welcome you to our Q3 financial results conference call. We issued a press release yesterday announcing our Q3 financial results. The objectives of the call are to summarize and comment on these results, discuss initiatives regarding improvements to various business processes, review significant business development and market conditions, and provide some visibility on our prospects and plans for the remainder of 2005.

This webcast will be archived in the "Investor Relations" section of our website. Before we proceed, I'd 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, assumptions, uncertainties, and changes in circumstances. These statements will include, without limitation, statements related to the implications of the Company's third 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 MBNA section in our most recently filed Forms 10-Q and 10-K. Our earnings release posted on our website are most recently filed with the Form 8-K. Any guidance we offer will represent the 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 let's proceed with the review. There were many positive developments in Q3. We've had record revenues as well as lower operating expenses, improved gross margin, reduced loss per share, and significantly smaller decrease in cash. Cash flow from operations turned positive following a sequential trend of improvement since Q4 of last year. The overall decrease in cash continued lower for the third quarter in a row, coming in at $3.5 million, due to $3.7 million in program investments, down from $5.4 million in Q,2 and $9.5 million in Q1. Continuing improvement of financial performance is a function of fostering growth while enhancing productivity. The lion share of the cash spent in the past 2 years has been for funding investments in new customer installations, primarily in Florida, Alabama, Mexico, and Latvia.

All total, we invested $40 million in 2004 and we expect to invest a total of about $15 million in 2005. The cash loss from operations in 2005 thus far has been about $4.6 million. We have $33 million in cash on hand. The $55 million invested in programs in the last 2 years is largely due to the acquisition of new customers, including large capital programs in Florida, Alabama, and Mexico. These are strategically important wins and fuel the Company's $200 million-plus backlog. The positive nature of these investments may have gotten co-mingled in the minds of some investors with the difficulties that we had last year and the associated escalation of operating costs.

Capital investment is a normal part of our business. We've had extraordinary marketing successes in 2002 and 2003 that led to an unusually high rate of capital investment in 2004 and soms carryover into 2005. As you can see, the pace of capital investment is coming down, as installation of these programs are being completed. Coincidentally, the cash operating losses are decreasing. We expect all pending major capital programs to be completed by year-end. We expect that the favorable trends in cash flow will continue. We believe the primary growth drivers for our business are the quality of service and innovation that we provide to our customers and business partners. But more than 95% of our revenue is coming from long-term contracts with government customers.

We are committed to building customers for life by exceeding their expectations on all levels and delivering high-quality, innovative solutions, products, and services at reasonable prices. Like in government programs, our patent licensees in the media and entertainment area of our business are also long-term business partners whose loyalty we earn by adherence to the same principles of customer service. The path to profitable growth also requires that we continue to improve productivity as we support this probe. Our aim is to return to profitable growth as soon as possible and sustain a superior return on investment for shareholders. We're focusing a great deal of attention on right sizing our cost structure to our revenues and margins.

Mike will now discuss the Q3 financial results. Mike.

Thanks, Bruce, and good morning, everyone.

We released our third quarter 2005 financial results yesterday and we achieved record revenues during the quarter with year-over-year and sequential increases of 14% and 8%, respectively. The increases were driven by 2 factors. First, with respect to sequential growth, we experienced the high point of our driver license issuance seasonality model, where third quarter issuance revenues are usually the highest in any given quarter during the year; and second, with respectable sequential and annual growth, we realize the benefits from near full deployment of our newer driver license contracts in Florida, Alabama, and Ohio. Looking at revenues geographically, international revenues increased $1 million in the third quarter or 23% to $5.4 million, from $4.3 million in the same period last year, primarily due to increased issuance volumes from our Mexico program, and large hardware sales to another Latin America country.

U.S. revenues grew approximately $2.2 million to $21.4 million, or 12%, over the third quarter of 2004, largely from increased issuance revenues from Florida, Ohio, and Alabama. Consolidated gross margin decreased year-over-year by 3 points, and increase from quarter-to-quarter by 3%. In looking at these changes, we note that the variable cost of goods sold for the delivery of incremental revenue has remained relatively constant from period to period as a percent of revenue. These costs include the cost to produce our identification cards and the cost of hardware, consumables, and software related to our product sales.

The year-to-year change in margins is largely a function of the increased cost of deliverying on some of the key strategic account wins, where we have provided a complete system replacement with a broader mandate than in those previous systems. These installations were different and more complex than prior programs. While we ultimately were successful in these deployments, we ended up with costs that were higher than would have been customary. As a result of these investments, we have developed a new expertise that we believe enhances our market leadership and growth potential.

