Digimarc Corp (DMRC) 2006 Q1 法說會逐字稿

Good morning. My name is Dennis and I will be your conference operator. At this time I would like to welcome everyone to the Digimarc Corporation first quarter 2006 quarterly earnings call. [OPERATOR INSTRUCTIONS]

I'll now turn the call over to Mr. Bruce Davis, Chairman and CEO. Please go ahead, sir.

Good morning, ladies and gentlemen. Welcome to our Q1, 2006 financial results conference call. Mike McConnell, our CFO, is with me on the call. I'm in Monterey at the AeA Micro Cap Investor Conference. Mike is back home. We issued a press release earlier today announcing our Q1 financial results. The objectives of this call are to summarize and comment on these results, review significant business developments and market conditions, and provide guidance 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 more detailed information about risk factors that may cause actual results to differ from expectations, please see the Company's filings with the SEC, including the MDNA section in our most recently filed Form 10-K 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.

As I noted in the press release, we completed a number of projects in addition to improving the quality of a number of existing customer installations in Q1. These activities coincident with delays and start up of some anticipated capital programs contributed to the loss for the quarter. Our continuing operational improvements and the completion of these projects dovetail with a quieter than normal U.S. credentialing market environment in anticipation of publication of federal regulations effecting driver licenses later this year and a DHS plan to fund REAL ID improvements. This gives us an opportunity to step up the pace of progress to our profitability by more aggressively reducing fixed costs.

We intend to implement measures shortly that will significantly reduce fixed expense run rates during the second half of 2006, bringing our operating costs and margins in line with achieving profitability within the next few quarters at revenue levels projected in our previous guidance that we reaffirm in this call. We expect that the U.S. driver license market will demonstrate strong demand, once the REAL ID ambiguities are resolved and that the changes we will be making will not effect our ability to serve the increased demand among our government customers. We are reiterating our 2006 revenue guidance and projecting that EPS and cash flow for the year will improve significantly over 2005.

Before we proceed with commentary on financial results I'd like to note some of the highlights of Q1, which included the highest quarterly revenues in our history. Cash flow continued its sequential improvement as we had projected, including positive cash flow from operations and a net cash burn of less than $1 million. We entered a new six-year contract with Indiana and extended contracts with several other customers. Our first customer for the Digimarc Identity Validation Suite achieved noteworthy success in its early deployment, as chronicled in local press. We introduced ExianEvident 3D, a breakthrough in security identity credentials designed to deliver see, feel, and machine validate authentication, with a unique 3D tactile security feature that a card inspector can feel, laser engraving and perforation that an inspector can see, and machine-readable digital watermarking. We completed implementation in Iowa of a new highly-secured digital driver license system that includes Digimarc IDMarc digital watermarking. More than 26 million U.S. driver licenses in circulation now carry IDMarc as a security feature, with that number growing daily.

The trade association for pure-2-pure file sharing companies formed a working group to determine the ways in which digital watermarking can be used to identify and protect copyrighted music, movies and images in p2p file sharing networks And our patent portfolio grew significantly, as we announced issuance during the quarter of more than 30 new U.S. patents, covering a range of innovations that enable better management and protection of music and movies, among other things. Notable developments between the end of the quarter and this call include: An agreement with Microsoft for use of Digimarc's® ImageBridge digital watermarking to protect its virtual earth satellite images; a second partner to bring Digimarc Mobile print-to-web linking technology to market, as Madrid, Spain based Aqua Mobile signed on to deliver the benefits of this technology to the 30 million mobile phone users in the Spanish and Portuguese mobile markets; and the contract extension, valued at an estimated $2.4 million over the next year, with our Russian partner OTT, to supply secure ID materials to satisfy projected volume increases and driver licenses issuances in Russia.

Mike will now explain our financial results.

Thanks, Bruce, and good morning, everyone. Before we discuss first quarter operating results I want to explain an improvement in the estimates of depreciable lives for our program capital assets that we are implementing and the impact of that change on our financial statement. Prior to January 1, 2006, our assumption had been that, in general, the useful lives of program assets were equal to the initial term of the contract associated with the program. This initial estimate that we've used since acquiring the assets from Polaroid was a reasonable starting point, given that we new the business and had no experience to draw upon. As we have gained experience and collected data for the last four years, we have noted that the useful lives of these capital assets is considerably longer than we assumed. Effective January 1, 2006, we changed our depreciation for these assets to better match expenses with the estimated useful lives of and related revenue streams from these program assets. This change in estimate reduced depreciation expense by $2.1 million or $0.10 per share in the first quarter of 2006. We have a more detailed discussion of this change in our Form 10-Q that is expected to be filed within a couple of days.

