Digimarc Corp (DMRC) 2007 Q2 法說會逐字稿

Good morning. My name is Regina and I will be your conference facilitator today. At this time I would like to welcome everyone to the Digimarc earnings conference call. (OPERATOR INSTRUCTIONS) Mr. Bruce Davis, you may begin your conference.

Good morning, ladies and gentlemen, and welcome to our Q2 '07 financial results conference call. Mike McConnell, our CFO, is on the call with me. We issued a press release earlier today announcing our Q2 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. This Web cast will be archived in the Investor Relations section of our website.

Before we proceed, please note that during the course of our conference call we will be making forward-looking statements regarding management's opinions and expectations about Digimarc's business, its markets and financial performance that are based on our current understanding and expectations. These statements are subject to assumptions, risks, uncertainties and changes in circumstances. Actual results may vary materially from those expressed or implied by such statements. For more detailed information about the risk factors that may cause actual results to differ from expectations, please see the Company's filings with the SEC, including our Form 10-Q to be filed later today, 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 SEC in Reg G. 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 June 30, 2007. The earnings release can be found on the home page of the website.

Keep in mind 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.

By way of introduction, we continue to execute the strategic plan in our previous calls. Market conditions are pretty much as we anticipated. Our overall financial results are generally in line with our previous guidance. As expected, key financial measures of gross margin, operating expenses, EPS, and adjusted EBITDA, and cash flow all significantly improved from a year ago on a similar level of revenues.

At this point, Mike will provide some commentary on the Q2 results, then I will return to provide an update on progress with execution in 2007, annual operating strategy and plan. Mike?

Thanks, Bruce, and good morning, everyone. For the second quarter of 2007, financial results were significantly better than the comparable quarter of last year and generally in line with our prior guidance. Revenues grew 10% over prior year to $27.4 million. Gross margins improved 5 percentage points over prior year to 38%, demonstrating the financial leverage we've achieved from restructuring initiatives over the last couple of years.

Operating expenses came in at $11 million, a $2.4 million improvement over the prior year and at our expected quarterly run rate, likewise reflecting the favorable impact of changes we have made in our business model and operations.

The $500,000, or $0.02 per share loss in Q2 was a $0.22 per share improvement compared to the prior year. Adjusted EBITDA for the second quarter was $4.2 million, an improvement of $4.8 million over the prior year.

It's also noteworthy that trailing 12-month adjusted EBITDA was nearly $16 million, or about 15% of related revenues reflecting the significant impact of previously discussed operational improvements.

Capital expenditures primarily supporting several customer projects were down to $4.2 million from $6.9 million in Q1. We ended the quarter with $29 million in cash and equivalents, short-term investments and restricted cash, down about $3 million from the end of last quarter and in line with our projections, in which we indicated we have a net cash outflow in the first half of the year before achieving positive cash flow for the second half and full year.

Our earning backlog is approximately $225 million, reflecting normal burn-off offset by bookings during the quarter.

For further discussion of the second quarter results, our business and financial models, and risks and prospects for our business, please see our Form 10-Q that we expect to file later today. Bruce will now comment on how we're doing in execution of our strategy for 2007.

Thanks, Mike. Regarding execution of strategy in relation to annual guidance and long-term market development, we have operated so far this year generally according to the plans described in our guidance call at the start of the year. Our top business objective remains to deliver sustained profitable growth, capitalizing our leadership in secure identity management systems and digital watermarking. We continue to make steady progress toward these goals as we demonstrate significant improvements in financial and operating leverage.

The primary growth drivers are as we anticipated. REAL ID, international ID, and digital watermarking proliferation. Let's talk through the status of each of these factors. First, with respect to REAL ID. The Department of Homeland Security has provided a REAL ID implementation plan proposal to the Senate and House Appropriations Committees describing general areas of interest for funding and providing a specific timetable for beginning implementation and disbursement of the initial $40 million of federal funding. According to the plan, DHS would begin making grants in October and complete the grant-making process by the third week of November. The plan must be approved by the committees. The plan has not yet been approved. We are awaiting notice of acceptance of the plan by the committees to ascertain whether the timetable set forth in the plan is a reliable roadmap. We are prepared to assist our customers in obtaining a fair share of the initial grant moneys. At this point, even assuming timely acceptance and implementation, it is not clear whether we can generate recognizable incremental revenues in 2007 from successful efforts to obtain this federal funding.

