Digimarc Corp (DMRC) 2005 Q4 法說會逐字稿

Good afternoon. My name is James and I will be your conference operator today. At this time I would like to welcome everyone to the Digimarc Corporation Q4 and FY 2005 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]. Thank you. Mr. Davis, you may begin your conference.

Hello everyone. Welcome to our Q4 '05 financial results conference call. Mike McConnell, our CFO is with me. We issued a press release earlier today announcing our Q4 2005 financial results. The objectives of this call are to summarize and comment on these results, discuss continuing improvements to various internal business processes, review significant business developments and market conditions, and provide some visibility on our prospects and plans for 2006. This Webcast will be archived in the "Investor Relations" section of our website.

Before we proceed please note that during the course of this conference call we will be making forward-looking statements regarding management's opinions and expectations about the business, its markets, and financial performance that are based on our current understanding and expectations. These statements are subject to assumptions, risks, uncertainties, and changes in circumstances. Actual results may vary materially from those expressed or implied by such statements. For a more detailed information about risk factors that may cause actual results to differ from expectations, please see the Company's filings with the SEC, including the MD&A section in the Forms 10-K and 8-K that will be filed shortly and our earnings release posted on our website. Keep in mind that any guidance we offer represents a point in time estimate. We expressly disclaim any obligation to revise or update any guidance or other forward-looking statements to reflect events or circumstances that may arise after the date of this conference call.

Now, this call will include the following: Our 2005 revenues grew 9%, quarterly cash flow trends were positive, we retained and grew key government accounts, and signed important new Digital Watermarking licensees. We improved the quality of our management and work force in internal business processes, we're offering more details and improving presentation and analytics for our public financial statements to investors in understanding our business and financial models, our key initiatives include changes to presentation of G&A expenses and a study of useful laws as program assets that may result in reduced annual depreciation expense. We remedied the internal control weaknesses identified in last year's report and achieved Compliance with Section 404 of Sarbanes-Oxley. We expect to continue to grow revenues in 2006 with better EPS and significant improvements in operating and net cash flow. We closed the discussion today with an [assessment of market] conditions and an overview of our strategy and plans for 2006.

In looking at 2005 a great deal of management attention was inwardly focused during the year improving the quality of management in the work force more generally in our internal processes laying the foundation for better financial and operational performance. Many functions that we previously managed on a local level were centralized improving management visibility control and accountability. Nearly the entire management team in our ID Systems area was replaced and we dramatically reduced reliance on contract labor. The contract labor reductions were part of the concerted plan to improve customer service, accountability, predictability and institutional knowledge, eliminate poor performance and generally reduce our labor costs. As a result of these activities we simultaneously improved the quality of our work force and lowered cost, knocking millions out of the analyzed labor cost.

We are continuing this process in Q1 as the majority of the remaining domestic contractors are being converted to employees or terminated. We intend to sustain these work force enhancements through a comprehensive training and organizational development program guided by a thorough strategic management process. These sustaining activities include Balanced Scorecard Strategic Management, Six Sigma Quality Process Improvement, the hiring of organizational developed personnel, and the benchmarking of corporate performance in all major functional areas. We now have a [coronal] of the winning team that will deliver on the Company's objectives. We believe that the improved skills, new energy, and fresh perspectives of this team coupled with improved internal processes, and better management of suppliers and customers will efficiently deliver best value to customers, leaving sustainable improvement in operating margins and return on equity.

At the start of 2005 bids were pending in Indiana and Texas. We won both bids. The Texas contract valued at $30 million over the life of the five-year agreement is the second largest contract in our history. Indiana awarded us a six-year contract early in 2006. We have projected that there could be a significant number of bids in 2005, including Arkansas, California, Georgia, Manitoba, North Dakota, South Carolina, and Virginia. Only North Dakota and Virginia actually went to bid. North Dakota awarded its contract to a competitor and the Virginia bid is still under evaluation. California and Manitoba chose not to go to bid and executed -- extended their contracts with us. We achieved most of the growth in domestic driver's license issuance that we had anticipated from the new accounts in Florida, Alabama, and Ohio. However, significant delays and associated cost overruns in completing the Florida and Alabama installations dampened the pace of 2005 revenue growth and long-term profitability of these accounts. These programs were all in production at year end. The Florida and Alabama installations both began in 2003 prior to management and process changes that I outlined earlier.