In one other case, we bid a program at relatively low margins as part of a market development strategy that we believe will yield good long-term performance. The fixed costs of these systems, which include amortization and depreciation of costs capitalized during the delivery process, as well as field service and operational costs to manage and maintain them, are higher than average and thus reduce reported margins. Due to competitive considerations, we choose not to provide greater detail on account-specific strategies, but we do anticipate that we will be able to improve margins in these accounts over time and are a good return on investment over the life of the account relationships.

The margin improvement from Q2 to Q3 is primarily due to the benefit of seasonally higher issuance revenues that primarily carry only variable costs, which are lower, as a percent of revenue, as compared to a fixed cost.

The current level of operating expenses reflect increased investments in all areas the business. In sales and marketing, we continue to enhance our sales and account management teams, bids and proposal efforts, and marketing and public policy initiatives to improve our sales effectiveness. In research and development, we are investing in the creation of standard products and offerings for secure card, biometric, and enrollment solutions. We believe these standardization efforts will result in lower delivery and support costs and quality improvements for future contracts and also change the product mix in ways that improve gross margins over the longer term.

Our G&A costs moderated a bit from prior quarters, as the legal and accounting costs associated with our restatement are winding down. Our costs include the use of higher-priced consultatative labor, while we have filled open positions in finance and train new staff. We are beginning to reduce reliance on the consulting resources and expect to largely eliminate these costs during the next 3 to 4 months. The non-cash charge for amortization and customer intangibles increased over the prior year, due to changes in estimates of useful life for certain specific account balances.

There's a balance of $18 million in the customer intangibles account on the balance sheet. As expected, that the majority of the balance will be fully amortized by the end of 2013, subject to adjustments due to changes in contract status and other aspects of customer relationships that may lengthen or shorten management expectations as to useful life. The customer intangible is a carryover of a presumed bargain purchased element from the acquisition of certain assets deployed in 2001.

Turning to the balance sheet at September 30, 2005, we had approximately $33 million in cash and cash equivalents, restricted cash, and short-term investments and nearly $36 million in working capital at quarter-end. We had cash flow from operations of $300,000 and EBITDA of $1.1 million. Total net cash expenditures were $3.5 million, and the use of cash included $3.7 million of capital investments, primarily attributable to programs that will contribute to future revenues. The improvement in overall cash flow is primarily due to the lower operating loss.

DSOs, based upon average receivables outstanding, were 52 days for the quarter, compared to 62 days in the third quarter of 2004. This significant improvement is due to improvements in our billing and collection processes, improving customer satisfaction, and better account management. Backlog, as defined in our SEC filings, at the end of the second quarter was approximately $212 million, down approximately $17 million, compared to the balance at the end of last quarter, due primarily to a natural burn off of revenues previously booked. The decline in backlog largely reflects reduced bid closure activity in the domestic markets during the quarter. More than $20 million of our Q4 revenues are currently in the backlog. We expect the net backlog to increase in Q4 by at least $18 million, given that we've already closed over $38 million of business in the first month of this quarter.

This concludes my prepared remarks on the third quarter financial results. On the process side of finance, I'd like to update you on the status of our initiatives under Section 404 of Sarbanes-Oxley to improve internal controls and remedy the deficiencies noted in our 2004 review of internal control. As a reminder, the deficiencies noted in the 2004 year-end report did not prevent us from issuing reliable financial statements, due to the employment of extensive compensating procedures that gave us and our auditors confidence that the financial statements for 2004 and the first 3 quarters of 2005 fairly reflected the financial performance of the Company, despite the weaknesses in internal controls that were identified.

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 until the remediation is completed. We continue to make significant progress towards remediation of those reported weaknesses and particularly focusing on enhancing the depth and breadth of our corporate finance and accounting staff. In addition, we have focused on the remediation of critical accounting processes related to our manufacturing and inventory control system areas, as well as enhancing the rigor and thoroughness of our monthly close and consolidation processes.

Before turning the call over to Bruce, I'd like to give some guidance concerning our expectations for the fourth quarter and make some comments regarding estimates of analysts concerning the quarter. Four analysts have published estimates for the quarter with projected revenues ranging from $24.9 million to $27.8 million, and loss per share between the $0.18 and $0.24. We expect that Q4 revenues will be in the range of $23.5 million to $24.5 million, and for the loss per share to be in the range of $0.30 to $0.35. As we look at the endless models, we see considerable variability in a number of line items. We attribute the variability to the unusual circumstances of the Company over the last year or so and not being in a position to provide guidance during this period.

While we focus on assessing and enhancing our internal accounting and control processes for several quarters, we provided little guidance to analysts to help in shaping their models. We appreciate the effort of analysts covering the Company to try to provide views of the business during the difficult period that we went through. As our circumstances continue to improve, we believe that we are now in a position to work more closely with our analysts in the coming quarters to help them gain a better understanding of our business model, leading to improved analyses and forecasts from these financial and industry experts.

