Digimarc Corp (DMRC) 2006 Q4 法說會逐字稿

Good afternoon. My name is Tonya and I will be your conference operator today. At this time I would like to welcome everyone to the Digimarc 2006 fourth quarter and fiscal year earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]. Thank you.

I will now turn the call over to Mr. Bruce Davis, CEO of Digimarc Corporation. Sir, you may begin your conference.

Thank you. Good morning, ladies and gentlemen, and welcome to our 2006 financial results conference call. Mike McConnell, our CFO, is with me on the call. We issued a press release earlier today announcing our Q4 and full-year 2006 financial results. The objectives of this call are to summarize and comment on these results, review significant business developments and market conditions, and provide an update on the execution of our strategy for 2007 as outlined in our last conference call on January 10. This Webcast will be archived in the Investor Relations section of our Web site.

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 with market and financial performance that are based on our current understanding and expectations. These statements are subject to assumptions, risks and 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 MD&A section of our form 10-K which we expect to file later today, and our earnings release posted on our Web site.

During the course of this conference call, we will also refer to certain non-GAAP financial measures as defined by the SEC and Reg G. Definitions of these non-GAAP financial measures or reconciliations of them to their most directly comparable GAAP financial measures are included in the earnings release for the year ended December 31, 2006. The earnings release can be found on the home page of our Web site. 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 from the forward-looking statements to reflect events or circumstances that may arise after the date of this conference call.

By way of introduction, I note that the financial benefits of the strategic improvements in cost structure and business processes that we implemented became obvious in the second half of 2006. Key financial measures are gross margin, operating expenses, EPS, adjusted EBITDA, and cash flow all significantly improved from prior periods. We have clearly articulated the path of sustained profitable growth, capitalizing on our leadership and secure identity management systems, and digital watermarking, and demonstrated significant progress toward that goal. We believe that the key to do this is to earn a position as a trusted and responsive partner with our customers, continued targeted R&D addressing our customer's needs and changes in our markets, and to continue to run our business efficiently. We believe our markets are rich with opportunity.

We made noteworthy progress in 2006, I want to congratulate and thank our employees for the remarkable transformation in our business and that they have enabled with their dedication and excellent work. With special thanks to my management team to their conscientious and courageous actions in business process improvements and rightsizing our cost structure. Our entire team is committed to delivering sustained profitable growth to our shareholders.

At this point Michael will provide commentary on Q4 and full-year 2006 results, and I will return to provide an update on progress with our 2007 annual operating strategy and plan.

Thanks, Bruce, and good morning, everyone.

Q4 revenues of $25.4 million was up 1% from last year, and near the low end of the range of our previous guidance. Domestic revenues rose 3% year over year to $19.3 million, and international revenues were down 5% year to year to $6.1 million due to quarterly variations in our foreign contracts. On a sequential quarterly basis, domestic revenues were down 14% due to our seasonality and international revenues were up 44%, primarily reflecting the impact of revenues from overseas contracts that are less predictable than revenues from our domestic issuance contracts. Gross margin for the quarter came in at 38%, higher by nearly 12 percentage points versus last year and roughly equal to gross margin in the prior quarter. The improvement over prior year is primarily attributable to lower overall operating expenses, and from lower depreciation, resulting from an improved estimate of useful lives of certain depreciable assets, implemented at the beginning of 2006.

Operating expenses in Q4 were $10.9 million, $3.4 million lower than the same period a year ago, due to substantial efficiency improvements in our operations, and up $600,000 from the prior quarter, primarily due to normal year-end increases in audit and Sarbanes-Oxley related expenses. Approximately $700,000 of non-cash stock-based compensation expense was recorded in the fourth quarter and was spread between the cost of sales and operating expense lines. Adjusted EBITDA was $3.4 million compared with a deficit of $1.8 million in 2005, reflecting the overall improvement in our financial performance. EPS for the quarter was a loss of $0.04, substantial improvement of $0.33 per share over the $0.37 loss of a year ago and $0.05 less than the $0.01 profit in our quarter results and was in-line with our guidance of an EPS loss in a range of $0.01 to $0.05 for the quarter.

For the full year of 2006, revenues were $104 million, just below the range of $105 to $115 million guidance given at the start of the year, representing a 3% increase in overall revenues. The quarterly run rate for operating expenses in the second half of 2006 ranged from $10 to $11 million, approximately $3 million lower per quarter than the first half of the year, due to the improvements in our cost structure. We intend to maintain spending levels roughly at this amount through 2007.