We had some gains in voter identification in foreign markets, including an agreement funded by the Organization for American States to produce more than 3 million voter I.D.s for use in the recent Haitian election. This was the first ever photo identification card for Haitian citizens. We produced these cards in our secure factories in Mexico demonstrating operating leverage and strategic value of that account win in 2004. We won additional contracts for voter I.D. cards in Yemen and Liberia. There have been some significant developments in our markets, most notably, in 2005 President Bush signed the REAL ID Act into law requiring that by 2008 only REAL ID compliant licenses will be accepted for prescribed Federal purposes, including boarding planes and accessing Federal buildings. $40 million of funding was appropriated by Congress to be administered by DHS, thus far, New Hampshire and Kentucky have each been allotted $3 million for pilots. The remaining funds are to be distributed after Congress receives a report from DHS on how it intends to allocate the funds. As is often the case with government initiatives, the entire process is behind schedule. Nevertheless, we believe that the movement of Federal funds into the driver's license market is likely to create significant opportunities for growth and may draw new competition. For other noteworthy market developments and secure credentials and ongoing references for important developments, we suggest that you visit the SecureID Industry News section of our website.

Elsewhere, general market trends for digital watermarking are encouraging and our strong well-established IP portfolio continues to garner respect giving rise to new patent licenses with Thomson and Dolby. Nielsen also became a Digimarc licensee by requiring audio audit and assuming our license to them for broadcast monitoring. Industry standards for media security repeatedly embraced digital watermarking as audio and video watermarking were included as requirements in the digital cinema specification and interim license for high-definition DVD noted the final license is expected to include the digital watermarking requirement. The DVD CCA, which holds the patents for digital video play back on standard definition DVDs, issued a request for expressions of interest to evaluate technologies for use in DVD copy protection and play control, and indicated that the optimal solution for their needs is likely to be audio watermarking. And the DCA, the trade association for the peer-to-peer file sharing companies, announced a resolution to support digital watermarking for the protection of entertainment contents authorized for P2P distribution and the formation of a new P2P Digital Watermark Working Group to foster its implementation. For more information about Digital Watermarking developments and accomplishments on our licensees, please see the Digital Watermarking Industry News section on our website. At this point Mike will discuss our Q4 and 2005 results and offer some financial guidance for 2006, then I will return to discuss the market outlook and our strategy. Mike?

Thanks, Bruce. And good afternoon, everyone. As Bruce stated we released fourth quarter 2005 financial results this afternoon. Q4 revenues were 13% higher than last year due to new customer and new product revenues in both domestic and international markets. International revenues increased 26% over Q4 of 2004 to $6.2 million, primarily due to issuance revenues from the Haiti Voter Identification Contract, as well as increased issuance in Latvia and Mexico. U.S. revenues grew 9% to $19 million, largely from the increased issuance revenues from Florida and Alabama, as well as initial revenues from our Document Verification and Facial Recognition Solutions.

Before we discuss fourth quarter gross margin and operating expenses I want to discuss a change that we have made in reporting certain G&A-related expenses to enhance comparisons with other companies and industry benchmarks. We had been including IP infrastructure and support and facilities cost in the G&A line in our operating expenses. Beginning with our 2003 financial statements we are reclassifying certain of these expenses to the departments that they support. As a result, certain expenses previously classified in G&A are now included in COGS, R&D, and sales and marketing. We have also broken out intellectual property cost to provide insight into the investments we continue to make in that area. Given that IP licensing is core to our strategy, IP costs are more akin to R&D expenditures than G&A as they are used to produce the assets that we license to produce revenues. For more details in our retrospective view of the impact of the these changes see Notes I and XI of our 2005 Form 10-K that we expect to file within the next couple of days. With these changes in mind let's proceed with the discussion of gross margin and operating expenses for the fourth quarter of 2005.

Gross margin for the quarter came in at 27%, slightly lower-than-expected primarily reflecting higher program depreciation charges and to a lesser extent higher fixed overhead costs. The gross margin decreased by eight percentage points year-over-year and 10 points from Q3. Cost of sales includes direct variable costs, fixed overhead, and program depreciation. Direct variable costs, which include the cost of materials to produce our identification cards and the cost of hardware, consumables and software related to our product sales have been pretty steady. Thus, the change in gross margin from the prior quarter is largely driven by seasonally lower domestic issuance revenues matched against fixed overhead and straight line program depreciation. Approximately seven points of the drop from Q3 is due to seasonality with the remaining three points reflecting a slight change in our revenue and cost mix. The year-to-year change in gross margin is largely a function of increased cost of delivery for certain key strategic account wins where we have provided a complete system replacement with a broader mandate than in most previous systems. These installations were different and more complex than prior programs. While we were ultimately successful in these deployments we ended up with costs that were higher and had been customary, and in a couple of cases noted earlier higher than anticipated. As a result of these investments we have developed new expertise that we believe enhances our market leadership and growth potential complementing the upgrades of our management, work force, and internal business processes that we noted earlier. In one other situation that contributed to the change in gross margin we bid a program at relatively low margin as part of our market development strategy that we believe will yield good long-term performance.