In examining the differences between analyst's estimates and our estimates for the quarter, we believe that a significant portion of the difference may be related to understanding of the seasonality of our issuance revenues. Issuance revenues, which historically have accounted for 60% to 70% of our total revenues, are seasonal. The fourth quarter is generally the lowest quarter of the year for such revenues. Historical data on issuance revenues indicates that these revenues are generally greater in Q3 and lowest in Q4. We have discerned the following general patterns in issuance revenues during the past 5 years. Q1 increased over Q4 by about 8%; Q2 increased over Q1 by about 4%; Q3 increased over Q2 by 6%; and Q4 declined from Q3 by approximately 11%. Keep in mind that these are averages over the last 5 years, and while useful for modeling, they may not be indicative of future trends, given that many factors are involved across our customer base in creating such patterns.

It is important to note that while a substantial portion of our revenues are seasonal most of our costs of sales are not seasonal. Thus, the seasonal revenue decline and steady fixed costs were generally combined to cause a quarter-to-quarter reduction in gross margin in earnings from Q3 to Q4. With respect to Q4 '05, we expect that seasonality, revenue and exchanges, and costs associated with some large programs, as explained earlier, will result in a lower gross margin during the prior quarter and a year-ago period. Seasonality explains most of the decrease in gross margin quarter-to-quarter, as fixed cost of operations and straight-line depreciation are applied to the seasonably lower revenues. By way of comparison, last year there was a 5-point lower margin in Q4, as compared to Q3. The delta this year may be a bit larger, due to high fixed costs associated with some new system implementations.

Operating expenses are expected to be roughly in line with Q3. The effect of our cost reduction initiatives that are underway will be counterbalanced by higher than usual audit costs, as we orient our new auto firm and complete 2005 Sarbanes-Oxley compliance work. We expect moderation in G&A expense beginning in Q1 and continuing thereafter, as the extraordinary matters are completed. Although a loss per share is expected to be higher in Q4 than in Q3, we believe it is likely that the favorable cash flow trend will continue. We intend to provide 2006 guidance at the next quarterly conference call.

Now, I'll turn the discussion back over to Bruce to discuss significant business developments, underlying market conditions and trends, and our plans. Bruce?

Thanks, Mike.

In Q3, we continued our steady trend of recovery. The improvement in cash flow was particularly noteworthy, as it should provide comfort to investors who may have been intimidated by the large cash outflows we've experienced over the last 2 years. As I explained earlier, most of the use of cash was for investments and new programs that represent expansion in market share and a platform for profitable growth. We recognize the path to superior returns for our shareholders is paved with profitable growth. We recognize that along the way, we must reestablish our credibility with the investment community through clear communication about our business and financial models, objectives, initiatives, and performance. We must earn the profitable growth by serving our customers well. They are the engine of that profitable growth. I'm pleased to say we're making enormous progress in enhancing Digimarc's position as the preferred supplier of driver license issuance systems.

As we're completing the rollout of the new digital driver license system in Florida, we look forward to a long and prosperous relationship with the Florida Department of Highway Safety concerning the citizens of that state. We are proud to report that 2 other leading states that we have had the privilege of serving for many years have extended those relationships. In the first of those, the Texas Department of Public Safety awarded us the second biggest driver license contract in our history, on the selected Digimarc in a competitive bid for image collection, biometrics and driver license production, pursuant to a new 5-year contract valued at nearly $30 million. Texas was a big win. The program is a flagship for our new high-security axiom evident cards and other security features. The system will also showcase our facial recognition and fingerprint matching solutions.

On November 3rd, we announced that the California Department of Motor Vehicles, a longtime customer and the largest issuer of driver licenses in the US, has agreed to a 2-year contract extension. Under this contract, Digimarc will continue to operate the nation's highest volume central issue driver license system. The system includes a world-class card production factory in more than 170 enrollment locations. In addition to the issuance system contract awards, Massachusetts awarded Digimarc 2 new contracts designed to strengthen the security of the registry of motor vehicle driver license issuance process.

The R&V will institute the Digimarc ID [VS], combining facial recognition and sophisticated identity document authentication to reduce fraud in the process of applying for driver licenses, a key area of concern in the recently passed REAL ID federal legislation. The Massachusetts award, in an open, competitive bid, is noteworthy as our first sale for ID VS. During the enrollment process, R&V operators will use Digimarc ID VS to scan, authenticate and archive documents presented by applicants for driver licenses. ID VS will validate numerous security features in various documents excepted by the R&V, including the Digimarc ID mark, digital watermarking security features that have been adopted by over a dozen states across jurisdictional authentication.