$0.57 loss in 2006 is a substantial improvement in EPS from $1.13 reported in 2005, cutting the full-year loss nearly in half. Adjusted EBITDA for 2006 was $5.7 million compared with a deficit of $3.4 million for 2005, reflecting overall improvement in financial performance and a positive swing of $9.1 million as we generated higher revenues while lowering our operating expenses. Capital expenditures were $10.5 million, $5 million below last year's level of $15.5 million. We ended the year with $33 million in cash and equivalents, short-term investments, and restricted cash up $2 million from our prior quarter and $1 million on the prior year end. And earning backlog approximately $250 million. For a further discussion of fourth quarter and full-year 2006 results, our business and financial model, and risk and prospects for our business, please see the form 10-K that we expect to file later today.

Bruce will now comment on how we're doing in the execution of our strategy for 2007.

Thanks, Mike. The focus of this update is on strategic execution in relation to annual guidance and long-term market development. In these quarterly calls, we will evaluate our progress on strategy execution and note significant changes in market conditions. Especially noting where quarterly financial results may imply significant variation from annual or multiyear financial trends that we have projected.

At this point, early in the year, we continue to operate according to the plan described in our last call. As you know, our top business objective for 2007 is to deliver sustained profitable growth, capitalizing on our leadership and secure identity management systems and digital water marking. We intend to achieve this objective by maintaining a position as a trusted and responsive partner to our customers, prudently investing in R&D and establishing strategic partnerships to broaden our offerings while continuing to make business process and work force improvements to gain further productivity benefits. We have positioned our company at the heart of a potential major expansion of our market motivated by Real ID and the needs that it addresses. 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 implementation of real ID.

Driver license issuers are looking to us for expert advice in market-leading solutions as they upgrade 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 more secure enrollment and production, better credentials, and more reliable post issuance verification. The draft regulations were published about a week ago. In addressing the financial implications of Real ID, Department of Homeland Security Secretary Chertoff confirmed that DHS's estimate of cost indicated that the state's estimate of costs of $11 billion in costs over 5 years was, in his words, about right. For more details, please see the draft regulations.

Secretary Chertoff commented further that, quote, "if we were to take the amount of money that states are going to pay when they issue a license and ask what additional costs above and beyond the normal costs will be borne by the individual as a consequence of these measures, we've estimated that to be about $20. So basically it's going to be a $20 privacy fee and security fee if in fact the states choose to pass that on to their citizens. I think it's obviously not a trivial amount of money, but is the question is, is it a reasonable amount of money that people should pay to prevent people from getting on airlines or getting in buildings and killing Americans. And by the way, so we can be confident that our licenses are harder to clone, and harder to counterfeit, and harder to forge, I think most people would say, that's pretty reasonable, that's $20 well-spent." End of quote.

As we await final regulations and more visibility on the market potential and funding strategy for Real ID, we are working diligently with our customers to assess the implications of the regulations, consider how we might move forward with upgrades that are likely to be consistent with the final regulations, and continue improving our business operations and capacity to manage growth, better serve our customers needs, and prepare to assist them with compliance. In the commercial sea, we are encouraged by many positive developments and growing appreciation for the value of digital watermarking, and providing better identification and management of digital assets, while enabling new consumer experiences. We've recently published a number of statements regarding ways in which digital watermarking may be useful in developing legitimate business models for emerging channels of distribution and consumption of digital media. We believe that digital watermarking can provide an improved approach to digital rights management that combines good accounting with optimized marketing and enhanced consumer experiences.

In parallel, we will continue our market development work on IDMarc for improving inspection of driver licenses, and Digimarc Mobile for simplified mobile commerce. Mike will now provide an update on our financial expectations for the first quarter, full-year 2007, and succeeding years and I will return with some closing remarks.

Thanks, Bruce. With respect to our key financial measures, we're not making any significant changes in our guidance for 2007. We still expect revenues to grow 5 to 10%, similar to the range of growth in the past several years, and perhaps higher, depending on the impact of revenue growth drivers that we have identified. We believe we can be profitable at the lower end of the revenue range, and demonstrate significant financial leverage if we can get higher levels of growth.

