Digimarc Corp (DMRC) 2006 Q3 法說會逐字稿

At this time I would like to welcome everyone to the Digimarc Q3 quarterly earnings conference call.

[OPERATOR INSTRUCTIONS]

Thank you. Mr. Bruce Davis, you may begin your conference.

Thank you. Welcome to our Q3 2006 financial results conference call.

Mike McConnell, our CFO is with me. We issued a press release earlier today announcing our Q3 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 the remainder of 2006. This webcast will be archived in the Investor Relations section of our Web site.

Before we proceed please note that during the conference--the course of this conference call we will be making forward-looking statements regarding management's OPINIONS and expectation about the business, its markets and financial performance that are based on our current understandings and expectation. 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 MBNA section in our most recently filed Form 10Q 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 Securities and Exchange Commission and Regulation D. Definitions of these non-GAAP financial measures and reconciliations of these measures to their most directly comparable GAAP financial measures are included in the earnings release for the quarter ended September 30, 2006.

The earnings release can be found on the home page of 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.

The financial benefits of strategic improvements in cost structure or business processes that we outlined in previous calls became evident in the third quarter. Key financial measures of gross margin, OpEx, EPS, EBITDA and cash flow all significantly improved from prior quarters. Our top business objective is to deliver sustained profitable growth, capitalizing on our leadership and secure identity management systems and in digital watermarking.

We inted to achieve this objective by earning a position of trust and trusted and responsive supplier with our customers and by continuing R&D, business process and workforce improvements to gain further productivity benefits. Growing share pocket is fundamental to our business strategy. We want more business from our existing distribution in all areas of our business.

Being a trusted and responsive supplier reduces competitive risk and associated marketing costs. We are intent on being the best supplier in the market, earning unrivaled loyalty from our customers by cost-effectively delivering the technologies and solutions that they need, when they need them at fair prices. Having a reliable source of supply is always important but it is especially critical when the market is going through a major transformation such as is anticipated with the implementation of Real ID.

[Inaudible] toward our goal evidence in the high level of bookins, especially the high proportion of sole source extentions, renewals, and add on sales. In Q3 we booked new contracts or extensions totalling more than $50 million with the four provinces of Atlantic Canada, Florida, Georgia, Ghana, Louisiana, Oregon, Utah and others. Our backlog at September 30 grew to more than $250 million.

Year to date bookings as of the date of this release exceed $100 million. With the value of the state issued driver's license increasing and the royalty driver license expanding beyond simploy a document that proves ability to operate a motor vehicle to a secure credential that has broad implications not only for transportation safety but also Homeland Security, economic security and other aspects of personal security we believe that we are approaching a significant inflexion point in this area of our business.

Driver's license issuers are looking to us for expert advice and market leading solutions as they operate their systems to better serve their customers and prepare to comply with Real ID. These improvements range across the full spectrum of the driver license life cycle including a more secure enrollment, production, better documents and more reliable post issuance verifications. The principles of Real ID are sound, focusing on enhancing the security of the driver's license itself and improving verification of the identity of citizens who are issued this general purpose credential.

The specifics of the regulations and the funding strategy are still being worked out. The Department of Homeland Security has said the draft regulations will be published before year end. The financial implications of Real ID are awesome to contemplate. During Q3 the National Counsel of State Legislators, the National Governors Association and the American asSociation of Motor Vehicle Administrators held a joint press conference in which they announced their estimate that Real ID compliance would cost more than $11 billion over the next five years.

We have worked hard to position our company at the heart of this potential radical expansion of our market motivated by Real ID and the issues that it addresses. As we await final regulations and more visibility on the market potential and funding strategy for Real ID we continue to focus on improving our businesses capabilities better serving our customers needs and preparing to assist them with compliance. During the third quarter in one aspect of this preparation we further extended our product portfolio, introducing new products that bring additional security enhancements to our proven secure driver's license solution including the Digimarc document inspector to automate the inspection of driver license, the next-generation of Digimarc biometric identification which a growing list of states including Oregon, Texas, Massachusetts, Alabama, Kansas, and Colorado have begun using or are in the process of implementing to deter driver license fraud during the enrollment process.