In another significant contract award, this time from a new customer, we were awarded a contract with an estimated value of $1.5 million, to supply the Provisional Electoral Council of Haiti with over 3 million secure citizen ID's in support of the country's upcoming elections. Production is underway in our facility in Mexico. In a very positive market development, the federal government has appropriated funds to improve the security of driver licenses in associated issuance systems. On October 18th, the President approved $40 million for discretionary grants to states to implement the REAL ID Act of 2005, as part of the Homeland Security Appropriations Bill for fiscal year '06. The appropriations bill requires that at least $6 million be made available for pilot projects within 60 days, in order that lessons learned and best practices in the integration of hardware and software and information management systems might be made available to all states as quickly as possible.

The remaining $34 million may not be obligated or allocated for grants until the Committee on Appropriations receives and approves an implementation plan for REAL ID by DHS, including proposed uses of the grant monies. We believe that we can provide significant help to the Department of Homeland Security to achieve its objectives and help our customers to comply with the resulting regulations in the most timely and cost-effective manner possible.

We are also pleased to report the defense sector has expressed interest in digital watermarking. The recently passed Senate DOD Appropriations Bill contained $1 million for a pilot project, including digital watermarking. The money is to be split between Digimarc and our partners, GCS and SK Electronics, for a test project to assess the viability of digital watermarking and other technologies and improving sensor and camera capabilities to enhance the effectiveness of real-time battlefield information.

In the media and entertainment area, profitable growth is dependent on the success of our patent and technology licensees. We believe that our licensees will add maximum value to our shareholders when they are well supported by our technology and evangelism. Things appear to be really jelling in media and entertainment, with a swirl of recent activities. Digimarc and its licensees are delivering a variety of digital watermark-based solutions. Among other things, digital watermarking has been adopted for forensic tracking in pre-released music and movies by most major movie studios and record labels and for broadcast monitoring by a number of producers of television and radio entertainment, news, and advertising. Both audio and video watermarking were included in the recently announced digital cinema systems specification released by the DCI to help deter piracy of digital movies shown in theaters around the world. DCI is a joint venture of Disney, Fox, MGM, Paramount, Sony Pictures, Universal, and Warner Bros.

During Q3, we welcomed a new and important business partner to our licensing program with the timing of a multi-year patented licensing agreement with Dolby, including their wholly-owned Cinea, Inc. subsidiary. The agreement facilitates the expansion of Cinea's current digital watermarking business to offer a more complete range of solutions for protecting the management and distribution of digital movie content. The agreement supports Cinea's innovative running marks forensic watermarking offerings to the motion picture and television industries as a means to provide robust digital video content, tracking, and security. We also noted in the announcement by Sony Pictures that they have licensed Verance's copy management system for audiovisual content. Sony joins Universal Pictures as an adopter of Verance's copy protection technology.

According to recent statements by studio executives, such as published in the October 27th edition of Warren's Consumer Electronic Daily, we note that audio watermarking technology may also be under consideration as a security element for the protection of new high-definition media formats, such as HD, DVD, and Blurite. Subsequent to the end of the quarter, the DVD CCA issued a request for expressions of interest to evaluate technologies for the purpose of selecting a technology for use in marking audiovisual content to convey a certain copy control information. The selected technology will be used to enhance the content scrambling system protection that is used for audiovisual content in protecting DVD movies. According to the DVD CCA request, it appears that they anticipate that the optimal solution for addressing their needs is likely to be audio watermarking. More information can be found at www.DVDCCA.org.

The DVD CCA's earlier watermarking evaluation efforts concluded in July of 2002 without selection of a watermarking technology. The unsuccessful conclusion to that process created doubts in the minds of some followers of digital watermarking as whether it would fade away. The reinvigoration of this process is testimony to the increasing appreciation of the value of digital watermarking in the management of media content. It is a very positive leading indicator of the viability of our Company's vision. There were many more than noteworthy market developments during the quarter. Due to time constraints on this call, I suggest that analysts and investors who want more background visit the "Digital Watermarking Industry News" section of our website.

Being a trusted supplier is more important than ever in our markets. REAL ID represents a paradigm shift in driver license issuances. The basic principles expressed in it are focused on protecting homeland security. Nevertheless, adherence to such principles would add value in many other ways, helping to deter identity theft and fraud and improve traffic safety by reducing the number of illegal drivers, and helping to keep alcohol out of the hands of minors. Many of our customers are looking to us for advice as to how to meet the REAL ID Act's compliance requirements without degrading customer service to their citizens.

Recent contract wins or extensions with Texas, California, and Massachusetts are a testament to our belief that satisfied customers translate into loyal, long-term relationships and profitable growth. Our dedication to our customers, improving operational performance, and leading innovations in secure driver license issuance authentication solutions demonstrate market leadership that should lead driver license issuance agencies across America to recognize that Digimarc is the right choice to guide them through the major transformation in their business mandated by REAL ID.