We continue to expect an operating loss in the fist quarter, with improving bottom line performance later in the year due to seasonality and growth of revenues in relation to a flat quarterly expense rate of around $11 million. We expect to generate adjusted EBITDA of more than $18 million, capital expenditures should be in the range of $15 to $18 million, depending on the pace of implementation of our existing programs, the pace and funding strategy of real ID upgrades, and our success in gaining market share from new customer acquisition opportunities that may become available during the year. Operating cash flow should increase to over $15 million, and our backlog may increase in the second half of the year in anticipation of higher growth rates in 2008 and 2009, depending upon a number of factors, including Real ID, domestic ID market share gains, new international customers, and growth in digital watermarking. Bruce will now offer some closing remarks.

Thanks, Mike. We are optimistic about trends in our markets and the improved capabilities of our company. Over the course of the next few years, we see opportunities for accelerating growth rates and continuing market expansion and productivity gains, leading to sustained profitability and attractive cash flows. Our views regarding key growth drivers of the business for the next few years are unchanged.

In our Secure ID business, they include real ID, which we expect to dramatically increase issuer needs for upgrades and business process reengineering, with billions dollars of upgrades being discussed, we are the incumbent supplier to 70% of the market. An expanded portfolio of goods and services that we anticipate bringing to the market is another factor, including the fruit of the last several years of R&D and some new alliances that we are working on and hope to finalize in 2007. We also see opportunities for new international customers from a list of identified opportunities, being examined and nurtured by our recently-expanded international business development team.

The digital watermarking, we see growth drivers, incoming accelerating rate of adoption across various applications resulting in more income from existing licensees, and the addition of potential new licensees, favorable market conditions and production distribution and consumption of digital media, including the noteworthy failure of first generation DRM, and the recognized need for more effective solutions, and lastly the maturation of our multi-year market development programs for IDMarc and Digimarc Mobile. In general, market conditions are favorable to our strategy, and we are ready to serve the needs of our customers.

We are planning to present at the following upcoming financial conferences: the IFC West 2007 Roth investor event on March 29 in Las Vegas, and the AEA Microcap Financial Conference May 6 to 8 in Monterrey, California. This concludes our prepared remarks and we are now prepared to take questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of David Sterman of Jesup & Lamont.

Good morning, guys. How are you?

Hi, David. Fine, thanks.

Good, Dave.

Just a couple of housekeeping questions on the P&L. On a macro level on the sales growth, I know with Real ID coming, some of the states have held off with some of their planned upgrades, but you gotten some upgraded contracts in '06. Or at least some upgraded contracts. We're in a period here looking year over year of pretty much flat sales growth for the last three quarters and it looks like you're still thinking it's going to be accelerating later in '07. Can you give us a sense of when you think you really start to see more robust year over year comparisons?

Yes. We first note with respect to 2006 that we said that at the start of the year we anticipated it would be a slow year waiting for the regs and it was. So that was consistent with our expectations. The growth drivers that we've identified in the largest revenue area of our business in the ID area are Real ID and international.

Real ID, there's quite a lot of public information available now, so we can all take our best guess, but our customers have differing views of how to proceed at this point from the publication of the draft regulations. I will say there are a significant number of customers who are anxious to get going and are asking us for advice and trying to figure out ways to move forward in a way that is comfortable with whatever uncertainty may be perceived with regard to the regulation. So everyone's assessing regulations with us and determining the best way to move forward. So the answer to your question lies in how soon they're comfortable moving forward. That's a little bit difficult to handicap on a real short-term basis. Is it Q2, Q3, Q4 or even early '08?

So I think we're just going to have to wait and watch. You can trust that we're working diligently with our customers to deliver improved driver license systems as soon as they're ready and able to work with us to do that. It's a little bit difficult to get real precise at this point.

Okay. While we're on the difficult topic of trying to forecast sales traction, jumping over to international, can you give us any further sense of where you might be in terms of cultivating a pipeline and when that pipeline may start to convert for you?

We've already cultivated the pipeline and we have lots of activity and we announced one of our successes this morning with the Mozambique driver license contract win. So hopefully we'll have many more of those. This is one of the reasons why I've been encouraging people not to get too fixated on quarterly variations. Which month those come in on is difficult to tell in advance. In looking at the year, as Mike said, we're still comfortable where we started out and we still see some variation up and down possible, but there's a lot of reason to be enthusiastic right now about the marketplace. But if you're trying to shoe horn it into a particular quarterly, particularly say next quarter versus the quarter after, that's beyond my capability.

Okay.