With these changes in mind, let's proceed with the discussion of our first quarter operating results. Q1 revenues were 12% higher than last year due to increased domestic issuances and some higher international sales. On a sequential quarterly basis international revenues increased 13% to $7 million, primarily due to a large consumable sale to an international customer, and U.S. revenues grew 6% to $20.2 million, largely from increased issuances due to seasonality. Issuance revenues for Q1 of 2006 also benefited from Florida and Alabama being in full production. Gross margin for the quarter came in at 28%, consistent with our forecast that margins will lower in first half of 2006 compared to 2005, due primarily to three programs going through short-term transitions. The gross margin decreased by six percentage points year-over-year and increased two points from Q4, reflecting a seven percentage point benefit from the change in depreciation.

Cost of sales includes direct-to-variable costs, fixed field support and manufacturing cost, and program depreciation. The direct-to-variable cost component, which includes the cost of materials to produce our identification card, and cost of hardware, consumables and software related to our product sales, was comparable to prior year and up slightly on a sequential basis. Both current and prior year quarters reflected a sales mix that included lower margin sales of hardware and consumable products that occur from time to time.

The change in gross margin from prior year is driven by a higher fixed field support and manufacturing cost, and the change in gross margin from the prior quarter is largely driven by the benefits originating from changes in the program depreciation expenses discussed previously, offset by these higher fixed costs. The year-to-year change in fixed field support and manufacturing generally reflect increased costs of delivery for certain key strategic account wins, where we provided a complete system solution replacement with a broader mandate than in most previous systems. These solutions were more complex than prior programs. While we were ultimately successful in these deployments positioning us for future total solution projects, we ended up with costs that were higher than have been customary and in a couple of cases higher than anticipated.

As a result of these investments, we have developed new expertise that we believe enhances our market leadership and growth potential, complimenting the upgrades of our management, our work force and internal business processes that we have noted earlier, all positioning us to lower our operating costs on our existing base of business. In Q1, we also experienced a lower cost deferral of labor to our capital investments that contributed to the increase in our fixed field support and manufacturing component of cost of sales. This was primarily due to investments made to improve the operational efficiency in some existing programs and delays in initiation of some capital projects. In the second quarter, we've already redeployed a substantial amount of our labor resources to capital projects, as we ramp up major programs in Texas and Indiana.

The overall gross margin reflects the average margin on all of our accounts, and gross margin tends to increase over time and accounts due to sales of additional products and services not included in the base contract and efficiencies in service in the accounts gained over time. We believe that the key to margin improvement is providing good value as a trusted and responsive partner of the customer. We are pursuing this goal through staffing and process improvements and various other strategic -- strategic initiatives that we anticipate will allow us to improve margins over the life of the new accounts and earn a good return on investment. Our operating expenses were up $500,000 from prior year and down $300,000 from prior quarter, in line with our expectations and guidance. Approximately $700,000 of the $800,000 noncash stock-based compensation expense recorded in the first quarter 2006 was reported in the operating expense line, versus only a minimal amount recorded in 2005. Approximately $600,000 of the total stock compensation expense reflects the January 1, 2006, adoption of new accounting rules for such compensation.

The EPS lost for the quarter was $0.30 which represents a decrease of $0.05 per share from prior year and a $0.07 per share improvement from prior quarter. Regarding the balance sheet that March 31, 2006, we had approximately $31 million in cash and equivalent short-term investments and restricted cash. Cash flow from operations was positive at $400,000. Net cash flow for the quarter was a deficit of $1 million, and represents our lowest cash burn since late 2003. The overall improvement in cash flow is attributable to: Lower program capital expenditures; a reduction of DSO's year-over-year from 57 to 48 days, that was driven by better customer satisfaction and account management; and advanced billings and collections for some contracts; and benefits received from a more efficient inventory and supply chain management. Our back log at the end of the quarter was approximately $220 million, down $10 million from Q4 and $20 million from Q1 of last year, due primarily to the natural burn off of revenues previously booked, net of new contracts and extensions, in a period of relatively low competitive bid activity.

Bruce will now provide some comments on our plan to improve our financial performance.

Thanks, Mike. Our focus for the past year has been on restructuring operations to improve the quality of management, our work force more generally, and our internal processes and learning and training programs to lay 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 and reducing cost. Nearly the entire management in our ID Systems area was replaced and we dramatically reduced reliance on contract labor. The contract labor reductions were part of a concerted plan to improve customer service, accountability, predictability and institutional knowledge, improve work force utilization and, generally, reduce our labor cost. As a result of these activities, we simultaneously improved the quality of our work force and lowered cost, knocking millions of annual -- out of annualized labor cost. We continued this process in Q1, as the majority of the remaining domestic contractors were converted to employees or terminated.

As I noted in my introductory remarks, we are now prepared to make further cost reductions in light of the efficiencies we have gained. We're in the final stages of restructuring the Company to achieve profitability. Our focus is on gaining efficiencies from our work force. We are trimming costs wherever possible, improving program management and associated allocations of labor, and making the organizational changes necessary to encourage versatility in our skilled labor pool so that resources can be efficiently shifted, based on the needs of our customers and growth opportunities. 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, risk and opportunity management and benchmarking of corporate performance in all major functional areas.