We are the experts in driver license issuance systems. Although there is still much work to do in rate sizing our costs, we are optimistic about our prospects. Our strategy is sound, our market is robust, and our operations are improving. Cash trends are positive and we're winning business. Cost is starting to come down. We intend to drive costs to reconciliation with our revenues and margins in an orderly, yet expeditious manner. We are engaged in the deliberate process to drive toward profitable growth with superior shareholder returns.

For further discussion of the quarterly results, our business and financial models, and risks and prospects for our business, please see our Q3 10-Q that we filed earlier today. With that, we're concluding our prepared remarks and we'll welcome questions.

[OPERATOR INSTRUCTIONS.] Rick Owen, Robins Group.

I appreciate the additional guidance in the call, as well. A couple of questions though, one for Mike and I guess probably one for you, Bruce. Mike, if I look quarter-to-quarter in the G&A, it was down about $700,000. You mentioned over the next 3 to 4 months, there's opportunity to drive that line item down even further. Can you give me some sense as to whether we're halfway through the process off the Q2 levels for 3/4 of the way, how much more savings do think that line item can show?

Well Rick, a couple of things. We did indicate that in Q4, it's going to drive up a bit because of the year-end audit review and Sarbanes costs and orienting our new auditors and it would begin to moderate at the end of Q1. We think we're on a good fast track to reduce those several hundred thousand dollars more just in the finance area, and in total, we're looking at all of our cost structure, not only G&A, but the whole Company as well.

Okay. And then Bruce, for you, with $6 million in federal funding to be spent over the next 60 days or by 45 days now and with the revenue guidance that you've given for Q4, does that include any uptick from that or how do you see that flowing to the suppliers and how is that all going to play out?

Our estimates for Q4 don't include any anticipation of revenues from that $6 million and there are a couple reasons for that, one is that a natural risk in our business and serving government customers is delay. Sixty days is an extremely short period of time, so we're not certain that DHS will adhere to the mandate, although it is a mandate. Second is, in revenue recognition, as you know, most of our revenues tend to be deferred. And so once we receive grant money from that program, we're not confident we would immediately recognize revenues. Those two uncertainties caused us to forecast to that zero for the quarter. It doesn't mean we don't think we're going to get any business.

Joel Fishbein, Janney Montgomery Scott.

A couple of questions, Bruce, it sounded to me like you said capital expenditures are going to at least decrease in '06. I'm just trying to get a low bit more visibility on that because clearly that would help drive cash flow and profitability. So any visibility there would be very helpful.

Yes, we didn't say that they would decline in '06; we said that the total for '05 would be about $15 million, so you could go back into the fourth quarter number. With respect to general terms, all of the pending major capital projects are going to be completed this quarter, so that leaves us with what we would forecast in '06, and you know better than most of what the bid activity is in the marketplace. There are only 2 open, significant bids right now in Indiana and Virginia.

Right.

And so those would be the capital projects for '06, if they were awarded in that period. And again, you can probably guess that the scale of the capital requirements are significantly less than what we have been experiencing for the past couple of years. So that, plus the fact that we run about $5 to $5.5 million of non-cash charges per quarter can help you in building your cash flow model for '06.

In the next conference call, we'll give more guidance on '06, more specific guidance on our forecast for that period, but those are some points that will help you there as an estimate.

Okay. With respect to California too, it appears since it's a contract extension, you're not going to have the capital requirements that would be if it were an open bid and you have to go back in there and put in infrastructure. Is that the right way to look at it?

That's right.

Okay. And for Texas there will be some capital investment.

There will be, although that he has an early 2007 commencement date.

And on both of these deals, are you using more sophisticated technology, as called for under REAL ID, even though the expenditures may not have been expended as rapidly as we would hope?

Well, actually I'm not sure about the rapidity of the expenditures. If the DHS follows the mandate and distributes $6 million in the next 40 days or so, that will be quite amazing. And we, at this point in time, don't know any reason why they wouldn't. I'm just saying that we're not planning on it because it's, obviously, one of the risks in our business is delay in governmental action. As far as the remaining $34 million goes, it's an FY '06 appropriation and the federal fiscal year ends in September, so at this point in time, we're anticipating that the federal government will put $40 million into the U.S. driver license market in the next 9 or 10 months.

Brian Ruttenbur, Morgan Keegan.

And again, I'll reiterate what the other guys said, I appreciate the guidance going forward now, at least some broad guidance. I had a question. First of all, on Haiti, you mentioned that you he had -- I don't know if I read this right, $1.5 million contract there to supply 4 million IDs. Is that correct?

It's over 3 million.