Nearly one half of the projected depreciation in 2006 for the Company's 30-plus ID programs where we have made capital investments comes from three newly acquired accounts. The fixed cost for these new accounts, which include depreciation of cost capitalized during the delivery process, as well as field service manufacturing and operational cost to manage and maintain them are higher than average and thus reduced reported margins. The impact of such depreciation on gross margin reflects a combination of the pricing necessary to acquire these accounts from competitors and substantial delays and cost overruns in their implementations. We have mitigated the risk of recurrence of such problems by the changes in management and business processes that we have described. The acquisition cost component of unusually high depreciation is often incidental to the acquisition of new accounts and should decline as the Company improves its non-price competitive differentiation. We intend to earn back the discount paid to acquire distribution by growing share of the pocket in these accounts like in existing accounts to increase margins over time and to establish attractive customer life time economic values from these investments. We believe the key to margin improvement is providing good value as a trusted and responsive partner of the customer, which we are pursuing through staffing and process improvements and various other strategic initiatives.

Our overall gross margin reflects the average margin of all of our accounts. Gross margin tends to increase over time in accounts due to sales of additional products and services not, included in the base contract, and efficiencies in servicing the accounts gained over time. 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 over the life of these accounts and at a good return on investment. The [MS] estimates for Q4 gross margins do not appear to have sufficiently accounted for seasonality and the higher fixed costs associated with these accounts. In our third quarter call we indicated that seasonality would likely reduce gross margin by 5% or so and that Q4, 2005, would show an additional impact due to the higher fixed costs associated with installations at certain new accounts.

Operating expenses were up 2 million from the prior year in-line with expectations primarily due to increased R&D investments and new auditor orientation costs. EPS loss for the quarter was $0.37, slightly more than our guidance. We had approximately $32 million in cash and equivalents, short-term investments, and restricted cash at the end of the year. Cash flow from operations showed its fourth consecutive quarter improvement finishing at 1.4 million of positive cash flow. Net cash flow for the quarter was a deficit of 1.5 million due to program investments. The improvement in overall cash flow is attributable to reduction of DSOs year-over-year from 62 to 56 days driven by better customer satisfaction and account management, advanced billings on some contracts and more effective inventory and supply chain management.

Backlog at the end of the year was approximately $230 million, up over 18 million from the end of Q3, 2005, and down approximately 30 million from the prior year due primarily to the natural burn off of revenues previously booked net of new contracts and extensions as in Texas, California, and Manitoba. On the process side of finance as discussed in earlier calls and in previous SEC filings, the Company received an adverse opinion in 2004 on the effectiveness of our internal controls. Through 2005 management conscientiously remedied the material weaknesses identified in the assessment associated with that opinion. Over the course of 2005 our employees tirelessly improved internal business processes and associated controls. We are pleased to report that these efforts have resulted in management's assessment that as of December 31, 2005, the Company's internal controls were affective and we expect a positive attestation to this affect from our auditors. Looking forward, we expect 2006 revenues in the range of 105 to $115 million, approximately 20 million of the Q1 '06 revenues and approximately 75 million of the 2006 revenues is in our current year end backlog.

We are not yet prepared to provide guidance on the cost of sales and associated gross margins for 2006. We are studying the estimated useful lives of our program assets. Our assumption has been that, in general, the useful lives of such assets is equal to the initial term of the contract associated with the program. This initial estimate that we have used since acquiring the [forward] assets was a reasonable but very conservative starting point given that we are new to the business and had no experience to draw upon. As we have gained experience and collected data for the last four years we may be able to better -- establish better estimates of useful lives of these capital assets. Our impression at this point in the analysis is that the average useful lives of these assets may be significantly longer than the initial terms of our contracts. We are discussing these matters with our auditors and audit committee to determine whether a change in estimated useful lives may be appropriate to better match recognition of cost to the useful lives of these program assets. Thus, we will defer providing guidance on gross margins and earnings until we reach a decision on whether we can improve our estimation process based upon data analysis. Possible improvements to our estimates that are being studied could have a significant positive impact on gross margins and EPS.