As we address the cost side of the business we are excited about the prospects in our markets, and as I noted above, we expect a temporarily -- temporary lull in U.S. driver licenses to be followed by a period of strong demand. In digital watermarking generally, market conditions are the most favorable we have seen in years. Along these lines we are very pleased with the recent decision by Microsoft to use our Digimarc's® ImageBridge digital watermarking software to embed digital watermarks into tens of millions of satellite images to protect copyrights in its new virtual earth mapping service. The recognition of the value of digital watermarking in the IT industry has lagged behind the growing momentum in the media and entertainment industry. Given the important role that the IT industry is expected to play in providing infrastructure for many new means of distributing news and entertainment, it is encouraging to see a major IT player like Microsoft adopting digital watermarking. As watermarking is increasingly used in entertainment content we believe that the relevance of this technology to IT suppliers will become more obvious and inevitable.

We continue to grow our IP asset base and serve as a catalyst to accelerate the adoption of watermarking. Our well-established IP portfolio continues to garner respect, giving rise to new business opportunities and relationships with Thompson and Dolby during the past couple of quarters. The Dolby relationship is already bearing fruit in the recent announcement by Widevine that it is using Dolby's watermarking in its IP TV security for set-top boxes from industry leaders Scientific Atlanta and Motorola. Industry standards for media security are increasingly embracing digital watermarking. Audio and video watermarking are included as requirements in the digital cinema specification. The interim license for high definition DVD formats notes that the final license is expected to include a digital watermarking requirement. The DVD CCA requests for expressions of interest to evaluate technologies for use in standard definition DVD. Copy protection and play control also include digital watermarking.

Most recently the trade association for the pure-2-pure file sharing companies announced a resolution to support digital watermarking for the protection of entertainment content in p2p distribution. Our Digimarc Mobile initiative got a boost during the quarter, with the signing of a license agreement with Aqua Mobile for Spain and Portugal. We also expanded our relationship with Media Grid, our Mobile go-to-market partner in Japan, to permit them to more broadly apply digital watermarking in the Japanese market. Media Grid has deployed a considerable amount of watermark reader technology and is now focused on embedding content to leverage their structure. Media Grid estimates that they now support over 30 million camera phones in the market in Japan, including multiple models from KDDI, DoCoMo and Vodafone.

At this point Mike will provide an update on financial guidance for 2006 and then I'll return with some closing remarks. Mike?

For the second quarter of 2006, we expect revenues to be in the range of $24.5 million to $25.5 million, up from prior levels and down sequentially from the $27.2 million in Q1, reflecting the absence of the large international supply sale that occurred in Q1 and also reflecting a previously-announced Q2 hiatus in our Mexico plant for elections in that country. Gross margin should improve sequentially as a result of lower fixed cost-of-sales component. Our recurring operating expenses are expected to be down as well, and EPS is expected to improve.

Operating cash flow is expected to be lower. We expect to have negative operating cash flow of $1 to $2 million, reflecting operating losses pending completion of fixed cost reductions and less cash from balance sheet efficiencies, as our receivables and inventories have been considerably optimized. Operating cash flow should return to be positive in Q3. Capital expenditures are expected to increase over Q1 amounts by $2 to $3 million, as we ramp investments in Texas, Indiana and other capital programs. For the year 2006, we reaffirm our expectations that revenues will be in the the $105 to $115 million range. Gross margin improvement will be a main focal point for our management team, as expected to improve the second half of the year as compared to prior year. We expect the full loss -- we expect a loss for the full year of 2006 that is significantly lower than in 2005 and quarterly trends that demonstrate a clear path to profitability. Operating cash flow will improve by $10 to $15 million over the prior years $3 million deficit and net cash flow will be approaching break even.

Thanks, Mike. Our Company operates in attractive markets. Over the course of the past 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, acting as a gateway document to social and economic services. Revenues from our digital watermarking will grow as the markets for applications that the technology enables develop, based on the Company's substantial patent portfolio and well-established IP licensing program. For various reasons during the last couple of years, our earnings have suffered and the path to regain profitability became murky. We have responded by establishing a new senior leadership team, acting with diligence and focus to improve the quality of our technologies, products, services, customer relationships, management, work force, business processes, and investor understanding of our business and financial models. Our plan is continuous improvement over the last year, paved with improving quality throughout our operations, growing revenues and improving cash flow, is intended to deliver sustained profitability.

