Digimarc Corp (DMRC) 2006 Q2 法說會逐字稿

At this time, I would like to welcome everyone to the Digimarc Corporation Q2 2006 quarterly earnings conference. [OPERATOR INSTRUCTIONS] Mr. Davis, you may begin your conference.

Thank you. Welcome to our Q2 '06 financial results conference call. Mike McConnell, our CFO is on the call with me.

We issued our press release earlier today announcing Q2 results. The objective of this call are to summerize and comment on these, review significant business developments and market conditions and provide guidance on our prospects and plans for the remainder of 2006. This webcast will be archived in the investor relations section of our website.

Before we proceed, please note 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 the current understandings and expectations. These statements are subject to assumptions, risks, uncertainties, and changes and 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 MBNA section and the most recently filed form 10-Q and our earnings release posted on our website.

During the course of this conference call, we will also refer to certain non-GAAP financial measures as defined by the FCC in Regulation G. Definitions of these non-GAAP financial measures and the reconciliations of these non-GAAP financial measures to their most directly comparable GAAP financial measures are included in the earnings release for the quarter ended June 30, 2006 and in the financial supplement each dated August 3 and available on our website. The earnings release can be found on the home page of the website and the financial supplement can be found by clicking the investor relations menu item. Keep in mind that any guidance we offer represents 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 call.

By way of introduction, we have made dramatic improvements in the cost structure of our business in Q2. Through workforce reductions, various Six Sigma projects and numerous internal business process improvements, enabling significant progress to our path of profitability. We provided details of these actions in a conference call on June 15th. These actions were a continuation of measures that we have been implements during the course of the past year to improve productivity. You can you see the leading edge benefits from the Q2 cost reductions in gross margin and operating expense sequential improvements during the quarter. These improvements present more substantial savings in Q3 and Q4, reflecting reduction of nearly 20% of our workforce since the beginning of 2006 and a reduction of more than 30% from the peak in mid 2005.

Our customer loyalty efforts paid dividends in Q2 and early Q3. Several state, including Oregon, Washington, New Jersey other others extended their contracts with us. The total estimated value of the extensions is in excess of $35 million.

As a trusted and responsive supplier we'll provide expert advice in market leading solutions to these issuers as they upgrade their systems to better serve their customers and prepare to comply with REAL ID. These improvements include more secure enrollment, verification and production processes and documents.

Internationally, we were recently awarded a 3.5 million contract by Ghana to deliver a comprehensive driver's licence enrollment and issuance solution. During the quarter we'd also delivered our facial recognition biometric identification solution to Massachusetts. More generally, we released a sleeve of new secure identification solutions that advance our agenda to improve the cost-effectiveness of America driver's license issuance.

Our impressive IP portfolio and well-established IP licensing program continued to bear fruit in new and expanded licensing activity amidst growing appreciation for the value of digital watermarking in deterring piracy and enabling innovative new consumer experiences. We have seen several positive developments this year. We saw new licenses in diverse areas, including geospace imaging, digital TV copy protection and mobile commerce. Digital watermarking remains under consideration in various industry-wide initiatives like the Digital Cinema Initiative, AACS for high-definition DVD and the DCIA digital watermarking working group exploring pure applications.

We believe that these initiatives could serve as important industry growth catalysts. And parallel we continue to grow our customer base for image watermarking solutions, expand our license base across a range of applications and work on market development initiatives fostering the use of digital watermarking and authenticating of driver's licenses and other credentials and in mobile commerce.

In some of the more notable deals, Microsoft adopted Digimarc [inaudible] Digital Watermarking Software to protect copyrights and tens of millions of satellite images in its new virtual Earth mapping service. In the television market we licensed VEIL Interactive's VCP for its rights assertion mark. VCP's mark is one of the primary content protection technologies under consideration by congress in proposed analog hole legislation known as the Digital Transition Content Security Act of 2005. This legislation is designed to plug the analog hole. The problem that occurs when protected digital content has to be converted into analog in the clear to be viewable on television set in consumers' homes.