Absent any changes in estimated useful lives and program assets, we expect gross margins for the first half of 2006 to be lower than in comparable periods of 2005 than trend upward in the latter part of 2006, compared to the same quarters of 2005 with the improvements coming from a combination of revenue growth, cost reductions, and efficiency initiatives. The expectation of lower first half gross margins is primarily due to three programs that will be going through short-term transitions. Two of these programs are converting from four to five-year issuance renewal terms for individual driver's licenses, and one international program will incur [short full] of production under its voter program due to a registration blackout prior to an election. Revenue growth during the first half will be similarly affected by these situations. Operating expenses are expected to remain roughly in-line with 2005 gaining financial leverage versus growing revenues. Cash expenses are expected to be significantly lower in 2005 with these reductions offset by more than $3 million of increases in non-cash expense from stock-based compensation charges brought about by changes in accounting standards. Regardless of the outcome of the depreciation study we expect to make considerable progress on the bottom line in 2006. Although we expect to post a loss for the year we believe that the loss will be significantly lower than in 2005. The expenses contributing to the loss are expected to include a higher percentage of non-cash expenses for amortization of customer intangibles, depreciation, and stock compensation than in 2005. As a result, cash flow is expected to improve more than EPS.

We expect operating cash flow to improve by 10 to $15 million over the $3.2 million deficit in 2005. Free cash flow will depend upon the amount and timing of program investments. We expect to bid on a considerable amount of new business in 2006. If successful, these activities will create capital investment requirements that we believe will be able to satisfy from available cash and cash flow from operations. If these are delayed or we are less successful than we anticipate free cash flow will improve. As you know we currently have no long-term debt. For Q1, we expect revenues in a range of 23 to $25 million, operating expenses are expected to be relatively flat from Q4 of 2005, even with an estimated $1 million increase in stock-based compensation expense due to the changes in accounting standards. The effects of cost reduction initiatives that are underway will be counterbalanced by these higher stock compensation charges. We expect to report a lower loss per share than in Q4. Cash flow from operations is expected to be around breakeven, lower than in Q4 due to annual payment cycles related to certain year end accruals, such as, 2005 incentive compensation paid to employees in Q1 and traditional year end focus services, such as outside auditors and Sarbanes-Oxley-related fees. We expect that improving quarterly operating cash flow trends will resume in Q2. Bruce?

Thanks, Mike. I will now discuss our market, strategy, risk, and opportunities for 2006. We closed out 2005 with 101 million in revenues, more than 200 million in backlog, and our fourth consecutive quarter of improved operating cash flow. We believe that the path to superior returns for our shareholders is through being a trusted and responsive partner for our customers who understands their needs better than any other supplier. This is the path to profitable growth. Our organization must travel this path of proper values, good focus, and increasing efficiency. The other key to shareholder value is credibility in the financial community. We are pursuing a trusted and responsive relationship with investors akin to the relationships we are building with our customers through clear and reliable communication about our business and financial models, expectations, risk and opportunities, objectives, initiatives and performance. The key to success factors in our business began with earning customers for life by profitably delivering exceptional value of fair prices and by growing our IP licensing margins as a trusted partner that supports our licensee businesses with innovative technologies, business development activities, and market evangelism. We believe we are making excellent progress toward these goals as evidenced by new contracts and extensions in Massachusetts, Texas, Indiana, and California, and recent signing of license agreements with Dolby and Thomson, two leaders in the media and entertainment field.

Over the course of the last five years Digimarc has become the leading supplier of secured government issued credentials in North America. The credentials that we produce are integral to many important aspects of travel, commerce, and national security. The great value of these and the improvements that we have made to the securities of the documents themselves are leading would-be criminals to look for weaknesses elsewhere in the secure identity management process, particularly in enrollment and post issuance inspection. We have invested considerably in anticipation of these trends, developing new products and services intended to improve security in every aspect of the secure ID life cycle from the time an applicant applies for the credential to secure production and issuance of the ID to legitimate cardholders, to authentication of the document at a traffic stop, bank, border crossing or store for the DMV.

Our particular R&D focus has been on enrollment and post issuance inspection with introduction and continuing development of the Identity Validation Suite and IDMarc Digital Watermarking. ID VS, the Identity Validation Suite does a modular offering that facilitates analysis of the identity of applicants by investigating biometrics, documents, and data supplied at the time of application better establishing that the personal applying for the credential is the person they say they are. IDMarc uses digital watermarking to provide a covert machine-readable authentication capability thus enables easy detection of counterfeit IDs that can augment the traditional visual inspection of credentials. On the REAL ID front we are monitoring Department of Homeland Security activities carefully and working closely with our customers to understand how they can meet the results and regulations in a timely and cost-effective manner. In the first quarter of this year we announced Digimarc REAL ID Migration Services, a set of professional services to provide safe and other jurisdictions issuing agencies with expert advice on how best practices and optimal technology choices can be made to move towards compliance with REAL ID by the May 2008 deadline.