For those of you who are interested in more details of the proposed implementation plan, we have posted a copy of the Department of Homeland Security REAL ID Implementation Plan on our website in the Industry News section of the home page, and in our REAL ID Resources section.

In other REAL ID funding news a proposed Senate budget amendment that would have provided $300 million of '08 funding for the program failed by a close vote last week. The House has proposed $50 million in funding for REAL ID for '08. It seems likely now that the range of federal funding for the '08 fiscal year ending September '08 will be $50 million or less.

So, together with the previously appropriated but not yet spent $40 million, we anticipate that there will be between $40 million and $90 million in federal funding to supplement state driver license upgrade budgets in the '07-'08 fiscal periods. Quite a significant sum, but far below what the states have been seeking in federal assistance.

On the international front, during the first half of the year we announced two new customers, Mozambique and Tanzania. Recently we announced a major upgrade program for driver licenses in Russia. As we look into the second half of the year, we are pursuing several hundred million dollars of business opportunities for government-issued ID programs. At this point any success that we may have in these initiatives will probably not contribute significantly to 2007 revenues given the likely dates for award and timetables for implementation in relation to our general revenue recognition policies.

In the digital watermarking area there was big news in the quarter with the announcement that Verance's watermark technology was being made available for licensing and implementation for high definition DVD copyright protection. We expect revenues from this license activity to begin ramping in the second half of '08, when volume shipments of compliant devices are expected to reach the market.

In addition to its potential financial significance in future periods, this announcement was noteworthy as a potential breakthrough in IT industry resistance to the adoption of digital watermarking for copyright protection. Given that the founding members of AACS, the governing body for selection of the technology, including IT industry heavyweights IBM, Intel, and Microsoft. This is the third major adoption of digital watermarking for the improvement of media management by the media industry following deployment of Verance's technology in DVD audio and adoption of a digital watermarking requirement in digital cinema last year.

As we witness entertainment companies and their business partners requiring watermarking in important new channels of distribution, we believe that we are seeing the early threads of an ecosystem of improved content identification via watermarking. As deployment continues, it will enable a new approach to digital rights in media management focused on enabling broad distribution in greater consumer choice, convenience and control, while providing a reliable basis for addressing financial arrangements among various participants in the value chain.

Alongside these positive developments we see possibilities of new alliances and associated growth of watermarking revenues and profits, some of which may mature in late 2007 or early 2008. We are engaged in preliminary discussions with major companies about the possibility of establishing such long-term business relationships.

Summarizing our views on the status of the primary revenue growth drivers as we have passed the halfway point of 2007, we note that although final REAL ID regulations have not yet been published, more than $30 million in federal funding is proposed by DHS to be granted in Q4 of this year. Questions linger about federal funding for 2008, and those questions will continue to be debated in the coming weeks and months.

Given the anticipated timing of the grants and continuing debates about additional funding, we believe that any positive effects of a successful pursuit of federal funding are likely to be in 2008 and later periods. The announcement and timing of the grant process could contribute to delays in procurements in the near term, continuing to depress near-term growth rates.

Likewise, there is not likely to be a significant positive impact on 2007 revenues from pending international opportunities due to anticipated timing of awards and implementations. In the digital watermarking area there are some possible significant upsides, but the timing of revenue recognition regarding second half of 2007 is difficult to estimate with precision.

Net-net, we expect to deliver very significant improvements of financial performance of 2007 over last year on single digit revenue growth and continue to expect significantly higher growth rates in 2008 and beyond, along with continuing improvements in financial performance.