We continue make progress in our market development plan for IDMarc. One of our executives testified yesterday at a US Senate Finance Committee hearing on border security. Where he presented the positive results from the U.S. Department of Transportation digital watermarking pilot in the state of Nebraska and demonstrated how IDMarc digital watermarking based security can be implemented as a cost effective means of authenticating driver's licenses presented as proof of identity at U.S. borders. IDMarc has been incorporated into more than 35 million circulating driver's licenses. It provides entities that rely on the authenticity driver's licenses with a machine readable security feature that enables reliable cross-jurisdiction authentication of licenses.

imperceptible to the human eye digital watermarking enables trusted authentication of a driver's license using commonly available scanners and special software. We anticipate that by the end of the year, one in every three issued driver's licenses will include digital watermarks and this number is growing rapidly. We made the point at the hearing that IDMarc and other complimentary machine-readable features in the U.S. driver's licenses could be leveraged by the federal government to improve the security of U.S. borders within 6 to 12 months, if funding is authorized.

Our Digimarc mobile initiative got a booster in the quarter with the signing of the license agreement with AquaMobile as our go-to-market partner for Spain and Portugal. AquaMobile's print to web mobile linking application, which is based on our Digimarc mobile platform, was recently awarded first place out of 200 entrants in Spain's NETI competition, a Spanish acronym for innovative technology based startups.

AquaMobile plans to rollout pilots of the application across Spain and Portugal this fall. Digital watermarks offer brand-sensitive companies as a elegant, unobtrusive alternative to industrial style bar codes and QR codes, allowing companies to easily extend their print campaigns to the mobile world without having to use the visible marks that detract from the brands.

In Japan, our mobile commerce go-to-market partner MediaGrid estimates that they now can support over 30 million camera phones in the market including multiple models from leading providers like KDDI, DoCoMo and Votophone.

At this point, Mike will provide some commentary on the Q2 results and update our financial guidance for 2006.

Thanks, Bruce, and good morning, everyone.

Q2 revenues of 24.9 million were slightly higher than last year within the range of previous guidance. Domestic revenues rose 4% to 21.1 million, reflecting full deployment of our Florida and Alabama programs. International revenues were down 15% to 3.8 million. Due to quarterly variations in foreign supply contracts, and the previously-announced Q2 hiatus in our Mexico plant due to national elects. On a sequential quarterly basis, domestic revenues rose nearly 5% due to seasonality and international revenues were down 46% primarily reflecting the Mexico plant hiatus and the absence in Q2 of a large international supply sale comparable to the one that occurred in Q1.

Gross margin for the quarter came in at 33%, consistent with the same period last year and up 5 percentage points over the 28% margin in Q1 of 2006. The sequential improvement in Q2 over Q1 is primarily attributable to improved product mix -- I'm sorry, improved revenue mix, notably the absence of any large low-margin international supply sales, like that which occurred in Q1. Lower overall operating expenses due to internal process efficiencies and cost reduction initiatives and more work on capital projects related to customer programs primarily for Texas and Indiana which resulted in a higher rate of capitalization of labor costs in Q2 than in Q1.

Operating expenses in Q2 were $13.4 million down 1.2 million from the prior year and down 600,000 from the prior quarter, in line with our guidance. Operating expenses included about $550,000 of non-recurring, restructuring charges related to staff reductions. Approximately 800,000 of non-cash stock-based compensation expense was recorded in the second quarter and was spread between the cost of sales and operating expense lines. Approximately $600,000 of this expense related to the January 1, 2006 adoption of a new accounting rules for such compensation. The EPS loss for the quarter was $0.24, an improvement of $0.06 per share over both prior-year and prior-quarter results.

Regarding the balance sheet at the end of the quarter, we had approximately $30 million in cash and equivalence, short-term investments and restricted cash at the end of the quarter. Net-cash flow for the quarter was a deficit of 600, I'm sorry, of $800,000 and represents our lowest cash burn since late 2003. Adjusted EBITDA, which reflects earnings before interest, taxes, depreciation, amortization and stock compensation for the quarter was a deficit of $600,000, an improvement from the $1.1 million deficit in prior year and $1.8 million deficit in Q1 '06, reflecting improved operating results.