In Digital Watermarking, in addition to our work on improving the security of government issued credentials, we continued to development our patent portfolio and technology offerings. We now have more than 230 issued U.S. patents, 59 foreign patents, and more than 500 domestic and foreign patent applications pending. Digimarc's strategy is to foster large scale adoption of Digital Watermarking Solutions licensed under the Company's IP, and to maintain our leadership of driver's license issuance systems while improving margins. There are two basic premises to this strategy. Revenues from digital watermarking will grow as the market develops based on the Company's substantial patent portfolio and well-established IP licensing program. The Company's direct provision of Digital Watermarking Solutions focuses on document security, primarily Banknote counterfeit deterrence and counterfeit tamper deterrence for ID documents. We rely on patent and technology licensees to deliver solutions based on audio and video watermarking, primarily to media and entertainment industries. The Company is fostering growth in Digital Watermarking Solutions by non-exclusively licensing suppliers, assisting licensees in business development, evangelizing potential customers, educating and influencing policymakers, and monitoring and attempting to influence various industry standard bodies.

We believe the key to growth in government credential issuance systems revenues is to provide market-leading innovations and quality of service that earns gains and market share, and a share of pocket from existing and newly acquired distribution. The growth strategy for government credential issuance systems is to grow share with pocket of customers with add-on sales, primarily of software and services. In the first few years since entering the market we have acquired some large accounts. The initial margins on new distribution are generally lower than on [inaudible] distribution due to the price competition involved in taking the account from a competitor, and the fact that add-on sales generally have higher margins than based issuance contract revenues. We incurred some additional costs due to project overruns and commencing operations in some new accounts. We have since improved the quality of our work force and internal business processes so that those won't recur.

Organizational development is integral to the success of these strategic initiatives. We have strengthen our infrastructure in many ways, including transformation of our management of work force, improvements to internal controls and other business processes, implementation of a strategic performance management system that is designed to advance the Company's missions by explicitly linking objectives, measures, and targets to strategy. Our primary objectives for 2006 are to continue to grow revenues while reducing loss from operations; generate significantly greater cash flow from operations to fund additional projects and investments; become a trusted and responsive supplier to improve profitability of accounts; improve the investor perception of the value of the Company by demonstrating continuing financial and strategic progress; and by better articulating our business and financial models; and by establishing a learning environment for our employees with clear shared values to help achieve and sustain profitable growth. The key to success for this plan include improving cash flow and demonstrating a prep to profitable growth; effectively communicating our business and financial models; improve your contract performance, implementation of programs and field operations; understanding the Company's customers and markets better than any other supplier; becoming a trusted and responsive supplier to these customers; improving planning, pricing and quality with customers and suppliers; improving [inaudible] utilization, including the productivity of employees; implementing effective standard operating procedures; hire and training and retaining a winning team, and providing a learning environment with clear assured values.

Our financial goals for 2006 assume organic growth only and do not anticipate any material strategic business initiatives, such as, acquisition or divestitures. Key financial projections include continuing revenue growth, increasing operating leverage, improved EPS, and significantly better cash flow from operations and net cash flow. Our financial projections represent expected values based on management's best assessment of the most likely unfolding of events over the course of 2006. The main risk we see for 2006 include possible procurement, product development and/or implementation delays that could slow bookings and revenue recognition. Department of Homeland Security may confuse the market with its various initiatives and passports, border crossing cards, and REAL ID driver's license compliance. The competitive prices on strategically important accounts could cause loss of market share or slow grow. We could [slowly] grow margins in key programs throughout our sales and more efficient provision of services.

Our outlook in verification of Digital Watermarking Solutions for government issued IDs might not be as successful as we anticipate, and the entertainment industry could get distracted from digital watermarking reducing the momentum we witnessed in 2005. On the other hand, we see many potential upsides in 2006, including that REAL ID funding could flow faster and larger -- than in larger amounts than anticipated. There may be unplanned opportunities that arise to expand provision of new technologies, products, and services to DL and other government ID issuers. We may generate additional efficiencies and identify further cost reductions. Our applicant Verifications and Digital Watermarking Solutions for government issued IDs may be more successful than anticipated or there may be an acceleration of up-front revenues due to REAL ID funding and other sources of government funding. We may execute a home run license agreement that could be closed with a major digital watermarking partner. There could be growth in digital watermarking deployments by our technology and patent licensees that is greater than anticipated.

We know what we want and we know how to get there. Our goals are to develop the quality of relationships with our customers where they will want to do business with no one else. We will want to be a good partner to our suppliers so they will view us as a valued customer. We want to build confidence among shareholders in our ability to provide a superior return on investment, and we want to have loyal productive employees that consider Digimarc a roaring place to work. As we noted in our Q3 conference call we were optimistic about the prospect of achieving these aims. We have a sound strategy, robust markets, and improving operational performance. Cash trends are positive. We are winning new business. Operating costs are under control and being subjected to ongoing careful scrutiny. We intend to drive cost of reconciliation with our revenues and margins in an orderly, yet expeditious manner. We remain engaged in the deliver process to achieve profitable growth and superior shareholder returns. For further discussion of the quarter results, our business and financial models, the risk and prospects for our business, please see the 10-K that we will be filing shortly. The Company will be presenting and meeting with shareholders and perspective investors at New York Society of Security Analysts 2006 Homeland Security and Defense Industry Conference on March 14 and 15 in New York City. This concludes our prepared remarks. We will now take questions.