Mike will now provide an update on our financial expectations for the third quarter and the full year 2007, and I will return with some closing remarks. Mike?

Thanks, Bruce. The factors that Bruce discussed lead us to believe that 2007 revenues are likely to be near the lower end of the range of guidance that we gave at the start of the year. If this projection is reasonably accurate, then the bottom line could show a small loss or small profit, depending upon the timing and composition of revenues that we recognize in Q3 and Q4. Nonetheless, we expect cash flow from operations to be better than originally forecast and continue to believe that we'll achieve significantly higher growth rates in 2008 and beyond, along with continuing improvement and financial performance.

With respect to key financial measures for 2007, we continue to expect revenues to grow at least in the range of growth for the past several years with the most likely scenario being near the lower end of guidance given at the beginning of the year. Regarding EPS, we expect a range from a small loss to a small profit near the lower end of the revenue range, and significant financial leverage if we do better, with all of this being subject to the timing and mix of various revenue growth opportunities.

We continue to expect improved bottom line performance in the second half of the year due to seasonality and growth of revenues in conjunction with the relatively flat quarterly operating expense run rate of around $11 million.

We expect to generate adjusted EBITDA of more than $18 million for the year, a rate of more than 15% of revenues. Capital expenditures should be in the range of $18 million to $20 million, depending upon the pace of implementation of existing programs, the pace in funding strategy for REAL ID upgrades, and our success in gaining market share from new customer acquisition opportunities that may become available during the second half of the year.

Operating cash flow should be strong increasing more than previously anticipated to between $15 million and $18 million. The backlog may increase in the second half of the year depending upon a number of factors including REAL ID, domestic ID market share gains, new international customers, and growth in digital watermarking foreshadowing higher growth rates in 2008 and 2009.

Bruce will now offer some closing remarks.

Thanks, Mike. Ladies and gentlemen, our Company is much stronger than in previous years. We are well positioned to move the American driver license to a higher level of value to our society and to become the supplier of choice for issuers. I see our strategic vision for watermarking unfolding. We continue to believe that we are approaching an inflection point in our markets leading us to believe that over the course of the next few years we will enjoy opportunities for accelerating growth rates, continuing margin expansion and productivity gains. We have a good strategy and we are ready to serve the evolving needs of our customers as the growth drivers we have identified bear fruit. This concludes our prepared remarks. Thank you very much for your interest and support, and we will now take questions.

(OPERATOR INSTRUCTIONS) Your first question comes from David Sterman of Jesup and Lamont.

Hey, guys, how's it going? I just wanted to really talk a little bit about 2008. I understand that watermarking is a little bit of a wild card for you and the international sales are going to unfold as they do. But REAL ID and its contribution to the driver's license contracts domestically is the big wild card for you, for it sounds like some '08 prospects you guys have. Looking at all the push and pull of REAL ID, the positives, the negatives, can you give us a little more flavor on how -- your latest thinking on adoption by states for more robust driver licenses in 2008 and any reason we shouldn't think that that's going to get pushed back into 2009 and beyond?

The environment, we try to educate the public and the financial community to the best of our ability about all of the complexities surrounding the political environment of REAL ID. What is happening there is what we would call normal growth rates are being depressed as customers who would contemplate upgrades without REAL ID are sort of sitting on their budget wondering whether if they spent the money now, that that would conform to the final regulations that haven't yet come out. And then there are others who have things they'd like to do that they'd love to do with federal money if the Feds put up some money and they are able to get a hold of it. And so it creates a very complex environment at the procurement level while the ambiguities persist.

So, the first point I would make is that once the ambiguities are resolved, I believe the growth rate will be significantly higher than normal just because there is what I call pent-up demand. That is, they've been sitting dealing with ambiguity now for a couple of years.