Okay. That seems like a relatively small amount of money per ID. Is that a profitable contract or is that -- it's a very low-end contract. Can you give us a little bit of color on that?

It's a simple deployment. We're using our Mexican factory in order to produce the documents and there's no supporting infrastructure in country from us, so we're merely producing the documents for the electoral commission. It's not a driver license system, in other words. The driver license system has a lot of other aspects that aren't present here.

Okay.

And that's why the relatively low price is still a good price for us.

Do you see a trend out there moving to higher and higher cards. We see that in the US. Do you see that in other countries that you are dealing with, going to more secure, high security cards, if there is a shift to biometrics, things like that?

It's not clear that there's a trend yet. The marketers of Smartcards and biometrics would like everyone to think that. But our observation is that there's still a very broad range of products, and the selection of the product is a function of many, many factors that vary from jurisdiction to jurisdiction. And so, in the case of Haiti, as you see, they're buying relatively inexpensive documents from us in order to foster a democratic election. And then once the election is done, we anticipate that they're going to want to have more identification documents. And when they choose the additional identification documents, we don't yet know what level of cost they're willing to bear, and so most of the decisions are built on a foundation of, I'll call it, budget in jurisdictions and they're adopting the very expensive solutions. There is generally a government mandate in which there are some factors other than, I'll call it, basic security in play, like in the European Union. The European Union has an initiative to promote Smartcards, so the governments there buying them, don't necessarily mean they think it's the best technology choice for the citizens. It means they believe is the best economic choice for the European Union.

And so, we find that in our market that the documents that we produce in our newest systems are very, very good documents and they're very secure. And the states are more interested now in investing in the total security of the system. And so you see, for instance, in Massachusetts, which is a leading state in technology selection, they're investing their money in improving the enrollment process. Because once you have the document to a certain level of security, the bad actors will look for a means to get a valid document illegally, rather than try to counterfeit a very, very secure document. So, I think that's what I observe in terms of the largest market that we serve, the U.S. market, is that there is much greater interest at this point in time in improving the overall security of the system than there is in making a technology choice about the documents themselves with our superior document solution as the base, in other words, starting with the most recent generation.

My next question is about maybe you don't have to mention the locations, but how many locations are you currently losing money in, if any, on the driver license side on your ID side?

We don't give a contract-by-contract analysis.

I'm not looking for like in Florida, you losing money. I'm not saying that. I'm not at all going in that direction, but I was just wondering maybe you could give us a percentage that -- 5% or kind of below water and the rest are making money and -- can you give us any kind of color like that?

No. No, it's really, the question is sort of a bit off base, and as Mike just explained, the largest cost components we have are fixed costs, which are allocated to customers. So to say, is this contract profitable versus that one and so forth gets into the question of what is the amount of fixed cost being applied?

Okay.

We're going to get profitable by managing our fixed costs in relation to our revenues and margins, and you see we're making a lot of progress in that respect. So, we're going to drive towards that. We're going to manage all of our accounts to the best of our ability, serving customers well and charging fair prices, which implies fair margins. Occasionally, we'll take a step up, as we did with some wins in prior years, and occasionally we'll bid a program for strategic value, but in all of those cases, we're seeking to obtain profitable business.

Okay. And then, my last question is dealing with the possibility, as I was working through the model, just kind of checking it out for '06, I don't see profitability on a earnings-per-share line anytime soon. Do you have a goal in mind internally? Is it going to be 2 years, 3 years? What kind of time horizon are you thinking and can you give us some kind of idea along those lines?

I think I'll defer on specifics to the next call when we'll talk about our specific plans for 2006, and we'll probably include a bit longer horizon, but --

So that's it after the next quarterly -- after your next quarter, you'll give us a little bit more color on the profitability.

That's right, but I can respond to what you just said in this call without getting to the level of specifics. The timing basis for achieving profitability is a function, really, of only 2 things, both of which we think will happen - that is growth and reduction in costs. So, we're not going to tell you or anyone else that we're going to sort of sit on our hands and wait to grow out of this. So we've already, as you've seen, been improving our costs. We intend to continue to do that. We intend to continue to grow and we're taking measures margins and improve efficiency and improve productivity throughout the entire spectrum of the business, so management is very determined to right size the cost. And so, we're not anticipating telling you, you have to wait a long time for us to get to profitability, but we need to continue to do our work in this measured fashion. We've been doing it, because we have a dual objective here of getting the costs in line and providing excellent products and services to our customers so that we can fuel the profitable growth on that side of the equation. So it's really, it's a two-sided sort of ambition and requirement that we need to satisfy and we're working both sides of it very aggressively.

[OPERATOR INSTRUCTIONS.] [Walter Gincur], [Hyden Capital].