Really, we're focused on moving along in a fashion that serves the citizens well and that's comfortable for our customers. As I say, there are some customers who are willing to accept more ambiguity than others and there are some customers who have been holding off as long as they feel they can hold off. There is some pent-up demand and a desire to get going, but we'll sort of know when we get there in the near term here. In the longer term, I'm quite comfortable in a very robust demand environment.

My final question goes to the expense control. Which was obviously a great story for you earlier in '06. I saw G&A jumped up a good bit in Q4 to $4.4 million. I was wondering if there's one-time events in there and if there's some sort of new baseline for G&A we think about for '07?

This is Mike. I think we've identified some seasonality in some of our G&A expenses in Q4 and Q1 of every year. That's when the majority of the audit and Sarbanes, the work is extended. Obviously, as we become more efficient, we're working to reduce those fees, working to spread those out during the quarter to be more consistent. We clearly have an uptick in Q4 when a lot of that work occurs and it continues a bit for Q1 for the first couple of months. That's a pretty standard approach for us on a year to year basis.

Okay, all right. Just as a final question, on Q1 itself, you talked about expectations of maybe a modest operating loss, but I don't think you talked about a revenue range. Is that something you want to put out?

Well, we've indicated previously that we think that Q1 will be comparable overall to Q4. Again, Q4 and Q1 are our two low quarters as it relates to the domestic U.S. driver license revenue trend. So we're pretty comfortable with sticking with that approach at this point.

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

David, let me add a point here on modeling for the benefit of all the analysts on the call, I think I've probably mentioned several, but I want to make it clear that our domestic issuance volume which has contribution margin is seasonal and pretty predictably so and the fourth quarter is the lowest quarter of the year and the first is the next lowest, and so Q2 and Q3 is the highest. Q3 is generally the highest. In terms of routine business expenses, Q4 and Q1 seem to be the highest. We have a bit of a correlation there, where that tends to depress Q4 and Q1 in relation to the other quarters. I hope that is helpful to everyone.

Okay. I appreciate it. I'll step back in the queue. Thank you.

Your next question comes from Rob Stone of Cowen & Company.

Hi, guys.

Hi, Rob.

Bruce, I wonder if you could just comment a little bit on the anticipated time line for the regulations. You mentioned that the draft was recently published. What are the next milestones in terms of comment period and final regs and so forth?

The comment period runs 60 days from the date of publication of the draft and then it gets a bit less definite in that DHS will then consider the comments that they've received and consider whether to make any revisions and then publish the final regulations. There are some contradictory forces in the marketplace and in the public policy arena. Just about everybody wants to move along as fast as possible for the final regs, except for some of the political forces that try oppose this who would like to drag it out so they can make the argument that they can't get going because the regs haven't gotten done. I think the great weight of opinion and power is in favor of getting the regs finalized.

So I don't know how fast they can do it. Obviously they haven't been real quick historically here, but we're impressed that the regs got out as early as they did in draft form and we believe that they'll be a serious effort to move these forward as quickly as possible and the reg then could be done in the summertime. It would be -- is our best guess. Summer to early fall. But the question for our customers and the marketplace here is how far are the regs from where people believe they may end up. That's the assessment that we're doing with customers now.

So it may be possible to begin to move forward in a way that wasn't possible prior to the publication of the direct regs, because they have come out and we've all had a chance to read them and study them and there will be conversations between our customers and the federal government, I'm sure, and customers are pretty comfortable that they can rely on the mandate described in the regulations, we may see people moving forward sooner rather than later.

A question on the $11 billion figure in relation to federal budget allocation to the states. If memory serves, it's only a few tens of millions that's in the fiscal '07 budget for Real ID. So doesn't the rest of this cost represent a pretty substantial unfunded mandate to the states? And if that's the case, will it not require -- what would be the typical mechanism in the states that you're familiar with to authorize additional fees or figure out how to make up the $20 difference. My personal reaction is that, yes, it's a relatively small amount of money given the issues at hand, but because the a fee that's regulated by somebody, I'm wondering about the process of where the extra funding will be generated and how long that might take.

Yep, good question. So the states estimated $11 billion. The Homeland Security Office of Management of Budget examined the assumptions and said, yes, seems like a pretty decent estimate. They then put a -- there's a spreadsheet in the regulations that describes in more detail their view of the budget if you would like to take some time to look at that. And it breaks it down in things like card production versus IT and so forth.