As the systems age and as threats evolve, and as other issuers upgrade their systems, there is pressure to upgrade. So, all of that is, I'll call it kind of collateral to REAL ID. And REAL ID, as we see, will have some funding, and there's a continuing debate about how much funding. I won't try to encapsulate that today because it will take too long, but it's a little hard to handicap how the political process all turns out on how much funding is provided in any given fiscal year. But we know there will be 40, at least, and then there is probably going to be some more, maybe 50 maybe more. And their fiscal year is different than ours, so that 40-plus X will be available presumably between now and September of '08.

Once the final regulations have been published, the ambiguity will be mitigated to a point where people can move forward with or without funding. We know there are some states, like Oregon, that want to move forward regardless whether there is funding because they think it's a good idea. And there are many other states like that. And then there are, as you know, a small number of small states who say they don't care to upgrade to comply with Federal regulations. It doesn't mean they don't care to upgrade for their own reasons and in their own direction.

So, that's why we feel quite comfortable about next year being a good growth year under any outcome of REAL ID. We don't believe based on our assessment of all of the political influences that repeal would happen.

So, if it doesn't get repealed, then we're going to have kind of a sticky situation emerging in '08, in that there is a federal law that needs to be complied with by the end of '09. Hopefully, the regulations have been finalized and there is some funding, so it's going to be time to get going for some of the states. And we hope and believe that some of the leadership states will actually become compliant and we'll move the market forward and it will be quite clear that not being compliant is not a good thing.

So, that's a summary of my views on how REAL ID plays out. I don't think it's one of those things that continually gets pushed forward ahead of us. Because it really is just the embodiment of two principles -- one is good security motivated by an interest in prudent national security and immigration control, and the other is a funding vehicle, if you like. Other than that, the market would move forward naturally anyway with technology upgrades. So, it should generally be an instigation to hire the normal investment for those reasons. Right now, however, because of the ambiguities and the lack of resolution of the process, it actually has the opposite effect of depressing growth rates.

Gotcha, okay. Shifting gears slightly over the enhanced driver's license pilot with the State of Washington, do you think that there are some other states that may be looking at doing a pilot in that area?

There are many states who are interested not only in pilots but production. Again, that relates to a law known as the Western Hemisphere Travel Initiative, and that's under an implementation deadline as well. I don't know anyone other than perhaps a card production company that likes the idea of a separate pass card as has been proposed.

But quite a number of issuers appear to be comfortable with the idea of allowing their citizens to have an option to have an upgraded driver license that has special international travel privileges associated with it.

So, we're very excited about the Washington pilot, and we believe it could be the leading edge of a substantial technology introduction in our market with chip technology, which has not been part of the business historically.

I would assume that at this point any interest in the enhanced driver's license is only coming from border states?

I think that's a fair statement.

And then lastly, can you give us an update on the shelf offering that you have filed; any progress you've made and any revisions you're thinking about uses of capital that you might raise?

Nothing has changed. We filed it for the purposes stated in the associated documentation just in case we need it, and it's been declared effective, so that's the current status. It's available if we need it.

Okay, I'll step back in the queue. Thanks for the insight.

Our next question comes from Jeremy Grant of Stanford Group.

Good morning. I wanted to actually ask a follow-up on David's question about the Washington State pilot and the enhanced driver's license with RFID. One of the observations I've had is you've had some states that are embracing REAL ID, you've had others that have said, well, we just don't want to do this. And oddly enough, Washington State has been one of the ones that's been sort of on the anti-REAL ID bandwagon; Maine has been another. Yet both of them have been out in front as the leaders saying they want to do the enhanced driver's license with an RFID chip that DHS would supply.

So, going forward, when you start to look at how some of the REAL ID states are going to roll out, do you really see this as a separate initiative that for some states that would opt not to do a REAL ID related upgrade, which could obviously deprive you of those revenues in an upgraded system. This is another opportunity for you to get an equal or perhaps greater amount of revenue per card for doing the second enhanced driver's license?

