Digimarc Corp (DMRC) 2007 Q3 法說會逐字稿

Good afternoon. My name is Janice and I will be your conference operator today. At this time, I would like to welcome everyone to the Digimarc earnings conference call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (OPERATOR INSTRUCTIONS)

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

Thank you. Hello, and welcome to our Q3 2007 financial results conference call. Mike McConnell, our CFO, is with me on the call.

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 development and market conditions and provide an update on the execution of our strategy for 2007.

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'll be making forward-looking statements regarding management's opinions and expectations about Digimarc's business, its markets and financial performance that are based on a current understanding and expectations. These statements are subject to assumptions, risk, 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 our Form 10-Q to be filed later today and our earnings release posted on our Web site.

During the course of this conference call we may also refer to certain non-GAAP financial measures as defined by the SEC and Reg G. Definitions of these non-GAAP financial measures and reconciliations of these non-GAAP financial measures to their most directly comparable GAAP financial measures are included in the earnings release for the quarter ended September 30, 2007. The earnings release can be found on the Home Page of the Web site.

Please 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 call.

By way of introduction, I'm very please with our company's performance for the third quarter which nicely reflects effective execution of the strategic plan outlined in previous calls. Key financial measures of gross margin, earnings per share, adjusted EBITDA and cash flow all significantly improved from a year ago on a similar level of revenues, evidencing tremendous strategic progress in building a world-class organization.

Notable development in our markets included the announcement of pilots for image sharing and enhanced driver licenses in the domestic ID market. These activities provided early glimpses within the kinds of investments, new investments, that we expect our customers to make as the regulatory ambiguities associated with REAL ID are resolved.

In foreign markets we announced a significant upgrade in Russia, strengthening our long-term relationship there and laying a foundation for future growth in this promising large market.

There was a raft of news during the quarter concerning the increased interest among media companies in digital watermarking. We are working on very exciting opportunities to help media companies harness and monetize the massive transformation of media distribution and consumption that is going on.

Mike will provide some commentary on Q3 results. Then I will return and provide on progress of the execution of our 2007 annual operating strategy and plan. Mike?

Thanks, Bruce, and good morning, everyone.

Overall, our financial results were generally in line with our prior guidance and significantly better than the comparable quarter of last year. We achieved an operating profit of $0.04 per share versus $0.01 a year ago and generated very good cash flow as indicated by our adjusted EBITDA and operating cash flow results.

More specifically, revenues increased slightly over prior year to $27.1 million as driver license issuers continued to invest cautiously pending finalization of REAL ID requirements. Gross margins came in at 40%, a 3 point improvement over the prior year, primarily reflecting financial leverage achieved in our field support and manufacturing operations areas.

Operating expenses for the quarter of $10.4 million were relatively flat compared to the prior year, demonstrating financial leverage from improved operations. The $0.04 per share profit in Q3 compares favorably to the one penny per share profit last year, demonstrating gains in financial leverage and improvements to internal business processes.

Adjusted EBITDA for the quarter improved 20% over prior year to $5.5 million coming in at 20% of revenues. Capital expenditures, primarily supporting customer projects, were $3.8 million.

We ended the quarter with nearly $33 million in cash and equivalents, short-term investments and restricting cash, reflecting our much improved operating cash flow over the past five quarters. Our ending backlog was approximately $220 million, reflecting normal burnoff offset by bookings during the quarter.

For further discussion of third quarter results, our business and financial models and risk and prospects for the business, please see our Form 10-Q that we expect to file later today.

Let's now turn to an update on financial guidance for the remainder of 2007. Our guidance for the remainder of '07 is consistent with the guidance we gave in our last call. Mainly that for the full-year we expect revenues of 109 to $111 million, evidencing growth of 5 to 7% over last year.

EPS may range from a small loss to a small profit subject to timing and a mix of various revenue growth opportunities which equates to an approximate $11 million improvement over last year. Adjusted EBITDA will nearly triple over prior year's results to approximately 17.5 to $18.5 million, a rate of 16% of revenues for the year.

Capital expenditures should be in the range of 19 to $20 million and operating cash flow is expected to be between 15 and $18 million, an estimated 6 to $8 million improvement over our prior year.

Bruce will now offer some closing remarks.

Thanks, Mike.

As 2007 draws to a close, we are anticipating more than $11 million of improvement in the bottom line for the second year in a row on single-digit growth, demonstrating the tremendous progress we continue to make in improving the performance of our company.

Cash flow has improved significantly as evidenced by operating cash flow and adjusted EBITDA measures. We are working hard and effectively to deliver sustained profitable growth as an acknowledged leader in the markets in which we operate.

With a track record of improvements in operational and financial performance now established, we are shifting our priorities from internal matters to growth opportunities as we move into 2008. Our top business objective is to deliver sustained profitable growth, capitalizing on our leadership in secure identity management systems and digital watermarking.

We continue to believe that we are approaching an inflection point in our markets that will provide opportunities for accelerated growth rates, continued margin expansion and productivity gains over the course of the next several years. Our employees have done a remarkable job of transforming the Company as we anticipate significant opportunities opening up in our target markets.

As we have noted previously, we believe the primary growth drivers will be REAL ID, international IDs and digital watermarking. Let's talk though the status of each of these factors.

First, with respect to REAL ID, delays in publication of final regulations continue. The latest indications we've gotten from Department of Homeland Security are that the regulations that they had promised to publish in October are now not likely to show up until February of 2008.

The amount of money that the federal government will provide to help fund the costs of associated upgrades is unclear. What is not unclear is the strong support of Americans for this legislation. As confirmed in the second nationwide telephone survey conducted by the Information Technology Association of America during the quarter, the survey indicated overwhelming support for new national rules and regulations regarding state issued driver licenses designed to help prevent terrorism, identity theft and other crimes. More than 80% of survey respondents favor upgrading of driver licenses.