Near the end of the quarter and keeping in our market leadership and responsiveness to customer needs we also announced a SmartCard driver license option to support states with driver license upgrades in anticipation of new federal standards for IDs in use crossing the Canadian and Mexican borders. Recent federal border security initiatives would require citizens to obtain a passport or a special border pass card in the future. Many U.S. states, particularly along the country's borders have expressed a desire to enable their citizens to continue to use their driver's licenses as valid IDs for border crossing.

Digimarc Smart Crad enabled driver's license solution has been designed to give these issuers and the Federal Government an economical and convenient alternative means to meet the pass card objectives with a low risk, low cost solution that leverages existing state ID issuance infrastructures. We hope to convince the Federal Government to authorize the use of such an enhanced driver's license for border crossing purposes.

Our market development plan for IDMarc Digital Watermarking in driver's licenses continues as one of our executives testified during the quarter that a U.S. Senate finance committee hearing on border security where he presented the positive results from the U.S. dEposition 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.

We anticipate that more than one in every three driver's licenses issued in 2006 will include digital watermarks and this number is growing rapidly. We made the point at the hearing that IDMarc and other complementary machine readable feature in the U.S. driver's licenses could be leveraged by the Federal Government to improve the security of the U.S. borders immediately if funding is authorized. In other watermarking developments shortly after the quarter, we learned that the U.S. Department of Defense, fiscal '07 appropriation include $2.6 million in funding for the U.S. Army night vision electronics sensor directory for the second phase of a product that uses Digimarc Digital Watermarking for more effective identification and management of video based military intelligence to improve battlefield intelligence.

Elsewhere in the commercial sphere we are encouraged by many positive developments and growing appreciation of the value of Digital Watermarking in providing better identification and management of digital assets while enabling new consumer experiences. Our well established intellectual property licensing program and market development efforts are expanding as a result.

Our watermark based Digimark mobile initiative made progress in Q3 with the signing of our first U.S. based licensee, Mobile Data Systems. Digital watermarking is a required security feature for digital cinema initiatives. It is also being considered in a number of other digital media contacts including the security for high-definition DVD and the digital--the DCIA's Digital Watermarking working group exploring peer to peer applications.

We believe that these initiatives can serve as important industry growth catalysts for watermarking. One of the most notable developments in the quarter was the formation of the Digital Watermarking Alliance. Digimarc together with 11 other leading suppliers of commercialized Digital Watermarking solutions, many of whom are licensees and business partners, joined forces last month to launch this new industry group. A number of companies include Dolby Cinema, GCS Research, Europe, Media Grid, Media Sciences, International, Phillips Electronics, Signum, Teletrex, Thompson, (inaudible) Matrix and Digimarc.

With billion so of watermarked objects and hundreds of millions of watermark protectors already in the market supporting various applications, the providers of Digital Watermarking solutions felt it was opportunie time to form an industry alliance to promote the value of digital watermarking to content owners, industry, policy makers and consumers. For more information about this exciting organization and the successes of its members in the marketplace please visit www.digitalwatermarkingalliance.org.

At this point, Mike will provide some commentary on the Q3 results and update our financial guidance for 2006 and then I will return with some closing remarks. Mike?

Thanks, Bruce, and good morning everyone.

Q3 revenues of $26.7 million were about the same as last year and within the range of previous guidance. Domestic revenues rose 5% year-overyear to $22.5 million. International revenues were down 21% to $4.2 million due to quarterly variations in foreign contracts where revenues are less predictable than in domestic issuance contracts and the previously announsed Q2 hiatus in our Mexico operation which was slower to ramp up in the third quarter than expected after the election in early July.

On a sequential quarterly basis, domestic revenues rose 7% due to seasonality and international revenues were up 11% primarily reflecting the Mexico plant returning to production. Gross margin for the quarter came in at 37% higher by one percentage point versus last year and up four-points over the 33% margin in Q2 of this year.