There was an increase in restricted cash from quarter-to-quarter, related to performance bond requirements in various government contracts. Our bond insurance companies require varying degrees of collateral in the form of letter of credit which in turn requires some percentage of cash be set aside as collateral. There was a large contingent of bond renewals at the end of the quarter and one of our insurance companies added a $5 million letter of credit requirement. $11.5million of restricted cash at June 30th, supports a $31 million performance bond portfolio. We're working with our customers to reduce the size of the bond portfolio to reduce the collateral requirement. These efforts have resulted in reduction of more than $4 million in performance bonds since the beginning of the year. Our backlog at the end of the quarter was similar to the prior quarter in year-ago numbers at $220 million reflecting the natural burnoff of orders previously booked in the new contract and extensions.

Now, let's move to 2006 guidance. We are updating our financial guidance as follows: In Q3, we expect revenues in the range of 26.5 to 27.5 million, similar to the year-ago quarter and up 6 to 10% from Q2, reflecting the high point of seasonal US driver's license revenues in a return to full production in our Mexico operations following the national elections near the end of Q2. Continuing sequential improvement in gross margin by 5 percentage points primarily due to lower fixed costs of sales, resulting from companywide labor cost reduction.

Operating expenses to be approximately $1.5 million lower than in Q2 and EPS in a range of a loss of $0.01 to $0.03 per share, compared to a loss of $0.24 in Q2. Adjusted EBITDA to improve from a deficit of $600,000 to a range of 3.6 million to 4.1 million positive contribution driven by improved operating results from a combination of high revenues and lower operating costs. Capital expenditures to be around 5 million compared to 2.6 million in Q2, due to increased system implementation activities in capital programs for our customers. For the full-year, we expect revenues will be in the lower end of the previous guidance of 105 to 115 million range due to lack of any REAL ID funding and some delays in foreign bid activities.

Gross margin improvement to continue in the second half into the low 40s. A loss for the full year in a range of $0.55 to $0.60 per share, significantly lower than the $1.13 loss in 2005 with quarterly trends that demonstrate a path to profitability. Adjusted EBITDA to improve significantly to between 4.6 and 5.8 million compared to a deficit of 3.4 million for all of 2005, reflecting overall financial improvement, due to financial leverage from higher revenues and lower operating expenses.

And finally, capital expenditures for the year to be several million dollars below last year's $16 million level. Bruce will now offer closing remarks.

Thanks, Mike.

We continue to trim costs wherever possible, improve program management and associated allocations of labor and make organizational changes 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 remain focussed on improving qualities throughout our operations, growing revenues, improving cash flow and delivering sustained profitability. We have stepped up the pace of progress of 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 in the next few quarters. Further improvements in the value of Digimarc should follow as we obtain and improve profitability, demonstrate the growth potential of our businesses and establish linkages to adjacent high-growth, high-value markets.

We see exciting prospects in our markets, it's shaping up to be a good year for digital watermarking. In the identity management area, although the federal government has not yet published regulations for REAL ID or dispersed any associated funding, we continue to expect that the US DL market will demonstrate strong demand once they REAL ID ambiguities are resolved.

Now as you witnessed in the bookings reported earlier in the call, several of our customers have grown impatient and are moving forward with substantial upgrades, confident that we will work with them to satisfy the REAL ID requirements once they are finalized. Investor interest in the Company is increasing, this has lead to new research coverage and more invitations to investor conferences than any time in our history. In furtherance of the goal of reinvigorating appreciation for the value of Digimarc's surveillance briefings, conferences and non-deal road shows, we presented at the five investor conferences in Q2. Our next investment presentation will be at the Pacific [inaudible] Technology Forum on August 8 in Vail. For further discussion in the quarter results, our business and financial models and risks and prospects for our business, please see the 10-Q we will be filing shortly. This concludes our prepared remarks and we'll now take questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Rob Stone with Cowen and Company.

Good afternoon/good morning, guys.

Hi, Rob.

Hi, Rob.

Mike, could you just go over again, I didn't quite catch it, the CapEx in Q2, and if you could break that out between capitalization of labor and the PP&E type of CapEx, and also if you have a depreciation figure handy.