It would be great if the federal government funded the whole thing. I don't know of very many people who believe that is likely to happen. However, there's a strong desire by many parties involved to have the federal government pay some of the bill at least. And thus far, Congress appropriated $40 million in 2006 that has not yet been sent. And then, Secretary Chertoff noted in publishing the regulations that Homeland Security would accept up 20% of grant requests under the existing Homeland Security grants to states to be allocated to real ID improvements and we've done a little bit of research and estimated that to be probably around $100 million. So that money would compete with other uses of Homeland Security funds. It's not supplemental, it's an opportunity for some discretion by the states.

That means there's about $140 million available to get started, and so we believe that a number of states are prepared to move forward with covering the residual costs through issuance fee increase, and that's where the secretary's remark about $20 per person came from. And if he is correct in they assumption, I won't try to stand by anybody's math on this that's publicly available that would be $2.50 per year on the eight-year maximum term per license to have a vastly superior driver license issuance system for America. I don't think any citizen in our country given all the value of the driver's license would resist that small marginal investment. Particularly, when the alternative is the driver license is not upgraded to the satisfaction of the federal government and the substantial investment haven't made in it for other reasons, the logical alternative to it is the passport that cost $100 for ten years, and has only one value today, pretty much, which is for international travel and it's quite inconvenient and on and on and on. So the driver's license investment makes so much sense.

That's why many of the states, even though they're strongly advocating for funding, and they're arguing vigorously against an unfunded mandate, I believe recognize that this is a worthwhile investment for their citizens. They just want the feds to pay their fair share. Now the implication for us of the funding model, which I believe we may have outlined previously, but it's important for everyone to appreciate is if issuance fees are increased to pay for real ID, that's our traditional model. So our business will grow significantly and the economic model will stay pretty much what it has been. If a substantial amount of federal funding is provided, it seems likely that the money would not be able to be retained by the state, thus it would be given to suppliers in which case, we could see a substantial change in the positive sense in our basic business model during the multi-year period of Real ID upgrade. We're standing by to see how that plays out.

But as you know, we normally carry a significant number of millions of dollars of deferred revenue on our balance sheet, and that's where customers have some money that they entrust to us while we deliver the goods and services. That could grow a lot if the feds decide to put up some funding.

Thank you. Housekeeping question for Mike. What would you anticipate is roughly the quarterly run rate for FAS-123R this year?

We'll be a little bit higher than last year. We really haven't provided the details of that, Rob, but obviously as each year progresses, it does grow a bit. Just north a little bit of where it is.

So what was it, 7 --

A little over $700,000 this year. So it'll be a bit up from that.

Okay. So up from that, but less than 8, or --? What's a bit?

It could be in the 8 to $900,000 a quarter range based upon stock issuance, rising price, and the all variables if you've read the 123R, it's quite complex, but we do a pretty good job of estimating that at this point.

Okay, thank you.

Your next question comes from Jeremy Grant of Stanford Group.

Hi, guys.

Hi, Jeremy.

I wanted to start off with just to drill down a little bit more into Real ID. My impression has been that some of the new stories we've seen in the last week have been from some of the folks that have been on the hating side of things. Either state legislators that want the feds to pay for it or privacy groups that may honestly never be happy with the way these things come out. It seems to me that one of the stories that was really overshadowed is the news of states that actually want to go forward. The Department of Homeland Security, Assistant Policy Secretary, for example, said he thought a lot of states wouldn't apply for delays. He thought ten would be ready by May of next year. I know both Michigan and Oregon were in the public press the last couple of weeks, saying they were excited about Real ID and wanted to go forward. Can you give any color on other states you see that are likely to be at the forefront of this?

I don't think it would be appropriate for me to identify individual states, but I do agree with your observation and that was my point earlier in the call, is that there are many states, particularly larger states who recognize the overarching benefits of the increased investment in driver licenses and they want to get going. We have seen a change in the tone in some of the editorial, particularly in the U.S.A. Today editorial earlier this week, where the arguments are beginning to get more sensible. The early fear, uncertainty, and doubt be largely instigated by the ACLU, is now being supplanted by some extent well-reasoned argument about the security of the various aspects of the proposed upgrade and the cost. And I believe the privacy concerns have been way overblown.

There's nothing in the regulations about building a federal data base and there's a lot of misunderstanding about the data that's already collected by states. And there really isn't much new that's being asked to be done. The thing the federal government would like to see is some means -- secure means and respectful of privacy, of trying to get to one driver, one license, and that doesn't necessarily involve any substantial increase in privacy risk. It just involves being able to query a data base and get a 1.0 decision on whether there's an issued license for the individual involved.