First, I will add my strong appreciation of the fact, because I've been complaining about it, about management's efforts to try and provide better guidance and better modeling on the long-term basis. I strongly look forward to the end of the next quarter when we get a better longer-term picture. But a couple of questions. When you talked about seasonal patterns, that is an apples-to-apples seasonal pattern of a contract with no upgrades as it goes through the year? Because you've got new contracts coming in and there's a lot of other moving pieces. That seasonal pattern was meant to be the seasonal pattern of a typical state doing driver licenses without any upgrade along the way.

It's a -- these are averages that we have calculated from literal data of the change in revenues quarter-to-quarter of all of our issuance volume altogether.

Okay.

So, there's some very -- the answer to your question, there's probably a little bit of noise in there in terms of what you were just talking about. The vast majority of those revenues are, I guess, the foundational revenues, the base revenues.

Okay.

The main point here is not so much the percentage differences, but the sort of magnitude of the changes quarter-to-quarter and the predictability that Q4 will always be a down quarter.

Okay.

And that's the point we're trying to make in terms of modeling the business. It's very important that you not extrapolate a linear growth pattern in Q4 because you're going to overestimate revenues if you do that.

Okay. But again, I know you said it, but just clarifying, to the extent you are ramping up Florida or something, or someone else, and as you continue to bring a new state on, it has nothing to do with this pattern?

Every state that we bring on will contribute to the overall pattern unless it has unusual characteristics, so each state doesn't necessarily follow the pattern, although the states in aggregate follow the pattern.

Okay.

So, for instance, Florida might have a different seasonality than Minnesota.

Correct, no, okay.

Because of differences in climate, or differences in the number of days offices are open, or demographics, and so on. There are many factors that contribute to the seasonality, so there's substantial variation from jurisdiction to jurisdiction in seasonality, But in aggregate, we've observed what appear to be pretty reliable trends.

Last quarter, someone asked a question about what revenue level does the Company need to achieve profitability and Bruce made a tongue-in-cheek response, but basically said what he sort of reiterated here, which is profitability is, in large part, our ability to control and right size our costs plus getting some growth in the business. To what extent is it also a function of the fact that the contracts in place need to be enhanced over time with additional features or the contracts, as currently constituted with right size costing, should be profitable?

I think you're getting to an important point in understanding our business and financial model, Walter, and that is that because of the deferral of much of our revenues and costs, our P&L has a substantial historical component in it. When we entered the business in the beginning of 2002, in fact, and we all know that we struggled a bit, and during the period of 2002 to 2004 we invested a lot of capital, which translates into depreciation, and then we carry and amortization component from the acquisition of the assets in December 2001. And so that's all invested capital, but that gets translated in the P&L statement in the current quarters. All right?

All right.

That's not changeable. Those non-cash charges will stay the way they are as we move forward, and so the improvements in the business that we make don't affect those elements or cost. As we grow the business and we do better business, then that will tend to begin to mitigate the effect of those historical costs on our current financial statements. So you see then that's where the cash flow improvement should be quite an interesting measure for investors and the focus, obviously, of management is that the cash flow should begin to improve in the business in a way the P&L can't keep up with because the P&L is carrying the historical cost component.

Thank you. One last --

So if the business is getting a lot better, you're still going to have a bit of a lagging indicator.

Right.

From that.

A large amount.

Yeah, yeah.

Last question, it's almost November, obviously. Can you give us a general sense of how much nonrecurring costs, be they Sarbanes-Oxley, internal controls, consultants, new accountants, and I realize some of it will carry into next year, but some gross idea of how much that he has -- will likely impact '05 versus '06 at delta?

Hi, Walter, this is Mike. I think one point I made earlier is that we expected today would be several hundred thousand dollars per quarter benefits going forward after the Q1, and so that extrapolated, obviously, is over $1 million, but even this year we spent well in excess of $2 million, maybe $3 million for the combination of legal and accounting and consulting costs. So it's been quite substantial and that's why we're pretty bullish on the moderation of G&A going into 2006.

[OPERATOR INSTRUCTIONS.] Steve Lidberg, Pacific Crest.

I guess with regards to the contracts that you renewed over the last couple months, you look at Massachusetts, California, Texas, what kind of margin application should we assume, as we look at 2006, and the renewal of those contracts?

We don't comment on margins on specific contracts. We've listed a small enough number that it's -- I can't really give you a specific answer to the question, Steve.

Okay. If you look at the contracts that you've renewed over the last year and a half, the trend has been higher costs associated with those contracts and less profitable contracts over all.

No, that's not true.

Okay.

What we said earlier in the call, let me clarify them, we may have created a misunderstanding, is that we had contract wins in 2002 and 2003 that were quite large and involved a creation of a complete new system for customers. And those systems were expansive in terms of our historical deliveries. That's what we were referring to. We weren't referring to renewals at all in that comment.