Yes, you have quite a sophisticated view of this, Jeremy, that I appreciate. Let me try to put together sort of a comprehensive response. I don't think there is an over-arching coherent strategy yet for a range of products in the DMV, but I think that's where we're going. And that is that the old single driver license notion actually is not even true today in that we have commercial driver licenses and ordinary driver licenses, and then in virtually all of our issuing locations, we issue non-driver license, state-issued credentials for people who don't drive but need the other functions of the driver license for identity management and access to privileges.

And so we anticipate, and this will be very healthy for us and we think we're uniquely qualified to deliver a range of products for an issuer. So, an issuer might have conceivably an option of an ordinary driver license, a REAL ID compliant driver license, and an enhanced driver license. And maybe there's a super-duper that has everything in it. We're prepared to deliver that entire portfolio, And that's why we did the R&D that we did and made the announcement we did in August of last year about chip-enabled driver licenses, and that's why we've been very closely involved in the development of the REAL ID specifications. We intend to be able to deliver whatever our customers need when they need it.

Okay. Looking at -- actually, I think this is something Mike talked about. I didn't catch the number for backlog for the quarter, or where it stands right now?

About $225 million.

How much of that is expected to be realized in the next year?

Actually, what we generally disclose is what's left remaining in the year, which is about $40 million of that is going to roll out in the next two quarters.

Okay, $40 million.

Our next question comes from Andy Hargreaves of Pacific Crest Securities.

Hi. I'm just wondering on the new opportunities that you mentioned in digital watermarking for the second half of this year and the first half of next year, if you could give us any more detail on those?

I can't give any specifics about relationships or potential relationships beyond what's been publicly disclosed, but I can reiterate and reemphasize my view that this is a very exciting year in terms of the change in market conditions moving in the direction of what we had always envisioned would be true, thus causing not only the media rights holders to be enthusiastic about watermarking, but for the first time ever, really, some resistant elements of the value chain starting to show openness to improved media management and rights management through watermarking.

Watermarking is the answer, and this is what caused me to begin working on this 11 years ago. In an environment in which the movement of media objects is not predictable, you have to have intrinsic identification. And given that there are many different formats and many different channels of distribution, and many different general forms of media, we have the universal identifier, digital watermarking is that. There is nothing else like it. And so it's sort of in a sense about time they figured that out.

As I've said to investors and analysts over the years, the questions about what's caused it to not happen so far really relate to economic relationships and the inertia of existing business structures more than the fundamentals of the technology.

What's happening is that it's becoming impossible to defend the legacy infrastructure. It's crumbling, it's falling apart, it's being transformed, and in that transformation I think we begin to blossom. And I think there's really a renaissance of interest all across the value chain in watermarking, and thus I think our time is near at hand here. And so we should see more relationships, we should see more licensees, we should see a growth in that area of our business pretty darn soon.

So, can we assume, then, it's kind of a multiple digital entertainment format, meaning audio-video that the stuff applies to? And then the only other question, does the momentum here change your thoughts? I know you were contemplating doing more work in terms of building your own applications. Has that changed now given this?

I'm not quite sure how to answer that. It's a good question, kind of a complicated answer. Our general strategy is to enable others under license to our IP to build solutions and serve markets. We have always been willing to serve the interest of those who have a need for our technology if other companies won't serve it. So, we do have our own applications, for instance, in central bank anti-counterfeiting and in the image area with ImageBridge and MyPictureMarc and IDMarc for driver licenses. So, we have a mixed model now, but our bias is toward enabling others. I hope that's a fair answer.

Yes, that helps, thanks.

Our next question comes from David Sterman of Jesup and Lamont.

Just a follow-up a little bit on what you were just talking about there on the international contract with Russia, where it sounds more about service provisioning and technology offering than it is actual card issuance management. Can you just kind of walk through the profit margins contrasting that type of contract with traditional card issuance management program?

We generally don't break out margins on individual contracts. This is just -- it's too helpful to competition and potentially disruptive of relationships. So, I'd rather not answer that question, David. That's a longstanding relationship, now more than a decade long, and this is a very positive development as they move from film to digital, and we're optimistic about this being a long-term, profitable relationship for us.