As we announced today, we intend to step up the pace of progress toward profitability by implementing measures to significantly reduce expense run rates during the second half of 2006, bringing our operating costs and margins in line with achieving profitability within the next few quarters. Further improves in the value of Digimarc should follow, as we attain an improved profitability, demonstrate the growth potential of our business, and establish linkages to adjacent high-growth high-value markets. Investor interest in the Company is increasing, creating more interest among investment banks. This has led to new research coverage and more invitations to investment conferences than at any time in our history. The furtherance of the goal of reinvigorating the appreciation for the value of Digimarc through analyst briefings, conferences and non-deal road shows we presented at three investor conferences and conducted one non-deal road show in Q1. The Company will be presenting at numerous investment conferences during May and June as outlined in our press release dated May 2nd. The press release is posted on our website. Further discussion of the quarter results, our business and financial models and the risk and prospects for our business, please see the 10-Q that we will be filing shortly .

This concludes our prepared remarks and we'll now be happy to take questions.

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

Morning, guys.

Hi, Rick.

Bruce, I wonder if you could quantify a little bit what you're thinking as along the lines of reducing expenses for the second half of the year, again, kind of off the run rate we saw in Q1. Is that mostly operating expenses or should we see some COGS benefit as well? And what is the timing, I guess, on, letting us know the specifics of these maneuvers?

Our cost reductions will affect the cost of sales as well as operating expenses. And as you know, in our business, our labor costs in particular run into three different buckets of capital expenditures, cost of goods sold and operating expenses. We do expect there to be more capital projects that we can invest our labor resources in later in the year, so that reductions will come from the increasing involvement in programs and decreases in the fixed run rates that will be reflected in both gross margins and OpEx. As far as more specifics, we will give you some more a little later in the quarter. It would be premature to go into much detail at this point, but I will say that we will be knocking millions of dollars out of the run rate going forward , so that the changes that we'll make will be substantial.

And just to make sure I heard you correctly in your prepared remarks, you indicated that, within the next few quarters that these actions should be enough to get you back to a profitable-type basis, at least on a quarterly level?

That's right.

Okay. Thank you very much.

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

Yes, thank you. First of all, I was wanting to just take off on that profitability question and understand your definition of profitability. Are we talking EBITDA? Are we talking cash flow? Are we talking EPS?

We're talking GAAP, GAAP EPS.

GAAP EPS. Okay, great.

And you know, of course, we're carrying between $3 to $4 million of stock compensation charges under the new regulations.

And you're going to be able to get past that $3 to $4 million, and even on a GAAP basis get back to profitability; right?

That's our intention, yes.

Okay. The revenue guidance I'm a little bit confused. We have notes and maybe our notes from last quarter are wrong, but we had published that your revenue guidance is 110 to 115. Is it different or did we just write something down from last quarter incorrectly?

No, that was was 105 to 115 from last quarter's call, so --

Okay, great, so there's no change there. Perfect.

No change.

That was just a mistake on our part.

We appreciate your optimism, Brian.

Okay, and you mentioned 30 new patents in the quarter. Can you talk about how many patents you have and are all of those around digital watermarking?

We're getting pretty close to 250 issued patents and closing in on 6,000 claims in those patents. The vest majority are watermarking related, or I would say content management related using signaling technology, probably 90%, 85-90%.

Where are the other --

Depends how you count them. Well, in credentialing.

Credentialing.

For the most part.

Okay. And then just a couple other clean-up questions, trying to understand things like the Microsoft deal. You mentioned that tens of millions of satellite images are going to have watermarking, going forward. Can you give us some kind of parameters? I still don't understand the business model and the watermarking area, about how big this is on tens of millions of images?

Yes. Everything that we do in all areas of our businesses is based on some concept of volume. In the case of the Microsoft contract, it's an annual subscription fee for a period of years.

Okay, and when do you book that revenue?

I'll defer to Mike on that question.

That's booked on a straight line basis, initially based upon minimum requirements, and then as volumes would exceed minimums, then that would be on a quarter-to-quarter basis.

Did you book any this quarter?

No, we did not.

Okay so you didn't book any in the March period, but you plan to on a straight line basis over what, two years, three years?

It's a number of years. We're not giving out all of the specific terms. We expect, actually, this to inspire others in related businesses to want to study the benefits of watermarking, so we don't want to get into a great deal of detail on the first contract in this area.

Okay. And then last question, I believe -- well I got one other one besides this, but the $2.4 million relate to Russia, can you talk about what's going on there? Are they -- I'd heard rumors flying around about them looking at a biometrics national ID card in there, and was just wondering what you were hearing and if you were going to compete on that, as it looks like a lot of the Eastern block is -- or old Eastern block is looking at going with biometric ID cards?

They are -- they still use film in the production of their driver licenses. We anticipate that they will go to digital driver licenses in the not too distant future. I've heard the same rumors that you've heard, but we don't have any basis to believe there's much substance to them. I think that the smart card suppliers are trying to make it out like the entire world is embracing their technology. We do expect them to go digital. I, frankly, don't think they're going to smart cards in the near future. We will supply whatever technology they need.