[OPERATOR INSTRUCTIONS]. Your first question comes from the line of Rick Owens with The Robins Group.

Hi, guys. Can you hear me okay?

We can hear you find.

Good. A couple of questions real quick. Mike, maybe you can help me understand a little bit better the impact of the project cost overruns? Are these things that get amortized over the life of the contract? Is this more of a one-quarter kind of a hit?

And then, Bruce for you, can you maybe talk a little bit more about REAL ID? I guess based on the guidance of revenue of 105 to 115 that would seem to suggest that maybe we are not all that optimistic that '06 is going to be the kind of a year where REAL ID really starts to impact the numbers. And I understand the uncertainties around DHS and all of that, but there are estimates that the upgrade cycle is going to be somewhere north of $1 billion. So can you help me flush out or understand a little bit better the inconsistencies there? Thanks.

Yes, Rick, I will take the first question. We alluded to some cost overruns and inefficiencies on some newer accounts. Those costs would have been capitalized during that delivery and implementation process and they will be amortized over the life of the contract. And so that's why you see the fixed portion of these programs being a bit higher now versus say prior programs. But I think with the efficiencies that we have identified in our processes, future delivery programs will be performed much more efficiently and also as we look at our field operations looking for synergies and leveraging those costs that we have around the states in the U.S.

Okay. Thanks.

On the second point of your question, Rick, our forecast does not contemplate much from REAL ID and that's not because we don't think it will happen. It's just that we are not confident that we can forecast when it will. We believe that the $40 million appropriated by the Congress for FY '06 is entirely insufficient to even begin the upgrade process, but they ought to spend the money in order to get people moving in the right direction though. We believe that the estimates that have been developed by others outside of the Federal Government are more reasonable and those do tend to be in the bills of dollars.

So our understanding is that Homeland Security is moving along with creating some regulations. That are quite far behind the schedule that Congress had set. And the way in which our revenue recognition works obviously is relation to a grant processes, the states would write grants. They would not only have all the grants reviewed, they would receive approval on the grants they've done, either issue an [RFP] or a sole source then that process would finish, then we would deliver and we would recognize revenue. So when you add up all of that it puts the impact of REAL ID, substantial impact possibly outside of the year or later in the year. So that's why we forecasted the way that we did.

Okay. I understand that. Now, just one quick follow on, then. I guess of the 6 million that DHS has already provided to two of the states, one of those states is a Digimarc customer, correct?

That's right.

And have you seen the benefit of that money or those funds being spent in your P&L from that state yet?

No. Neither of the states have spent any money, in fact, neither of the states have received any money yet. They were allocated 3 million each. Now they have to submit a plan for using the allocated funds. That plan needs to be reviewed, approved, and then the funds disbursed and then of the funding of suppliers would occur.

Okay, good. That's helpful. Thanks, guys.

Your next question comes from the line of Brian Ruttenbur from Morgan Keegan.

Great. A couple of questions, first of all, about cash. Can you elaborate a little bit about your cash burn in the quarter was it all -- I believe you were down about 8.7 million as I calculate it from quarter-to-quarter and I was just trying to understand if there was anything abnormal in that?

Actually our burn from Q3 to Q4 was about 1.5 million. We had about 1.5 million of operating cash flow positive and then we had about $3 million invested in CapEx.

Brian, I think you are being confused by the restricted cash.

All right. Okay, that's what I forgot to do is add the [inaudible] back in. That's my fault by doing a quick calculation on the balance sheet. Okay. Thank you. That helps me out a lot.

We were about 1.5 million positive cash flow from operations and then about 3 million of program investments and other capital expenditures for a net of 1.5 negative.

Okay. On your guidance for 2006 you mentioned 105 to 116; is that correct?

105 to 115.

115, sorry. And in that what do you need to do, do you have to win any new business or that -- any major new business or is it just kind of executing on an existing plan? I know you are pulling out backlog for a percentage of that. Is it all your calculations coming from existing customers for the difference between pulling out of backlog or are you counting on some new wins?

I'll tell you most of the answer I am prepared to give, which is that there is 70 plus million in the backlog, so the remainder of it will be generated from other sources. So it does assume some additional business. Some of it with existing customers and some new customers.

Okay. And can you talk a little bit about gross margin erosion in the first half of the year? Can you repeat that and just talk about why gross margins are going to be down in the first half? I'm just trying to understand that a little bit better.