A sequential improvement in Q3 over Q2 is primarily attributable to a lower operating expenses due to internal process efficiencies and cost reduction initiatives, improved revenue mix primarily due to seasonal high point of domestic driver's license issuance and more work on capital products relating to customer programs primarily for Texas, Indiana and the Atlantic Canada provinces which resulted in a higher rate of capitalized labor in Q3 than Q2.

Operating expenses in Q3 were $10.3 million, significantly down from $3.7 million from the prior year and 3.2 from the prior quarter primarily due to substantial efficiency improvements in our operations. Approximately $700,000 of non-cash stock-based compensation expense was recorded in the third quarter and was spread between the cost of sales and operating expense lines.

EPS for the quarter was $0.01, a big improvement of $0.22 per share over the $0.21 loss of a year ago and $0.25 improvement over the $0.24 loss in our prior quarter. Regarding the balance sheet and other key metrics for September 30th, we had approximately $31 million in cash equivalents, short term investments and restricted cash, up $1 million from the prior quarter. Net cash flow for the quarter was $1 million and represents our best quarterly cash flow since 2003.

Adjusted EBITDA which reflects earnings before taxes, interest, depreciation, amortization and stock compensation, was $4.6 million for the quarter an improvement from $3.3 million over the prior year and $5.2 million over our second quarter, reflecting significantly improved operating results. There was a $1.5 million decrease in our restricted cash over the second quarter and it related to the reduction of our performance bond requirements in various government contracts.

Our backlog at the end of the quarter was over $255 million reflecting $57 million booked in the quarter net of natural burn off of orders previously booked. We are updating our financial guidance as follows: in Q4 we expect range--results to range from just below break even to a small loss on revenues in the range of $25.5 million to $26.5 million, up 2 to 6% from the prior year. Traditionally Q4 is consistently our lowest driver's license issuance quarter of the year due to seasonality.

Revenues are expected to be higher than our seasonality model would normally predict due to international product sales that were booked late Q3 and early Q4. Gross margin to be in the same range as Q3 between 37 to 39%. Operating expenses to be up about 600,00 to 800,000 over Q3 primarily reflecting normal year end increases in our audit and Sarbanes-Oxley related expenses and to a lesser extent time and certain expenditrues in the sales, marketing and R&D areas.

EPS to be in a range of a loss from $0.01 to $0.05 compared to $0.01 profit in Q3 due primarily to the seasonally lower revenues in conjunction with increases in fourth quarter expenses as noted above. Adjusted EBITDA to be in the range of $3.3 million to $4.1 million, and capital expenditures in the range of $3 to $4 million compared to $3.5 million in Q3 reflecting continued work on driver's license, system implementations in Atlanta Canada, Indiana, Texas and others.

For the full year 2006, we expect revenues will range from $105 to $106 million within the range of guidance given at the start of the year. A substantial improvement in EPS reporting a loss in the range of $0.54 to $0.58, cutting in half the $1.13 loss in 2005.

Adjusted EBITDA between $5.6 and $6.4 million, compared to a deficit of $3.4 million in 2005 reflecting overall improvement in our financial performance as we generated higher revenues by lowering our operating expenses. Capital expenditures to be in a range of $10 to $11 million, $7million below last year's $16 million level and backlog to be in a range of $235 to $245 million compared to approximately $230 million at the end of last year.

Bruce will now offer some closing remarks.

Thanks, Mike.

We acheived profitability early in the forcasted range due to seasonality, some increases in sales and marketing expenses and customary year end increases in audit and Sarbanes costs, we expect to incur a small loss in Q4. We've come a long way.

We want to congratulate and thank our employees for the remarkable transformation in our business that they have enabled with their dedication and excellent work, with special thanks to my outstanding management team for thier conscientious and couragous action in business process improvements and rightsizing of our workforce. We are committed to delivering sustained profitable growth and we are very focused on continuing to improve our financial performance in 2007 by serving our customers needs better than any other supplier and by continuing to improve efficiencies throughout our operations.