Okay. And then the last question is on the SG&A line, I think what you were telling me on the SG&A, DNA, everything, when your revenue dips all of that should dip from quarter to quarter also? We should see a sequential downward movement in all of your operating expenses, or is it only specific line items that we should see a dip? From quarter to quarter, as you see less revenue in second quarter than you did the first.

Are you saying that the -- each component of cost of goods and each component of OpEx is that the question?

No. The question is on the operating line, your -- not your cost side. Your gross margins, you've already given kind of guidance that they're going to be up, but on your operating expenses , breaking it out by line item, I was just wondering, you know, on your SG&A, your DNA, are you going to see dips from first quarter to second quarter?

Mike, do you have an answer for that?

Yes, I do. Actually we will see some small reduction in those items. We didn't provide by line item between sales and marketing, G&A and R&D, but, overall, we expect a slight reduction.

Okay, great. I was just trying to figure out it if was one line item, but it sounds like ir's -- all of them are going to dip slightly. Is that correct to say?

I'm not going to really provide the details. I'm just looking overall. One item that gives us variability, of course, is the stock compensation that gets spread among all of the different areas.

Excluding stock based compensation. That's what I was just trying to figure out, because that's uncontrollable.

Right. I'm looking at reductions pretty well across-the-board, but I think we'll -- it's going to be rather small for the firs -- for the second quarter, and then we'll see, obviously, improvements going forward in third and fourth.

Okay, and last question, I promise. On the profitability in the next few quarters, you mentioned on a GAAP basis, and you defined that for me, but I was wondering what kind of revenue you're going to need or is it going to be a cost issue? Are you going to have to have $30 million, $40 million of revenue or is it just -- just kind of revenue and really controlling your cost structure to get to profitability? What are you guys looking at as a business model down the road?

I can help out on that one, Mike. Brian, you understand the seasonality model of our business. We provided guidance on that and it affects the quarter fluctuations in revenues. We've given a range for revenue guidance. When you add the two together, you get the answer to your question. That is the basis on which we are making the cost reductions that will bring us to profitability.

Okay so you're saying on $110 to $115 million annual revenue that gets you to profitability?

That's what we're saying.

Okay, great. Thank you ver --

Now that's on a quarterly basis in the second half of the year. The full year we'll have a loss.

Okay. But once you get profitable, you anticipate staying profitability, right?

Yes, that's the objective.

Thanks a lot.

Your next question is from the line of Eric Appell with Merriman Curhan Ford.

Hey, guys, how are you doing?

Hi, Eric. Fine, thanks.

Just one question on the drivers license. The number -- Q1's your weakest -- seasonally weakest quarter and you had a pretty strong top line; you said Florida, Alabama full production. Were there any other factors? Were there any upgrades? Was there any one-time non-recurring events taking place inside the DL revenue item?

This is Mike. I'll address that. Actually, Eric, Q4 is our lowest DL issuance quarter and has been for, I think, way back 30 years with Polaroid. In each of the successive quarters, Q1, Q2, and Q3, it rises up a bit, with Q3 being our highest quarter of the year. In the quarter, there was, obviously, the strong benefit of having full Florida and Alabama production compared to prior year. We also had a, you know, strong push a little in Mexico right before the voter hiatus. Other than that, there was nothing unusual on the domestic side. We did have a large sale, as we mentioned, for some consumables internationally.

Okay, and just on the REAL ID Act. Obviously, the states are making a lot of noise. They absolutely want funding for this project. How do you see it rolling out at this juncture? Have you got any more flavor on the $100 million versus the several billion, and have you heard anything about whether the Department of Homeland Security expects to provide a lot more grant money than, let's say, the $100 million that's been estimated and potentially allocated?

There's quite a lot of discussion and controversy surrounding REAL ID right now and another piece of legislation, known as the Western Hemisphere Travel Initiative they refer to as WHTI, W H T I. There were hearings last week in the Senate, foreign relations committee regarding the relationship between the travel initiative which covers travel between U.S. The -- there were hearings last week in the Senate Foreign Relation Committee regarding the relationship between the Western Hemisphere Travel Initiative, which covers travel between the U.S. and it's northern and southern neighbors and REAL ID and driver licenses and passports. And the State Department would like to have a lower-cost document that is suitable for national security purpose in crossing borders that's not a passport; passports are $95 a piece and they're kind of awkward to carry around. And so we, and a number of northern states and the Canadian government, have been saying to the United States government; hey, why not use your REAL ID funding and your mandate to make the licenses acceptable for the purpose of the Western trema -- Hemisphere Travel Initiative?