So, as you look at the pricing environment that you're facing in these renewals, how would you characterize that?

I think the larger customers are looking for the best supplier and the best technologies, which is what we provide. And I think you see a pattern in the marketplace where some of the smaller jurisdictions have been opting for other suppliers. We think that's quite risky for them to do that, but they, obviously, make the judgments that they make. But the major issuers have been going with us because they know that we're the best supplier in the market and we're reliable and we're focused on satisfying their needs and taking care of their customers. And so, I think that's the focus of the market.

Particularly now, in light of REAL ID, increasing identity theft, the general concern about privacy of data, all of those things create an environment in which the customers are willing to pay a fair price for good value, so I don't think we're in a market in which lowest-priced dominates. But there will be occasions where a state will be biased in that direction.

And in general, you've noticed the number of bid proposals out in the marketplace has started, has quieted down over the last 6 to 12 months, given REAL ID, would you expect that as we get into '06 that that activity is going to pick up again?

It's a little hard to handicap. I actually believe that there may be a substantial increase in business without necessarily a substantial increase in bid activity. And that's because, as we've continue to improve our leadership position in the market, a lot of customers are trusting in our expertise and looking to us for guidance, to help them work through this transition in their business model. And so in some states, there's a requirement that they go out to bid, so they'll be some bids because of those requirements, but that's in a relatively small portion of the jurisdictions. And then some states may choose to do go to bid because they just want to sort of test the market and see what's going on. So I don't know and I net all that out. I see that there are a couple of large opportunities for competitive wins for us coming up in the next year or so on full issuance systems, in which we intend to try to secure. But in terms of REAL ID upgrades, I'm not sure exactly how the customers are going to deal with those. I suspect they may turn to their general systems supplier, assuming that the suppliers will give them good value for fair prices and do business with them on that basis.

As you look at the product line item in terms of revenue, was that uptick primarily a function of the media and entertainment marketplace or was that on the driver license side?

Bruce Davis Which uptick are you referring to, Steve?

Products and services.

Yes, this is Mike, Steve. That relates primarily to a number of international programs. The international programs are primarily product sales, and to a lesser extent, issuances like we had in Mexico, and they happen from time to time. We had a nice uptick in that this quarter.

And in terms of Florida, Alabama, Ohio, how close are we to those contracts being fully ramped now in terms of revenue generation?

Actually pretty close, Ohio is pretty much at full, Florida were doing some minor office completion, Alabama is continued to roll out, but it's fully operational, they're just adding their various enhancements to the system that they've contracted for us, so we're looking pretty full here for Q4.

And Mike, the headcount side, where did it stand with consultants?

The consultants, total full-time equivalents were right around 600 headcount, and that's drifting down slowly and it's drifted down below that after the quarter-end. The consultants are still in 130 to 140 range at this time and we expect those to get below 100 on a permanent basis. We do have obligations for certain consultants in certain areas based upon contract provisions, but we are making good progress in that area.

And then I guess finally, Bruce, on the media and entertainment side of the business, we've kind of been here before as you look at the momentum in the entertainment industry pushing watermarking. Any ideas in terms of how you are going to approach the opportunity from a financial perspective, i.e. what does the business model look like? Is it a license per device, or royalty per device, or royalty for piece of content, or are we still too early in those discussions to really gain any sense of that?

While it is a bit of déjà vu, Steve, I have to say, I'm excited about it though. W ith the DVD, CCA, obviously, you and I and many others were hoping that was going to turn into a watershed in the late 90s, early 2000 period, and then it stalled, but it's back and it's back because they know it's the right technology choice. So, hopefully, they can work through their industry relations problems and adopt the technology this time. The basic model in our licensing program is volume-based, and the volume will either be device-oriented or content-oriented. It's usually both, to tell you the truth. And so in the case of digital cinema, high-depth DVD, ordinary DVD, broadcast monitoring, forensic tracking, peer-to-peer, all of these areas there will typically be 2 elements to the license stream, one would be on the content side and the other on the device side. We do work application by application in our licensing and we typically talk to our perspective licensees about their business models and we have certain ideas about the value of our technology in an application environment in relation to the devices and the content. And sometimes, and I would say probably most times, we prescribe per-unit minimums, and we give discretion above those minimums to the licensees to experiment with business models.

And at this time, gentlemen, there are no further questions. Are there any closing remarks?

No. I'd like to thank everyone for participating in the call and reassure all those on the call listening that we are very concerned about continuing to improve our financial performance and dedicated to doing it in line with providing superior level of service to our customers. So, thanks very much to everyone and we'll look forward to talking to you again soon.

Ladies and gentlemen, that does conclude today's Digimarc Corporation conference call. You may now disconnect.