Sure. The CapEx for Q2 was about $2.6 million. Of that approximately $800,000 related to the capitalized labor.

Okay. With respect to your outlook for the balance of the year, should we be thinking in terms of a seasonally slower Q4 then Q3 being the peak on the driver's license system or would something influence new project start or influence that differently this year?

Well, we have posted on our website some forecasts on earnings and the adjusted EBITDA and we do have variability built into the Q4 numbers, primarily due to the seasonality. As you recall, 70+ percent of our revenue comes from our issuance revenues and 30% is more variable with add-ons and upgrades from both domestic and international customers.

Okay. Finally, a question regarding -- you mentioned the revenue coming in towards the low end of your previous range of thinking, based on timing of REAL ID funding and then some international delays, can you comment more specifically what was delayed internationally?

Rob, this is Bruce. We don't comment on open bid activities, generally. We would prefer not to identify the specific opportunities. There are identifiable specific opportunities that have been delayed. That we expect to be completed, they're obviously subject to win/loss risk but as we noted earlier in the year, the P&L would be affected by a timing of certain contracts, so what we're seeing in REAL ID were we had anticipated a fairly modest amount of funding to be provided, none has been provided, zero spending under REAL ID. And in the international space, a few large deals that we're working on have been moving to the right and so that yields our guidance here. We're still in the range we said at the start year but we're now anticipating we'll be closer to the bottom than the top.

Actually, Bruce, that's the kind of color I was hoping for. Thanks. I was really just trying to separate out on the international whether it was delays in projects that you were already working on of some kind or timing of this, of the bidding and war process. Thanks very much.

You're welcome.

Your next question comes from Eric Appell with Merriman, Curhan, Ford.

Hey, guys, how are you doing?

Good, thank you, Eric.

On the Q3 guidance, a couple of questions, can you, 26.5 to 27.5, can you break that out between the services and products and subscriptions?

You know, Eric, we haven't in the past. It's pretty consistent, at least 70% of that is going to be in the issuance area made a little higher because Q3 is our seasonally high number, so the ratio may bump up a little bit in the services. We haven't traditionally provide that breakdown.

Okay. And you said operating expenses at 1.5 million lower from Q2 of '06?

That's correct.

Okay, so and the watermarking technology, you did a presentation. Do you think you're getting close to the point where you may think about or starting to dialogue with some of the leader companies about licensing the watermarking technology so that stores and borders can actually start identifying counterfeit driver's license? Are we getting close to that point or the penetration is not high enough yet?

Eric, we have actually begun selling reader devices and relatively small quantities and we have begun presentations to perspective licensees for larger volume. Reader devices and then as I mentioned in the script, we made a presentation to the U.S. Senate Finance Committee yesterday on the use of such reader devices for border control security and the--CSPAN and a number of other media outfits covered the conference. If you went to the CSPAN site you could actually see the hearing and see the product demonstrated there.

So we're doing some small volume production to just demonstrate how well it works and our, as you know, our ambition here is to not be in the hardware business but to license others who have established distribution and the points of inspection to read the watermark and to send us money.

Okay. Okay. Interesting. Now, if we look towards a sequential basis of Q2, Q3, Q4, as far as the sales and marketing go, maybe a little bit down and even with the R&D and also the G&A. The full effect of the cost reductions are going to take place in Q3? In other words, we haven't seen the impact fully in Q2, or have we?

No, you have not, Eric. I would expect each of the four large categories, the fixed cost of sales, fixed operating expense cost a sales line. R&D, sales and marketing, and G&A all to come down slightly, so that's where you're seeing the million and a half plus of operating products.

Okay, good. Thank you.

Your next question comes from Brian Ruttenbur with Morgan Keegan.

Hi, this is Brian Ruttenbur with Morgan Keegan. A couple of quick questions. You said a third of all driver's licenses, I think in the next year, are going have watermarkings?

No.

Are you prepared at this time to talk a little about the premium pricing you're charging on that.

Actually you misunderstood my statement. one-third of all the driver's licenses in circulation, all the valid driver's licenses in circulation are watermarked today.

Okay.