The issue of funding addressed in response to Rob's question, it's a big issue and I think the federal government needs to show some good faith here and they will receive a benefit from the improvement in security and they should contribute to achieving that resolve. That's our view and our customer's view. With that said, most of our customers, I think, appreciate that further investment in this product benefits their citizens and if the cost is completely passed on to citizens and properly explained to them would be one that they would probably be happy to bear.

Let me ask a little bit about the new contract in Mozambique. A value is not provided. Is there any more color you can give us on that?

Yes. We've tended to not put specific contract amounts lately, but it's the 7-figure sort of contract.

Okay. In terms of how you get paid, I know you said before it's tough to time exactly when it would hit the income statement. Is this the model be getting revenue similar to the states, where it's a per-card that you get paid, or more a one-time sale where you're working with a partner and will be delivering a system and get paid in more of a chunk.

Jeremy, it's Mike McConnell. It's actually typical of a majority of our international sales where there is up-front revenue where we supply the complete system, hardware, software, et cetera, and then there's an ongoing revenue stream of the consumables for them to be able to produce. That's our pretty typical international model today.

Okay. Just wanted to get down into some of the OpEx numbers. You talked about G&A being up in part because of the SOX compliance. Wanted to know, does that mean we should assume after Q1 G&A numbers would be a little bit lower in our models compared to where they are right now?

That's correct.

Okay. Other question was an R&D, I know coming in at $1.88 million, that's kind of -- looking at my numbers historically, that's a new low. I know a lot of R&D-based change with the reorg you did this year, should we assume it should stay under $2 million, or is it possible it could trend upward again?

Let me share with you a little bit of background there. We've spent a great deal of time and effort and cost over the last 18 months or so moving to a more standard product and we've just made phenomenal progress on that and obviously with our overall cost reduction approach, all areas had reduced costs. We'll continue to invest in R&D. Right now, it's possible it could flatten out or maybe be a bit lower. We're comfortable with our R&D investment today.

Okay. And assumptions on that? The other question I had was diluted shares looked like they were down by nearly 800,000?

That's because of Q3 we had a small profit. We had to bring in the affect of all the stock options and unvested stock for a profitable quarter. But for the quarter and for the year, it's not considered to be dilutive.

Okay. I think that was it. Thanks.

Okay.

Your next question comes from [Lee Odwire of Suns Partners.]

Good afternoon, gentleman. I had a couple of questions regarding the digital watermarking space. During the quarter, as you noted in the press release, you had a couple of significant patent issuances. Bruce, I was unable to be at some of the last the two conferences you attended and they weren't webcast, but I see from the presentation you devote a slide or two to what what you're describing as 21st century DRM. I'm wondering if you can give us a little color as to how you envision these patents maybe being applied in the realm of P-to-P and social networking.

Sure, I'd be happy to. We have observed some significant ongoing change in the distribution and consumption of music and television via the internet. That has caused a big crisis in the Media business and embodied in situations like Steve Jobs letter saying let's make music free and YouTube having various difficulties with major media companies about their copyright and subject matter coming up on the YouTube site.

So as we noted the changes in the marketplace, there was a growing awareness that the first generation of digital rights management was based on market assumption that has turned out to be false. That assumption was that the new media would look like the old media, only digital. Instead it has turned out to be amazingly fast, chaotic distribution. Really sort of unpredictable where any object would go on any given day but we know that it gets there fast, and that many people can gain access. So that's a beautiful environment for digital watermarking, because digital watermarking is an intrinsic identification of the media object.

So if we can put various recognition points around in that distribution, say in a site like YouTube, that means that copyrighted subject matter could be identified as its ingested into the site, and a database could be examined to determine what rights are available and then because the optic has been identified, advertising and other marketing benefits can be optimized and in doing all of that, there's no reason to stop anybody from enjoying the entertainment or receiving the news or other information and in fact because of the optimized marketing, they get an enhanced entertainment experience. So our vision of the new DRM is one in which watermarking is the means of identifying the media object. And rather than wrapping it up in a box, which was the notion of DRM and putting it in secured connections, let it run free, let the maximum number of people enjoy the entertainment, let's just keep a good accounting for it, let's enhance the entertainment experience, and let's sell them a lot of goods and services and community along with the thing they found attractive enough to view or listen to.

We have been describing this vision and we have built prototype software applications to demonstrate the vision, and we have begun talking with lots of people in the media business about this new approach to entertainment media and we find a lot of people find it quite fascinating and interesting and we're hopeful that we'll be able to bring water marking to bear on this currently unproductive distribution, this disputed distribution and turn it into maybe another golden era of entertainment. We're very optimistic about this.