Looking ahead we anticipate continuing organic growth while pursuing competitive wins in Secure ID both in driver's licenses and in adjacent product and geographical markets. Since we entered the secure identity management market by acquiring the Polariod assets in 2001 we have driven the organization to higher levels of customer service and customer intimacy and to developing understanding the market better than that of any other supplier; and surveying our customers better while charging fair prices for the value we provide. This strategy is intended to build revenue growth and margin expansion from increasing share of pocket with loyal customers, building a brand that provides a competitive advantage in acquiring new accounts and establishing customers for life that will reduce marketing costs and risk and provide profitable annuities to our shareholders.

In Digital Watermapping we added several high profiel licenses thus far in 2006 and formed an industry wide alliance to accelerate market growth. Signs of Digital Watermarking momentum are evident. While we believe that we are still in the early stages of market development we like what we see. The media companies appreciate watermakring, and the IT companies are learning its virtues.

The success of YouTube and My Space and other social networking sites portend a distribution environment in which Digital Watermarking is ideally suited as a means of identifying media content, managing rights, and delivering related goods and services in support of sensible business models for the benefit of all. We are very excited about these prospects. Our next investment presentation will be at the AEA Classic Financial Conference in Monterrey, California, on November 7 and 8.

Mike McConnell, our CFO, and Bob Eckel, the president of our government programs area of the business will be attending the conference. I have a conflicting appointment so I will not be there personally. For further discussion of the quarter results, our business and financial models and risks and prospects for our business, please see the 10Q that we will file shortly.

This concludes our prepared remarks and I will now been happy to take questions.

[OPERATOR INSTRUCTIONS]

Your first question comes from the line of David Sterman from Jesup & Lamont.

Good morning, guys, how are you? Just wondering if you might spend a couple of minutes talking about from the time that the cement settles around Real ID and it does look like it's in place, the feedback you've gotten from states as to how they plan to use that window before the deadline is officially, finally in place, what your expectations are the up take and kind of whatever it is, the twelve-month window they'll have to start to deploy Real ID compliance systems . How do you envision that shaking out your customer base?

Okay. The 2006 demand environment I believe was a bit subdued because of the uncertainties associated with finalizaytion of the regulations and arguments about who will pay what share of the cost between the federal and state governments.

In 2007 I expect both of those things to get settled and hopefully within the next month or two will get our first visibility on the final regulations. Once the regulations are published they will describe a grant process that the states will follow, and so the states have been working ever since the announcement of Real ID in 2005 on trying to understand what they could of the compliance requirements, and so the states have varied in their approach to dealing with the expected compliance requirements, ranging from, we can't wait any longer, we really are at a necessary upgrade cycle, we are going to move forward with our trusted supplier, assuming that will make adjustments that are necessary as they become known to us.

Others have tried to wait as long as they can to do significant technology upgrades in order to be efficient, and so there's a full range I would say of responses thus far to Real ID. Once the regulations are finalized I expect there will be a procedure that everyone will follow and it will involve submitting a grant proposal waiting for some period of evaluation, having it funded, then creating a statement of work and either doing a sole source or a bid associated with it, entering into a contract, taking implementation and then having us recognize revenues.

And so as I look into 2007 we expect continuing growth without Real ID dollars but we hope that some of the Real ID dollars will be recognizable as revenues in 2007, but if they are, it will be if they are it will be later in the year.

And a related level of licensed programs, can you comment for a moment on Ontario and what's happening in the bid process there?

It might be premature to comment on Ontario because they are in a bid process so I'd prefer not to comment at this point.

My last question, jumping over to the Digital Watermarking you had spoken a few quarters back about some renewed momentum on the license activity from some major media company's and it looked like it would be several quarters before there would be visibility on how they plan to use watermarking and what types of products and volumes. Can you give us any more insight inot traction on some actual watermarking licensee relationships?

All of the publicly available information is available today on various websites, either ours or the Digital Watermarking Alliance or the websites of the members of that alliance. I think you will fine it all out there in the public. It would be quite hard to summarize quickly everything that's going on. There's quite a lot going on across the range of applications.

Specifically though to your P&L, looking into '07 can we start to get a sense of, do you expect '07 to be somewhat of a break out year in terms of license activity revenue for you or is it still premature how '07 will shake out for you.