Let me actually give you a somewhat thorough response to that. We straight line our depreciation across the quarters of each year. And that means that when revenues are higher the gross margin will tend to be higher, when revenues are lower the gross margin will tend to be lower. Okay? And it's because the straight line depreciation methodology. And we have a couple of domestic accounts, which are in a transition from four- to five-year terms for driver's licenses. That's for the individual driver's license life. What that does then is that reduces the issuance volume for some period of time to then a new lower steady state. We are going through that downward plane in the first half of the year on those accounts. So that will dampen revenue growth and because the issuance volumes are quiet high margin that will reduce the gross margin as well.

Then in a foreign voter registration program they are having an election and so they have a moratorium on issuing new credentials for a period of time prior to the election. That's temporary. That will pass and then we will be back to normal production. So there's a little dip in the first half of the year that affects both revenues and markets.

Great. Thank you very much.

Your next question comes from the line of Steve Lidberg with Pacific Crest Securities.

Good afternoon, guys, I guess just to follow-up on that last question. How much of revenue do you think is being impacted on a quarterly basis by those two facts as you look at the extension of the expiration period, as well as the moratorium?

Steve, it's Mike here. We are not really prepared to talk about the individuals of the accounts on that. It's a -- it's kind of a one-year transition period and we expect that to recover as we exit '06. There is some degradation and all we've given so far is that the margins will be lower comparable to prior year.

Okay, let's try a different way then. As you look at I guess the last three or four years you haven't had a sequential decline from the December to the March quarters in terms of revenue. Obviously you've pointed to one this year, is that decline reflective of those two -- primarily those two factors?

It is reflective of that and we have given a range that we feel comfortable with. And those three factors have an impact, a negative impact on the revenues.

Okay. Also on the operating expense side of the equation, if you look sequentially depreciation grew about $400,000 sequentially. Your total OpEx is up about 1.5. What is that delta there?

The OpEx sequentially was only up a couple hundred thousand dollars.

I'm sorry, total cost of operations.

The depreciation was higher as the larger programs came into full production, so we brought in those costs. The people who were working on deployment, which are capitalized costs now, are working on operating costs, so those have an impact as well. And then as well if you talk about total cost, there is a mix of revenue where we had some large sales of very low dollar margin items that occurred in the quarter that had a drag on the margins as well.

Okay. And I guess related to that, the jump in general and G&A sequentially?

Yes, G&A actually was right on our internal target, which really is from two factors. Primarily the new auditor orientation, some of that in a normal year would be more evenly split throughout the year but because of the new [arc] orientation we had a big uplift in Q4 along with Sarbanes-Oxley work, a little bit of legal uptick as well. So that was pretty well on target for us. But we expect that to moderate over the coming quarters.

And as you look at your guidance for 2006 of approximately $10 million in cash flow improvement, where is that coming from primarily or I guess how much of that is coming from cost reductions?

The prime driver of that improved I think we indicated 10 to $15 million improvement is going to come from lower operating expenses and costs. There will be some margin mix benefit as well, but a great deal of it is going to come from improved costs. There is some balance sheet management benefits as well as we look at things like receivables and inventory, but you can only get those numbers so low based on a growing revenue base. But the majority of it's going to be in lower expenses, lower-cash expenses.

Steve as we moved into '06, we will continue to carry roughly around $2 million of amortization of purchase intangibles of customer relationship intangible. That really doesn't explain the improvement in cash flow as much as the stock compensation charge, which will be a new charge that will go into OpEx, and the increased depreciation. And as we noted in the script the increased depreciation is largely attributable to just a few accounts. And so the OpEx comparison '06 to '05 will contain a larger proportion of non-cash expense.

So it was the elimination of cash expense primarily coming from a reduction in your contract workers?

It's coming from expense management across all aspects of operations, but in particular a reduction in labor costs, not just the contractors but we've reduced all of our labor costs pretty significantly. And that will begin to flow through. The other benefits will be that if you look back on 2005 the first half of the year we were still finishing up the restatement work and the second half we were orienting a new auditor and doing Sarbanes-Oxley. So it's kind of a brutal year on overhead. That should be significantly better in '06.

Okay. And I guess lastly, Bruce, as you look at the landscape of contracts out to bid, what kind of year do you anticipate especially given the backdrop of REAL ID that could disburse some additional activity? Thanks.

Yes, I had thought back at the start of '05 that Homeland Security might be a bit more responsive than they have been, so I thought that bid activity might step up because of REAL ID. Now I think for the near-term at least it's probably the opposite; that is, that states that might be considering going to bid might be inhibited from doing it while waiting for the regulations at least to come if not the funding. And so it could be a pretty slow year for bids. At this point in time there's only one open bid. And so I'm anticipating that it won't be a very active year in bids, which if true would have a positive impact on our cash flow.