The volume of current issuance being watermark is higher than that. And we are adding more issuers on a pretty steady basis. So, we anticipate continuing significant growth in the amount of the installed based that is watermarked.

The way in which we, the economic model for the future is one in which we don't charge a separate price, as you know, and the way with which we work with are issuers, we have a bundled price generally on the new issuance system and substantial upgrades, but if we were to charge separately, we wouldn't charge much, if anything, to imbed the data because the benefit is received at the point of inspection and so we charge at the point of inspection. And the way in which we intend to charge as our enduring business model is to license the capability to read our proprietary patented feature with devices at the point of inspection provided by suppliers who already have distribution in those venues. So, airports, banks, convenience stores, restaurants, law enforcement, there are already suppliers of technology that is appropriate to reading our watermarks in those difference distribution channels, so we're not going to compete with those suppliers, we're going license our technology to them and receive essentially 100% margin revenue from them.

Okay, are you seeing any traction on a different front-- on the digital watermarking side, either in the DVD arena or the digital media or any other arena. I don't think you addressed that, any kind of traction, significant traction you're getting in there.

Yeah, I did, and actually we are. The answer is I did and we are. There are increasing number of licensees, I identified several of them in the script.

Okay.

And there are a number of industry-wide initiatives that are contemplating watermarking in the standards that they have developed, the digital cinema initiative has mandated, the AACS for high-definition DVD says it will be in their final license, they have an interim licence in effect right now, and the DCIA, which is the pure-to-pure file sharing trade association has said that they will include it in an open letter, they said they would include it in their products if the entertainment industry adopted it for the protection of copy rights in music and movies and television programs. And then in broadcast monitoring, we have three licensees who are gaining customers in their improved broadcast monitoring system based on digital watermarking there. So there's a lot going on in the digital media space of our watermarking and in mobile commerce, we signed a new go-to-market partner, which is again our well articulated, publically articulated strategy. Our strategy is to have go-to-market partners in foreign jurisdictions where they have more advanced networks and to provide mobile commerce enhancements through the use of digital watermarking in materials. So there's a lot going in watermarking right now.

Okay, thank you, I appreciate it.

Yeah.

Your next question comes from Frank Magdlen with The Robins Group.

Morning, gentlemen.

Hi, Frank.

Could you review for us the major issues left on the table for REAL IDs and the driver's license area to move forward. What it was 12, 18 months ago.

Sure. Not much is different, I believe, from 12, 18 months ago in terms of issues. I'm not aware, frankly, of any big issues. More just of the bureaucratic process of developing regulations. The Department of Homeland Security was charged by the Congress with developing regulations, they're very busy with lots of initiatives and they are getting it done in due time, in their view, and they had promised to get regulations out, the Congress wanted them in December of last year, they then promised they would get them out in the summer of this year. We're now getting more than halfway through the summer and they're not yet out and if they were to get them out shortly, they would go through a public comment period before finalization and thus they would be finalized in early 2007.

So, again, there is nothing holding the process other than the process itself. There is no controversy road blocks, big issues that I'm aware of.

All right, thank you. Okay.

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

Hi, as you look at the renewals of Oregon and Washington, are you actually seeing an increase in run rate of revenue on an annual basis given, I guess, the edition of new technologies, first of all?

I think the answer's, I believe, yes in both cases. But in the aggregate, would be true for sure.

Okay. Where did head count end at the end of the quarter?

We're just at about 440 head count and the full-time equivalence of contractors which we use rather sparingly these days, so it's down, in accordance with our plan.

And as you look at CapEx expenditures for the fourth quarter, you highlighted 5 million for the third quarter. Is it roughly flat or are you thinking up again sequentially?

No. It would turn down, we indicated, the total of CapEx would be a few million below the16 million of last year. When you look up at all the quarters, it will be down a bit in Q4.

Great, thank you.

Your next question comes from David Sterman with Jesup and Lamont.

Good morning, just wanted to get a little sense, you had mentioned in your prepared comments that some states are waiting for REAL ID mandates to filter in and they're kind of moving proactively. Besides watermarking, can you elaborate a little about some of the other initiatives and make any impact on pricing margins, et cetera, what that might mean for Digimarc.