We would like to defer providing specific guidance on '07 for awhile longer, we are hoping to provide guidance this year earlier than in any prior year regarding 2007, sometime around calendar year end, but we are not quite ready to do that just yet.

The question is generally is watermarking on an uptick, I would say the answer is clearly yes. But the way the economic model works is that we are sort of paid less in time and so the developments that you see are leading indicators of revenue and income growth for us but the translation can run across a fairly long period of time.

Okay, I appreciate it. Thank you.

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

Good morning, this is [David Neederman] in for Steve. Looking at gross margin could you talk a little bit about your targeted range for both the next quarter and for 2007 and potentially any points of leverage that's in there? Thank you.

This is Mike. We did give some indication of that last quarter that we expect margins to move into the 40's as we continue to gain efficiencies in our fixed operating expense areas that are charged to costs of goods sold. Obviously as we leverage that fixed cost with improved revenues that we would expect the margins to continue to improve.

And the mix obviously affects the margins as well so on a longer term basis it's--we don't have any really prescribed range. We believe our gross margsin and operating margins will be a function of the efficiency with which we deliver the goods and services and IP that we generate revenues from but we will be heavily influenced by mix and as watermarking gains momentum and as our business model is more successful there, a larger share of the revenues are expected to come from that area and those revenues are largely pure margin.

Thank you.

Your next question comes from Jeremy Grant from Stanford Group.

Good morning, guys, and congratulations on a great quarter, it's nice to see you in the black.

I actually just wanted to follow up a bit on the last question about both margins as well as what operating expenses will look like. I know the Company's insignificant restructuring both with reduction in force as well as trying to bring things together more around a common platform. Do you feel like you are at a place now where things are going to stay fairly level in terms of those levels of employees and quarter to quarter expenses or do you expect things to eveolve over the next year?

I think with made some very significant progress in rightsizing the organization and in our number of restructuring and cost reduction efforts.

I think our headcount is pretty stable at this point in time. Obviously it always various plus or minus 10 or 15 headcount any time. We're currently at around 440 people. So we really don't expect major swings in that area.

There are some expenses that are more front of the year loaded or back of the year loaded but pretty traditional projection of expenses in that area but nothing of significance that we expect at this time.

Thank you.

Your next question comes from [Sid Nagoncar] from Cowen and Company.

Hi guys, I was also going to ask about the expenses, so my question's been answered. Thanks.

Your next question comes from [Lee Adler] from [Sans] Partners.

Good morning, gentlemen, I had a question regarding the Real ID Act.

Some of the press I've been reading in advance of the regulations coming out is centering around the issues that some rural communities will have, with the physical reapplication for a driver's license such as an elderly person having to drive 100 miles to finds a DMV office, etc.

Can you talk a little bit about whether there is a feasible solution that would be, when I say feasible I mean cost feasible, for county treasurers and the like to stay involved in this process?

That's quite a sophisticated question you have there, Lee. You studied the market carefully it sounds like.

Yes, it's a big nationwide issue and hwo to to serve the rural populous, particularly the elderly and otherwise relatively immobile people. There are mobile issuance stations in a number of jurisdiction that we support so that may be part of the answer.

I think that the federal legislation presumption that an inperson meeting at some point in the identification process is important is a good one and so rather than have the people come to the issuer maybe the issuer goes to the people. And this becomes actually quite important political issue in those jurisdictions in which the argument is being advanced that voting ought to be based on a credential, the identification through a credential of an individual.

Obviously you don't want to disenfranchise voters who can't travel to a location, and so we have been involved in a number of projects with issuers to provide mobile identification more broadly than driver's licenses in just the situations that you're describing.

So that's probably a substantial part of the answer. It may not completely solve the problem but it could go a long way particularly in identified areas of immobility like retirement homes or retirement communities or rural communities that are quite distant from major metropolitan areas.

A follow up to one of the first questions. In terms--you mentioned in your prepared remarks just in closing, that you are looking at adjacent geographical markets. Can you talk a little about maybe what you are seeing in other states that might be coming up open again for international opportunities outside of Canada which of course you mentioned is in process?