We think that it makes a lot of sense and we know and I think you and other investors know that digital water marking has been very carefully studied by the entertainment industry, and is widely used by the entertainment industry for many different applications. This will be a very large one if they embrace it. We intend to very aggressively pursue bringing this benefit to the entertainment industry over the course of the next year or so.

Okay. One of the -- just as a further point of clarification, one of the frequent criticisms I read regarding the likes of digital fingerprinting or audio fingerprinting is this idea that the copyright owner has to proactively go out with takedown notices and such and notify those that are in breach of copyright that they've done so. My reading at the Grokster at the Supreme Court was, that should almost be flipped on its head and people just shouldn't breach copyright. Is what you're describing with this point of ingestion theory essentially that kind of solution, whereby people know immediately they're dealing with copyrighted material and they're not relying on somebody to notify them and send them an example.

The ideal we have that what is today an unauthorized and illegitimate distributor of entertainment probably gains some economic benefit from not paying for the copyrighted subject matter they're distributing, but if they were to use digital watermarking, they then could do an accounting and could properly pay for the content that they use. But because of the opportunity to optimize the marketing and enhance the consumer experience, we believe that there's a well-reasoned argument that they could probably make more money being legit than being illegit. It has to do with the persistence and the granularity and the reliability of the identification of all that media wherever it goes however it goes. We see a model here in which it's not merely a tax vehicle and it's not in any way an inhibition on the distribution, which is again as you outlined, the historical practice here and the first effort to deal with this new distribution has been largely by denying consumers the opportunity to enjoy the entertainment by arresting and then trying them by doing takedown notices at the site and all that. We're hoping that we can show the way to a very different kind of model in which everybody has more entertainment experience and those who provide it make more money.

Great. Okay. Thank you very much.

Your next question comes from Walter Schenker of Titan Capital.

Good afternoon, gentleman.

Hello.

A couple questions. First of which is, in the Real ID report you made reference to the fact that 5 to $6 billion, and those are ten-year numbers, are for cards. When one looks at that spread sheet, that's the part that would be most relevant to your market?

Yes, but that's not all that's relevant, but that is the most relevant part.

Okay. And therefore, their number not your number. If we take -- it's $5.6 billion, divide by 10, it's $0.5 billion a year, that is three times what the card market is today, or four times? Just trying to get some order of magnitude what the base line is?

Yes, that's pretty fair math.

Okay. Next, different question. You are -- credit to you, you've indicated in your press release you showed various components of fixed and variable costs for the quarter, realizing that is different between the intellectual property side and the ID side of it, but if in fact, there were a multiple increase in revenues on the driver's license side that variable cost structure of less than 30% might be a reasonable target?

I think you've seen in the releases we've been running a variable number of around 20% for the last couple of years and it can rise or lower based upon the mix. The majority of that is the driver's license issuance cost. So we are targeting to continue that level or as we look to ways to improve it, maybe enhance the margins.

So there's nothing -- again, it's early in the process, although it's taken two years in Real ID, which would cause you to -- always a double negative, not to think that you would still be able to maintain those type of variable margins?

We should be able to improve on them, Walter. We -- obviously we've been improving our business significantly, and we intend to continue to do that. In a situation in which there is an urgent need to upgrade, we expect the trust relationship we have with our customers to prevail and cause them to look to to us help them to upgrade and our promise back to them is to charge fair prices and fair prices are those which we make a reasonable profit, which we haven't been making. I expect the margins to improve because of the nature of the market right now and the quality of the relationships that we have with the customers.

Last question. Could you -- I know you've done this in the past. Could you give us an update on what activity you -- and I realize it's not cast in stone -- you expect to see this year relative to the 50 states and new contracts or reopening contracts for suppliers for their driver's licenses?

Who will go out the bid?

Yes, that's a better way of phrasing it.

It's always been nearly impossible to handicap, but probably more difficult this year than any other year. Our competition has tried to convince everybody every year that there were lots of states that would go off to bid and they would change and we all know that was not well founded. So we've only been seeing one or two bids a year. In these circumstances, it's a little hard to tell, you can make a good argument that there would be less, which would be then close to zero, or more in that some states might have been waiting to do a bid process until this came along, but then the counterargument on that one would be, well, they've been waiting but now they're in a rush. A bid takes a long time and incurs a lot of operating risk. I think the general trends to the market would be conservative and thus there's not likely to be a lot of bids.