So one of the things that paradoxes over our business is obviously if there's a lot of activity going on and we are winning a lot of bids then there's some capital requirements, if it's kind of quiet then the cash flow tends to improve the net cash flow. So we are prepared to bid and win. We are presented but it's a little hard to handicap right now what the flow of opportunities will look like in the year.

Great. Thank you.

[OPERATOR INSTRUCTIONS]. Your next question is from the line of Kevin Hanrahan from Hanrahan Capital Management.

Hello, Bruce. Can you hear me okay?

I can hear you fine, Kevin.

Okay, I had a question, I saw right at the beginning of this year, in January, you issued some options, I think it was about 0.5 million options which vested over time. And then some performance shares and the performance shares are based on the achievement of a specific stock price within three years it looks maybe by the end of '08. Can you tell me some details about those performance shares?

It's actually pretty straight forward. There were stricted shares granted to the executives, a portion of them were time-based over four years and another portion were performance-based and the performance criteria [wasn't] meeting a specified share price within a three-year period. And that share price is obviously significantly above the current share price.

Significantly above?

Yes.

So it's not below the current share price or anything crazy?

No, no, it's an ambitious target.

Is it -- what did -- can I ask you is it up in the teens somewhere?

Yes. I will say that, it is.

Okay. That's good. Last year you were saying, I think on one of the calls, it may have been the June quarter. You were saying that you had a lot of accounting costs and legal costs related to the restatement and the accounting and the Sarbox compliance which I was happy you finally met. And you expected those to fall as you went through time. But it looks like the costs were still pretty high in the second half of the year but you are expecting them to fall off this year?

Yes, when I made those remarks I didn't anticipate we would be changing auditors. And so we think Grant Thornton is an excellent audit firm but we had to spend the second half of the year educating them about our business. So there is obviously a substantial one-time cost of education associated with that. And we did make an excellent initiative on internal controls and achieve Sarbanes Compliance only six months after we got current on our financial statement. So in doing that we obviously also incurred significant non-recurring costs. So I had thought we would get done with the heavy costs a little earlier than we did, but I'm pleased to say that we are finally there. And so we should see benefits from not having to do those things any longer.

If I can ask, Mike, do you expect that the 10-K will be out on time and the Sarbox and the accounting will be no problem this year?

Right. We expect the 10-K to be issued in the next couple of days and we fully expect the auditors to give clean opinion on the internal controls. Management has made its assessment. We've assessed them as effective and we expect the auditors to do the same based upon where we stand today.

Okay, thanks, Mike. One last question, last year I know you had the restatement and then it finally became final around May, I believe. And then this year you are reclassifying some costs and then you're looking at these useful lives of these assets which could affect your costs and depreciation, I think. When do you think you will have that looked -- when will you be done looking at that issue?

We are planning on having that completed by the first quarter. So we are working on that very heavily now doing research and documenting our findings and making our assessments and recommendations as we study the lives of all the contracts that we have and the extensions we've received over the last four years.

That would be good, I mean, the legacy, you've dragged the shareholders through this issue, it seems like the accounting should be more simple for a company that's got such a high percentage of recurring revenue. It should be more basic than it has been, so,

We concur. [Laughter].

I wish you good luck on that in the future.

Thank you. These improvements that we are making in financial reporting are being responsive to shareholder requests to understand the business better. So we are looking for ways to enhance transparency to provide information that doesn't create a competitive detriment against our shareholders interest. So in the G&A reclassification we think this will be quite helpful in understanding our cost structure. And then in examining the useful lives, when we entered the business not having any experience and given the [assets] that we acquired with the Polaroid Corporation that wasn't a well run company, we took the most conservative approach available. And based on the experience of the past four years we believe that we may be underestimating the useful life of those assets.

So were looking at all the data and we'll make a proper presentation to the auditors and the audit committee. And then if we decide to make a change we will fully explain it to everyone. And our objective here is to do the best finance reporting that we can so that we gain credibility with the financial community. We went through a rough patch a year and a half ago or so, and so we understand that we've got a bit to prove and we are doing our business to show high integrity and the kind of values that will cause people to want to own our shares.

Okay. thank you.

At this time there are no further questions. Are there any closing remarks?

I want to thank everyone for joining us on the call. We do feel like we have got the rough times behind us. We are ready to roll. We are excited about the business. We have a good strategy and good plan. And we have improved our management and our work force and we are ready to do business and deliver improving financial performance. So thank you to everyone for the support that you have given to the Company and we look forward to our next call.

This conclusions today's Digimarc Corporation Q4 and FY 2005 earnings conference call. You may now disconnect.