I am sorry, could you repeat the question? I'm not sure I understood it.

Sure. Beyond watermarking, are there other initiatives, some of the -- the recent state contracts, you made comments that the states are starting to address the security issue.

Ah.

But I was wondering if -- aside of watermarking, what those are and maybe again what the impact for Digimarc might be for those type initiatives.

All right.

We've outlined in our corporate presentation of best materials, the product strategy that we have been developing the past several years that we began delivering in 2006. And our product portfolio now covers the full range of secure identity management for enrollment to post-issuance inspection and much of that is new to our distribution.

And what the states are doing is they were holding back for a while, and many still are, saying I don't want to get too far ahead of the curve, there are regulations pending once they come out it will be clearer what I should be buying and how I should allocate my budget, but a number of issuers have just said we can't afford to wait. We need to upgrade the security of our systems, we like the products we're seeing from Digimarc, we want to buy them. And so in the case of-- I'll use Oregon as an example, they wanted to move to central issue from over the counter and they just decided based on the overall value of driver's licenses and economic security transportation, safety, and national security, they couldn't afford to wait any longer. They moved forward with that long extension and included in that a shift in the way in which they do their production process to a more secure process.

Okay, and on a related note and we're moving to the realm of speculation here, but based on what you have been hearing directly and indirectly, regarding discussions of border crossing environments, there is an anecdotal thought about Canadian and Mexican border crossings, that a driver's license, if it's more robust might be more sufficient in place of passport. I'm just wondering if you all have seen any dialogue in those lines or do you think that is a possibility here that driver's licenses could be a border crossing tool?

There has been quite a lot of active debate about it, more than just a suggestion. In fact, the US Senate, several prominent senators have been focussed on this issue and we firmly believe that there ought to be a reconciliation or REAL ID in the western hemisphere travel initiative and not -- a role of REAL ID and encouraging the states to upgrade security so that the driver's license is a good credential for national security purposes, but implicitly should recognize that, that means can you cross the land borders with our friendly neighbors north and south. And so in the strange ways of Washington, that is not as clear as it would be to a reasonable person, but the debate is going on and we believe that is the right outcome.

And we have offered a number of specific suggestions to Homeland Security in the State Department about how that can be done and the hearing yesterday was a specific demonstration of the ways in which national security could be substantially enhanced through the use of our advanced technology and driver's licenses. They'll need to wait until a year or two or three from now to see the fruits of investment. We have an enhanced means of inspection available today that they can buy and install at the borders and make our nation more secure.

Okay, and then just a final question, running through the Q3 guidance, I missed the EPS range you that gave.

Yes, we gave a $0.01 to $0.03 per share loss guidance.

Okay. And all right. I'll step back in the queue. Thank you.

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

Hi, Mike. Just a couple of follow-ups and clarification on the expense guidance.

Sure.

First of all, you mentioned a sequential improvement in gross margin and sequential decline of a million and a half in operating expenses and later in response to someone's question you said we look for a decline in all four categories of expenses, including costs. So are you spreading that million and a half between COGS and the other OpEx categories or is the million and a half all below the gross profit line?

Yeah, Rob, the million and a half is below the gross profit line and I alluded that we would have lower COGS operating expenses which leads to that statement that I made that will improve margins by 5 points or more. So, we're seeing operating expense reductions in the COGS area as well.

Thanks and finally, are you expecting any additional restructuring charges?

Nothing of significance. We all have some severance costs related in our operation but it rose to a material amount here this quarter, that's why we segregated.

Okay, thanks.

Your next question is a follow-up question from the line of Eric Appell with Merriman, Curhan, Ford.

Yeah, actually I must have misunderstood on the percentage for the guidance on revenue of Q3. Let's say it's 27 million, halfway between the 26.5 and 27.5. The 70% you said was going to be services but typically, it's more like 80+%. Did I write that wrong?

70% or more we set it up taking Q3 as a percentive total because of our seasonality.

So 70% would be in the services revenue line?

No, the issuance is 70%. Since issuance is the most significant part of services we would see the services ratio increase in Q3 as a percent of total.