If we can help the federal government to understand the virtues of bringing those two initiatives together, that will create a huge upside, I believe, in the business and will actually -- it's the most rational outcome. It delivers service to the American citizens on a multi-application document they already have, enhancing its value for all of those services. It offers the lowest operational risk of any scenario the federal government has described. It offers the lowest cost, and it reconciles some of the political differences of federalism, where in many of the states were objecting to -- and many citizens objecting to the notion of a national ID. So having a federated ID issued by the states and databases managed by the states is the right way to go. And so there's public debate now, very substantial and vigorous public debate trying to educate the policy makers in the Department of Homeland Security and Department of State that we have a path forward and it involves not only funding REAL ID to the tune of the $40 million in the initial year, but providing adequate funding, which is much more than that, in order to benefit the citizens in all the ways in which they use this credential and to manage the task of national security more effectively and more quickly than any other strategy they could embrace.

So we're talking about a quasi passport intro Nor --

No, actually, what we're talking about is if you follow the marketing of smart card companies, they talk about, you know, how smart cards are terrific technology and they're especially good for multi-application purposes. Well, the United States driver license is a multi-application credential already and so we don't need a lot more specific use credentials, which would be what the border pass card that stated Homeland Security proposed for WHTI would be at -- they said $50 a piece for people to throw another card into their wallet. Why not just move on with a reconciliation of the ideals of REAL ID and WHTI and deliver an enhanced driver license; most convenient for the citizens and all of the other virtues that I just described. It actually moves the technology base forward in a way that everyone has talked about, but it does it by leveraging the existing infrastructure and, as you know, we're supplied 70% of all of the licenses in America, so we would be a key catalyst for that change.

Would this discussion of a quasi passport help explain the -- why we haven't seen the DHS propigate with the new standards for REAL ID? Is that playing a role in the delay?

I think that the staff at the Department of Homeland Security is trying to figure out how to do the right thing, and there is this complication of the coincidental passing of the Western Hemisphere Travel Initiative with REAL ID. And I think it's pretty obvious, as I summarized, the situation with the two laws that it would make a lot of sense to bring them together. They were not passed in that fashion. They were passed with separate legislation, with sort of separate motivations and sponsorships, so there's now open discussion about trying to reconcile them, and so I suspect that may have something to do with how they'll sort out the regulations ultimately.

Interesting. Okay, thank you.

Your next question comes from the line of Rob Stone with Cowen and Company.

Hi, guys, thanks for not hosting this call right after the close at the same time as five other companies.

[LAUGHTER] You're welcome, Rob.

The revenue in Q1 came in above your expectation, at least based from the last call. Was it the consumable sale internationally or where did revenue surprise you on the upside?

This is Mike, Rob. The consumable sale was definitely, you know, a large factor. We also had a little bit more revenue from our domestic international groups, Mexico as I mentioned was up a bit, maybe it was a push before the hiatus on the vote. And then there was a mix of upside on your number of domestic areas normally in the trend of our seasonality increase in Q1, but maybe just a little bit stronger than anticipated.

Okay. Can you comment a little bit more on the gross margin trend you're expecting in the second half? I guess what I'm trying to reconcile here is the comments about closing to profitability and how much of that is going to come in improvements in cost of sales versus other operating expenses. I know some of that is going to be because of headcount flowing into capital expense, so my related comment would be if you have a CapEx figure in mind for the full year?

We have not provided the capital projection for the full year other than it's probably going to be less than it was last year. If I recall we did about $15 million of CapEx last year, probably split close 50/50 between labor and hard assets. I'm projecting it will be lower this year. We haven't given a specific. But I think -- back to your note on the trend, I think we did indicate that we should see some small reductions in the operating line this quarter, some nice reductions in the GM area as people are working on capital projects and then, all areas being benefited Q3, Q4, thereafter from some of the expenses reduction initiatives that we're implementing now.

So it sounds like it's -- to get and just to be sure, I heard you say a few quarters and then I thought I heard Bruce say getting to GAAP profits this year, so I assume we're now talking about Q4. So is that what we're talking about and is, then, more of the closing of the GAAP coming out of OpEx than gross margins?

No, Rob, I believe you may have misunderstood what I was saying. Perhaps it is in the interchange with one of the other analysts. What I said was that we would show -- are projecting to show a loss for the year that's substantially less than last year and that, within the next few quarters, our target is to achieve quarterly profitability. And so, a few is more than one and less than a lot. So there are two quarters left in the year after this one, so --

Okay.

How far apart is what I'm saying.

But you weren't trying to guide people to expecting a GAAP profit in Q4 of 06?

I was not targeting a specific quarter, you're right.

Okay. Thanks very much.

Yes.

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

Good morning, guys. With regards to kind of the fixed field support and the sequential increase that we saw from Q4 to Q1, what is that largely tied to and, as you migrate contract related employees to full-time employees, are we seeing some double cost there that bring that category down on a go-forward basis?

This is Mike. I'll open this one. A lot of the change from Q4 to Q1 was reallocation of resources to work on some of our operating initiatives that did not charge their time to capital, and plus we had some delays of initiation into new capital projects. And so that's one of the large areas of expense. And I think we mentioned, even last quarter, that as we're closing up some of these newer installations, we're incurring more cost than we would have liked and traditionally had. And so now, as you bring closure to those, we should see some lower costs, which is what's driving the cost reduction that Bruce has eluded to previously.