Yes, within the United States where we serve over 30 of the jurisdictions, we are, we believe we are the best supplier of driver's licenses in the world and yet we continue to work intently to become even better and we believe that our countries interest in the--and the issuers interests are best served by them relying on us for the driver's license issuance systems.

There are a number of other vendors in the market. There are a number of vendors who purport to have a desire to enter the market. There is nobody who is as focused on providing the best driver's license systems in the world than us, and we listen to our customers, we talk to them every day, many times a day.

We are going to try to help them through this major transformation in the marketplace and we think that we can do it better than anybody else. So we believe that the issuers who are working with other suppliers ought to look really carefully at moving over to us during the next year or two because it's in their interests in reducing implementation risk and then providing the market leading technologies that are contemplated by the Real ID. So I think there are going to be a lot of opportunities for us and the customers who make that change will be very well served.

Great, and then one last question in terms of the Digital Watermarking in the media space. Can you give us a brief, I'm sure this could be a very long conversation but a brief outline between the difference between digital rights management in watermarking and what has been talking about in the press as recently as today, regarding fingerprinting and identifying what a song is as it were?

Yes, I can't give you a detailed answer because it would take way too long.

I appreciate that.

It's a complicated technical subject, but let me say a few things. First with respect to digital rights management. It would be mellodramatic perhaps to say D RM is dead but for us it's not far off the mark either. The market assumptions that were at the foundation of the traditional digital rights management architectures that have been promoted for the past couple of decades do not conform to the way in which the market has developed.

The entertainment suppliers are interested in what they call friction-less commerce, the pace of change is mind boggling. The consumers are impatient. The demand appears to be spectacular, and so in an environment like that, the notion of locking stuff up in boxes and shipping it from one secure connection to another just ain't going to work and it's a perfect environment for Digital Watermarking in which the media objects would have an intrinsic identifier built into them and you could at least identify where they are going and what's happening in the places they go to which then enables the development of business models to pay the creators and distributors of those objects but just as importantly enables the consumers to enjoy related goods and services, communities and so forth because the object is identified and can then trigger applications.

So we are really excited about the way in which the market has developed in relation to expectations of others that varied from ours over the years. It's kind of happening our way. The, so DRM is, the DRM paradigm needs to change and I think it needs to change in a way in which we become a great deal more relevant to everybody.

With respect to fingerprinting versus watermarking we are anticipating put out a white paper actually because it's a fairly technical subject but on the highest level, fingerprinting is a scientific technique for estimating the identification of media objects by looking at certain characteristics of the signal for it, and so you can do a pretty reasonable job of estimating that particular song is from a particular artist.

But it is in fact an estimation. It is subject to distortion and it does not identify the object other than as a class object. So you can't tell that the song came from Tower Records or the song came from a particular distribution channel in the digital media world. With watermarking we can identify media objects at any level of specificity that's appropriate to the application.

So you cannot only tell that the song is a Britany Spears pop tune, you can tell that it's the special version that gives the user a chance to join a fan club or it is a unit of a particular unit of that song that came out of a distribution channel and is now in an unauthorized distribution channel and so forth, and so there are ways in which fingerprinting and watermarking can work together particularly in identifying, primarily identifying objects and then watermarking them or in the case of watermarking, having a more efficient means of delivering that information to the applications.

So we will put together a technical paper and a business paper. It talks about watermarking versus fingerprinting and then on the DRM versus watermarking and fingerprinting I would stand by the statement that the paradigm that was developed and billions of dollars were invested is not matching well to the market and there is no reason to believe the market will move in the direction that formed the foundation for those original investments.

I think the people who own the DRM need to look more at watermarking and to integrate it more into their thinking about how to manage media and manage the associated rights, and we are ready for business on that.

Great, that's very helpful. Thanks very much.

There are no further questions at this time.

Mr. Davis, do you have any closing remarks?

I want to thank everyone for joining us on the call and for the support that you provide to our business. Thank you very much. We will get back to work.

Ladies and gentlemen, this concludes the Digimarc Q3 quarterly earning conference call. You may now disconnect.