Okay. I just -- you divided services and then product and subscription. So are you saying the product and subscription portion would be around a little less than 30%? Than high 20?

Yes. It would be less than 30%.

So the high 20. Isn't that -- that's typically, that's a typical for any of your quarters. Is that something taking place in the third quarter that is making this sort of an anomaly versus --

We have a pretty large amount of revenue that does come from supply sales and add-on sales and they occur from time to time, they're less predictable than the issuance revenues are, so the product revenues have more variability in them. If you look at our history, the service revenues trend up in the third quarter and then trend down in the fourth quarter and product revenues vary from quarter to quarter.

We're not anticipating anything terribly unusual here, Eric. It's the seasonality and the categories are not a 100% correlated. That's why it's a little difficult to track the required GAAP breakdown versus the way in which we would think about the business in ordinary terms.

Okay, all right. Thanks.

Your question -- next question comes from Walter Shanker with Tyden Capital.

Thank you. Going back to something that has been hit on a couple of times, I wanted to kill it a different way, you have assigned a number, this is on the upgrading of driver's licenses and REAL ID, there is a view that when REAL ID is implemented or fully implemented, the driver's license market will grow some multiple and become much larger. If the contracts you've signed so far to upgrade, be it Oregon, Washington, Nebraska, I am not asking for any one specific, still fall, the question is far short of a full REAL ID implementation would require?

No. No, let me try to explain the relationship between REAL ID and revenue growth.

The -- as I point out consistently in our investor presenting, there are four primary sources of revenues. The issuance fees, the general state budgets, federal grants and private money. REAL ID is a supplement to the existing budgets for driver's license issuance and so the contract extensions and upgrades that we have been successful in achieving here recently obviously have no federal money component to them. Once the federal money becomes available, we expect our issuers to ask for federal money to do more than what they've already asked us to do. That would be in business process, re-engineering, potentially moving to the higher level secure than currently contemplated and so forth. So what's happened here, some of the issuers were trying to wait, felt impatient, couldn't justify waiting longer and are moving forward.

On the assumption that one REAL ID regulations are finalized and when money becomes available that we will work together to conform what we have begun to do in our investment and in the upgrade of our system to make sure it conforms to REAL ID and to use the federal money as a supplement to the existing budgets in order to make whatever changes are appropriate to attain REAL ID compliance.

So, this $40 million sitting there appropriated by the congress to be spent. We anticipate that much more than that will need to be spent by the federal government to get what they want. It would be nice if they free up the 40. The 40 goes on top of all of this, in our view. That's why we're anticipating that 2007 could be a robust year for demand if the Homeland Security Department will put out the regulations and get them finalized and establish the grant process and spend the money that has been appropriate for us.

Okay. I am not going to waste everyone's time and some point we'll go over this some more. Thank you.

Yeah, can you call me, Walter, if there is something specific ambiguity you trying to resolve. Just trying to be responsive there.

No, I expect that. Okay. Thank you.

Your next question comes from the line of Lee O'Dwyer with Funds Partner.

Hi, Bruce, a quick follow-up. you've almost answered this question. I was listening to the finance hearing yesterday and it seemed to me the take away was at this point in time, there is at lest a stop-gap measure that you, that the government could employ using your technology immediately outside of REAL ID to at least verify the forged documents that exist today. Did I understand that correctly?

That's correct.

Perfect. That's all I had and thank you for all of the guidance as well, Michael.

Sure.

And at this time, there are no further questions.

Okay. I would like to thank everyone for participating today. I want to close just by saying that I don't think I can adequately express for you the amount of progress in terms of internal business process improvement we have been making here. And I want to reaffirm our goal to transform the industry, to provide a much higher level of quality than has been historically present in this market to enhance the security of the citizens across the wide range of the uses of driver's licenses and we think we can do that in a nicely profitable growth business.

We intend to exercise our leadership with increasing effectiveness moving forward and anticipate that once REAL ID has been resolved and as our quality continues to improve, and the effectiveness of our organization continues to improve, that we're going to have quite a nice business here. I thank you all for your support.

Ladies and gentlemen, we thank you for your participation in today's conference call. You may now disconnect.