And where did your headcount finish up?

Headcount was in the -- including contractors was in the mid 500's, 538, 53 --

Yes. I think it was around 535, 538, Steve, end of the quarter, which is down between the 12% and 15% from our peek run rate in the middle of last year.

Great and then lastly, with regards to the capitalized program cost and CapEx -- we touched a little bit on it with regards to the last question -- but those categories in the March quarter are down substantially, sequentially and on a year-over-year basis. You think those categories are consistent, as we migrate through 2006 or what do you see with regards to spending there?

Well, the spending will definitely be more towards capital, with that group of employees that worked on some operating initiatives. Right now, they've been moved into the timing tha's planned on things like Indiana and Texas, so there will be more capitalized labor in that going forward beginning in Q2. So I'm not going to provide the estimate for the balance of the year by quarter, but it is substantially greater than what we've seen, as we now have assessed our overall resource pool and allocated them to the various projects.

Right, and I'll add some comments, Steve, about my view of the U.S. driver license market and the large programs. We have two large programs that are publicly announced that we're working on, Texas and Indiana. There are not many major bids pending. In fact, there's only been one pending for -- now for the past year or so. So there's a little bit of a lull here and we do expect it to be temporary and we expect it to be followed by a period of strong demand. And you know the way that our business operates. The strong demand would be evidenced by the issues of RFP's or the execution of sole source extensions and renewals followed, then, by contract negotiations followed by a period of planning followed by implementation. And so we expect the capital spending this year to be lower than last year.

We do expect it to be increasing as the year goes along, and we expect that if that surge in demand comes, that would absorb a larger share of labor resources than was true in the first quarter of this year, significantly larger. So, we'll see how things go. My handicapping of the market right now is that there's a possibility of a surge in bid activity later in the year, if DHS stays on its delayed schedule, which would be to deliver regulations in the middle of the year, some time in the next several months. And if they don't, I still actually think there'll be an increase in activity, because the states will get to a point where they just say, we're going to go on anyway because we have to. So, there's been a little pause here while the states have waited to see if they can get more visibility on what the federal requirements will look like and the federal funding.

And then lastly, Bruce, as you look at the initiative to drive toward profitability and given the revenue projection - or your revenue guidance has remained relatively static versus last quarter, how much of that improvement in profitability is coming from a real reduction operating expenses versus a reallocation of, you know, accrual expen -- or accrued expenses versus what you're going to capitalize going forward?

I think that we'd defer a more detailed answer that we've given until we announce more specifics of the changes that we'll be making. We normally don't get to the level of granularity that you're asking here, and so I'd prefer to say a little higher level for the time being. And we'll do what we can in terms of specifics as we implement certain reductions and expenses. As you know, in comparing '05 to '06, we have the stock compensation noncash charge that affects the GAAP earnings. We also carry an amortization of a customer intangible for a couple of million dollars a year and then we have our depreciation expense. And so all of those get factored into the earnings and our noncash and -- expenses. Our focus really is on reducing the fixed cost run rate, while maintaining sufficient resources to meet the investment requirements of programs. And so, in a period in which there is a lot of program activity, the operating expense and fixed cost of manufacturing and field support will go down as a percentage of revenues, because more of the resources are focused on the capital projects, and the converse is true as well. And so in Q1, it was a relatively quiet period of capital investment and, thus, those labor costs were recognized in the EPS.

Thank you.

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

Good morning, Bruce.

Hi, Kevin.

I was interested to hear the questions from Eric Appell about the Homeland Defense and the REAL ID X, so thanks for that discussion. But in answering his question you mentioned the Canadian border. Given these recent immigration demonstrations, I'm interested the southern border, specifically Mr. Bush -- you know, he wants a worker visit program -- he mentioned specific words tamper proof card. So that sounds like it will be right up Digimarc's alley. Do you think there's an opportunity with Mexico. and are you trying to tie in Mexico with what you're working on in the northern border?

We're a unique supplier of credentials in relation to the issues that have become so publicly visible and intensely debated here. We're the largest supplier of government-issued credentials in North America. That means Canada and Mexico and the United States combined, and we do produce the primary citizen identification credential in Mexico. So I think we're uniquely positioned to help to create a system for greater security and identification of citizens on both sides of the border, and appropriate technology choices to give comfort to both of the governments for helping citizens of those countries move back and fourth across-the-border. On the northern border, there has been quite a lot of debate, as you know. And several of our customers have been involved in the debate, saying that we ought to work on improving the security standards for the products they issue, rather than issuing new documents that inconvenience their citizens and burden them, unnecessarily, financially. So I think that there's an opportunity here for us, Kevin, to play an important role in reconciling all of the interests involved in creating a fluid movement that is politically acceptable between our three countries. So we think we're in a pretty good spot on that, and we've made it known that we're ready to serve the national interest ,as well as the state interest, and to try to help reconcile differences that may emerge between our state customers and the federal requirements.