Okay. And it's now several quarters since you started to talk about really trying to increase your international sales presence and obviously it always takes the sales staff several quarters to really get up to speed. I'm wondering if you can comment on what you think the pipeline looks like here compared to six months ago internationally, or the sense of how the pipeline may be building going into '08 for international sales?

Yes. What we said at the start of the year, which we've been doing, is we added resources, hired some more people in international. We restructured our support organizations to provide a higher level of support the increased resources. And then we've been very conscientiously targeting a number of opportunities we believed that we're a viable bidder for.

And so in total out there in the market, I think I've indicated a couple times, there's probably a billion dollars or more of identified opportunity to pursue. A moment ago in the script here I talked about a few hundred million that has kind of been our crosshairs here, and so that's the sense of the scale of opportunities that are in the market.

Again, international is very difficult to handicap in terms of timing and probability of win, because it's a big world and we're not that big of a company. And so we do the best we can to stay on top of the key opportunities. It's one of the reasons that we focus and in a like fashion added resources here, and we prefer to talk about that business more when we capture it than when we pursue it.

Okay. And to the extent that your comments on the last question there relative to wanting to be a provider of technology solutions in some programs rather than actually managing the programs, does it make sense for you to start to look at partnering with more local players in Europe and elsewhere that are in the card issuance business but not necessarily have your suite of technology offerings?

We regularly partner with other companies on international endeavors. That's why the business model is a bit different than in the North American market, where we're the full issuance system supplier. We're entirely open to that. In fact what we hope to be able to do over time is to establish high-quality relationships with high-quality companies in various parts of the world, and share our expertise and technology to provide unparalleled offerings and win a lot of business. So, that's an explicit part of our strategy, to do as you're suggesting.

Okay, but we should presume that since we really haven't heard anything about that thus far this year that you haven't really in 2007 inked any kind of new global sales relationships?

Well, maybe I misunderstood your question a little bit. We're not interested in, generally, in inking global relationships. We're interested in optimizing delivery into a geographic market, and there are no companies -- this is one of the good things, one of the exciting things about the government issued ID business, is there is no dominant global brand. There are a bunch of brands that play. Most of our competition is horizontally oriented, and the uniqueness about our strategy is we're vertically oriented. And so we deliver a full issuance system solution including post-issuance inspection, applicant verification, sort of both ends of the process and all of the middle.

We're uniquely positioned in that regard in the global marketplace. Most of those players are, as you've mentioned, a card producer or a system integrator, or a biometrics company, or a security printer. And that's why we think we're going to win, because we are entirely focused on delivering into that vertical across the global market.

And so in any given market, our partner could be one of those four categories, one or more of them, and there are a partner of ours because they have the unique competence in that geographic market for that bid. So, look for us to have good partners in our bids as opposed to global partners that we always bid with.

Gotcha. Okay, that does make sense. All right. Thank you very much.

(OPERATOR INSTRUCTIONS) We do have a follow-up from Jeremy Grant of Sanford Group.

Hey, just a follow-up question. I wanted to talk a bit about gross margins on the quarter, if you could give a little bit more color into margins on services, which were up a couple of points over last quarter, as well as the product and subscription that was down a little bit, and where you see things going forward?

Sure, Jeremy, this is Mike. The service margins generally move up in the second quarter from our seasonality model, and we would see good, strong margin, also, in Q3, which is the height of that model for the domestic driver license business.

The products margins is somewhat driven by mix, and in some cases we may have very high margin type subscriptions or products, particularly selling some software/hardware pass-through with no related labor costs. In some cases it may have a heavy labor component. I think in Q2 we had a bit more safe film sales. Film sales generally have a lower gross margin. So, it really is a mixed play.

Okay, thanks.

At this time we have no further questions.

All right. I'd like to thank everyone for participating in the call. We'll look forward to updating you again at the end of Q3. Thanks for your support.

Thank you for participating in today's conference call. You may now disconnect.