Right now in terms of open bids, bid processes, there's Virginia and California and New Mexico. And Virginia has been open for two years and California is going on a year and New Mexico is the newest of the three. And none of them have been closed. So they're all continuing open processes. Our understanding with California is that it's not likely to make a decision until 2008, and Virginia's is less certain as to when they will finish, up to them to decide and New Mexico likewise, there's no sort of public deadline or target that has been published that I'm aware of.

Okay. Thanks a lot.

Okay.

Your next question comes from Kevin Hanrahan of Hanrahan Capital Management.

Hi, Bruce. Thanks for taking my call.

Sure.

I had a question, this is real brief. I'm on the question and answer -- or frequently asked questions that's on the Department of Homeland Defense Guidelines for Real ID. It says Homeland Security grant programs can provide significant funding for this year or beginning this calendar year, and it says up to 20% of the states grant programs could be used for Real ID. So your $100 million figure you threw out there, and I know that's ballpark, would that be per year?

No, it's even better than that, Kevin. I don't want to put an overly heavy emphasis on it, because I don't know how it will play out in terms of trade-off versus other uses of the money, but that's fiscal '07 money That's before the end of September.

Okay, so --

Next six months.

So the 20% number is potentially up to $100 million for fiscal '07? And then there will be some more money for fiscal '08, probably?

That's correct.

And future years as well?

Absolutely.

Okay. That's an interesting point there. And I know the states will be competing different projects within the state will be competing for that money, so who knows how it will happen.

And that's in answer to the earlier question that I wouldn't be surprised if we got some early business here.

Yes, okay.

Substantial uptick. I just can't promise you guys that.

Right, right.

One of the sources of that would be if some states looked at the best use of the Homeland Security money available to the state is to begin work on this Real ID stuff right away, and they call us up and said let's get going.

I got you.

And we've got a number of products and service we can deliver on on relatively short notice that are consistent with the goals of Real ID.

Okay.

I don't know yet.

Right.

There is a pot of money there.

Okay. I have another question. I read with great interest your letter to Billboard magazine. I thought that was really well written. And then I see you presented a panel discussion in Los Angeles, a panel called Covering Your Digital Assets, which happened right at the end of January. I guess on February 2, that's the day Viacom sued YouTube and your stock exploded. Can you just tell us -- and you already entered this, talking earlier to the other gentleman, talking about the similar topic, are you talking to some of the entertainment and media companies -- are you in discussions with them or did some things happen there in Los Angeles, were you in discussions with these people talking about these topics?

Well, let me answer the financial market question fist, because it's the easiest one. You guys are experts on that, not me. I have no idea what's happening on the stock market anymore. But with respect to our involvement in this initiative with the entertainment industry, you can assume we're talking to all of the major media companies and the infrastructure suppliers about this business model and the supporting technology. We've gotten some pretty good reception for it and it's a complex environment.

There are a lot of things going on in terms of the economics and the power relations of the various very large companies and so forth, but we really think we have an elegant solution here that can move the market forward in a way that sidesteps the painful sort of oppression of consumers and all the fighting in Congress about fair use and so forth and just essentially relegates this to the implementation of advanced technologies that allows this distribution to behave responsibly as an economic model while doing the kinds of things they want to do. It really actually fosters innovation and creative business models, and free flow of media. all the kind of things people thought were impossible, we believe are possible. So you should assume we're actively engaged in discussing this with whoever will listen to us.

So I could assume maybe all the usual suspects?

Yes, I think that would be pretty fair. Can you tell us -- just a few of your existing customers. I think WarneR Music and Sony, are those existing customers of Digimarc? We do most of our provision of commercial solutions through business partners.

Right, through Phillips, et cetera.

Yeah, so the best answer I can give you to that would be to go to digitalwatermarkingalliance.org.

Yes. And see who's identified there. They are essentially all business partners of ours and see what they're doing.

Whatever they're doing, that's what we're doing.

Okay. Thanks a lot, Bruce.

Yes.

You have a follow-up from David Sterman of Jesup & Lamont.

My questions were answered, thank you.

There are no further questions at this time.

All right. Terrific. Thank you, everyone, for joining us on the call and for the Q&A that ensued. We'll look forward to talking to you again after Q1 is reported. Thank you and good-bye.

This concludes today's Digimarc Corporation conference call. You may now disconnect.