Okay, thanks, Bruce, and congratulations on the Microsoft deal. Did I infer you to say that you thought that MSN's internet competitors should be looking at that technology, as well?

Oh, absolutely. The Digimarc® ImageBridge software allows any user, through downloading of a free plug in, to determine if an image that they want to use for some purpose is protected by copyrights and then to take appropriate action to gain a license or to not use it. This is an application that has been used for many years by Corbis, Bill Gates' stock photography agency to protect their copyrights, and they've been quite public about the benefits that they receive, including Mr. Gates reaffirming that in a public statement just a month or so ago. So it's about time Microsoft figures out what Corbis has known for years, and that is that you can protect your image copyrights on internet using digital watermarking. And the benefits that Microsoft is receiving and that Corbis has been recognizing for years are available to everyone who is in the business of putting images on the internet. So there's a large addressable market out there that hasn't quite caught on yet and that's why I'm excited about the contract with Microsoft because it's like, okay, guys, it's about time now. Will everybody else please pay attention. And when Microsoft does something like this, everyone does pay attention. So I'm hopeful that others will fall in line here and we will be able to spread the virtue of our technology across a large customer base that serves up valuable images on the internet.

So is Corbis already a licensee of Digimarc?

Yes, they have been for -- ten years. Nine years.

Whoa. So Mr. Gates knew about this before the rest of the Microsoft executives?

Yes. Maybe he had a chat with them or something, I don't know. But Microsoft's a very big company and they have lots of investments to make and so, they got around to making this one and we're going to do a good job for them and we expect -- you know, the satellite image mapping services are proliferating among the major players and so, if the rest of them choose to leave their images unprotected, I would think that the suppliers of those images will be upset with them. So I hope that they'll all come to us and get the protection that's available. It works very well. They can all call Corbis if they want a rec -- a reference.

Okay and if I can ask one last question, this would be for Mike, I think. Mike, regarding your D&A, in prior years, in 2005 and prior, you used to use the useful life of the contract and now, are you making an estimate?

We are. What we've done is we've studied over the last four years all the contracts that we have and the extensions that have been signed without any major change of the existing assets. And so, we found that the actual useful life of the assets only based upon the extension review was, you know, almost three years longer. So that we've factored into our depreciation estimates and that's where the change has benefited. And, clearly, it's an analysis we'll do on an annual basis, but the average life of these assets has been much longer than our average contract has been and then, also, it better matches revenues and expenses.

Right. So you're accounting before was maybe too conservative. Now, you'll be incorporating a portion of the extensions of the contracts? Is that a fair way to look at it?

That's a pretty fair -- definitely I believe it's been conservative, and we now have the data to document a closer estimate of the useful life. Obviously we're going to not be right on the edge. We, in reality, believe it could be a little bit longer, but I think what we've added is about 2-3/4 years to our average contract life at this time. We'll continue to study this and refine it, if it's necessary or if it's material.

Okay, and does -- Mike, does it effect only depreciation? It doesn't effect amortization?

Just depreciation of the program assets; correct.

Okay, thanks so much.

Your next question is a follow-up question from the line of Rob Stone with Cowan and Company.

Hi, two questions for Mike, if I could, please? One, could you walk through, specifically, the noncash expenses in this quarter, stock comp and others? And the second question, what is the average useful life of your capital assets now in years?

The average -- and I'll be summarizing here -- the average contract would be four or five years, four, five, or six years, and our estimation calculation of the life, based upon those extensions, is add another 2-3/4 years to that, so between seven and eight years would be the average, which we're finding is, you know, very, very accurate, based upon our history. Again, this is a system that's implemented, it's rarely changed. If it's a software upgrade, all the hardware say stays there and the base software stays there, so these assets really do have a long life. We have examples of customers who've been out there for more than ten years, definitely with the software but some them even with hardware, because it doesn't require an upgrade unless they want to pay for it.

As it relates to the noncash charges, I believe I indicated there was $800,000 of stock comp, there was about $573,000 of intangibles, and then the depreciation -- total depre -- program depreciation was 2.6 and then another few $100,000 of other infrastructure depreciation. So total noncash, that should add up that we show on our cash flow statement in the press release this morning.

Okay. Thank you.

And at this time there are no further questions. Please proceed with any additional or closing remarks.

Thank you, everyone, for joining us on the call this morning. We will be going to work on these cost reduction initiatives, and we'll make public announcements, as appropriate, providing more information regarding them. We'll look forward to catching up with all of you soon. Thanks.

This concludes the Digimarc Corporation first quarter 2006 quarterly earnings call. You may now disconnect.