We are pleased to note growing interest in enhanced driver licenses such as in the pilot we are delivering in Washington state for land border crossing security. We are also seeing considerable discussion at state and federal levels around correlating enhanced driver license systems with REAL ID compliance.

At this point we continue to believe that REAL ID will be implemented but at a slower pace than previously announced by the federal government. If final regulations are delayed until February as has been rumored, then domestic driver license revenue growth for 2008 is likely to remain in the mid to high single-digit range due to the customary timelines for securing, delivering and recognizing revenues from new business in this field.

Despite the delays we continue to believe that the domestic driver license business will experience higher growth rates over the course of the next few years. Publication of the regulations with or without federal funding is likely to initiate a number of upgrades that have been deferred due to uncertainty, thus fueling growth. Federal funding would kick this up a notch higher.

On the international front we continue to pursue a broad range of opportunities in Africa, South America and Asia including a big national identity management opportunity in a South American nation. It's difficult to predict timing on these decisions and the likelihood of success for any particular opportunity among these potentially large international deals.

We anticipate that digital watermarking currently holds the most promise for revenue growth in 2008 as our ideas regarding a new style of DRM based on digital watermarking are gaining favor. We are actively working on a broader role for Digimarc in making this vision a reality through a cooperative arrangements with digital media market leaders and industry associations.

Meanwhile, many of our licensees have been announcing customer's wins and other signs of progress in their growth strategies which generate income for our shareholders. Please see our Web site at digimarc.com and the digital watermarking alliance Web site, digitalwatermarking.org for further examples.

This concludes our prepared remarks. Thank you very much for your interest and support. We'll now take questions.

Thank you, sir. (OPERATOR INSTRUCTIONS) We'll pause for a moment to compile the Q&A roster. Your first question comes from the line of Jeremy Grant with Stanford Group.

Hi. Thanks and good afternoon. I guess good morning to you on the West Coast.

Wanted to touch base a little bit on the top line revenue number. I know on a seasonality basis, driver's license revenues are generally up, I think Q3 is usually the strongest, but Q3 revenues came in, I guess, what about a couple hundred thousand dollars less than we did in Q2. What drove that revenue mix this quarter and the total top line?

Well, one of the reasons that we have encouraged investors and analysts to take a broader perspective on the business is that quarterly variations can represent timing differences on various deliveries and contracts that we have.

In this year, we're actually, as the 2007 guidance would indicate, anticipating a fourth quarter that would be higher than seasonality would indicate, thus demonstrating significant growth. And that's due in part to forecasted business, which could conceivably not end up timing-wise in the quarter but it also is related to new business that we've not been able to announce, that we have in fact won.

And so the third quarter's a little light and the fourth quarter will be significantly above what would be expected on the seasonality curve that we've discussed historically.

Okay. And you know, a follow-up, you guys obviously came in, I think, a little under where all the smart guys on the street were expecting on the top line but EPS at $0.04 was significantly above forecast. Obviously, they were looking through the press release. There were margin improvements really across the board, both on gross margins being higher and OpEx being lower.

So I guess the question is what's specifically driving it? Is it something just besides some of the internal efficiencies you've been working on and perhaps, more importantly, what should our expectations be going forward as we model '08 and beyond?

Mike, would you like to comment on that question?

Yes, I think Jeremy, you're right on as far as we continue to look at our operational efficiencies, hold tight on some of the costs, continued improvements in our yields and our manufacturing process, our field support organization, all are coming through as we had contemplated in our strategy plan for the year. So as we move into the coming year, we're going to continue looking at those particular areas and we'll continue to be rigorous on the cost side.

So I think the margins we're very, very pleased on the gross margin improvement that we've made this year. And it's attributed to a lot of different people, not only on the cost side, but also the mix on the revenues and the pricing on some of the add-ons and upgrades we've received, all very, very good signs.

Okay. Just one particular item on OpEx, the R&D of about 1.7 for the quarter. Is that about a level we should assume going forward? I was, I think, significantly higher on that.

That's a pretty fair assessment. It can vary quarter-to-quarter based upon how we allocate our resources to various programs and what R&D projects we're working on. I think we explained in the past we have a labor resource pool that can work on a capital project, could work on a revenue project or could work on an R&D or maintenance type project. I think it's close to the range. And we'll provide, you know, in the future we'll provide a bit more guidance on that when we talk about '08.

Bruce, you talked a bit about the REAL ID visibility and the outlook and it more or less mirrors what we hear sitting in Washington. It's just continued foot dragging and obviously one catalyst could be when and if the Department of Homeland Security Appropriations Bill finally gets passed, maybe December, some funds at least coming out. I don't think -- I have so many questions there. I wanted to shift, though.

Your competition a couple days ago on their earnings call mentioned that there was a whole bunch of new competitions coming up in the state market. And they specifically said that none of them were theirs, which implied that a lot of it would be yours. And wanted to get an idea of what it is you're looking at over the next 12 to 18 months in that space.

Yes, I have a few comments on that, Jeremy. One that is the CEO of our competitor, I believe, has never met a DMV Commissioner but evidences an extraordinary understanding of their intentions that we can't seem to capture so I commend him for that foresight.

As you know, in studying the industry for many years as we have consistently said, we're not quite sure when anyone will go to bid. It's at the discretion of our customers and they oftentimes defer going to bid either through a sole source extension or renewal. And by our records, the majority of their customer base is up and eligible to go to bid within the next 12 to 18 months. A much larger share of their base than ours. But I frankly will never pretend to know exactly when our customers will exercise that discretion.

So as I've said in the past, I think that once the regulations are finalized, there'll be a flurry of activity, which again may or may not include system level competitive bids. But I'm quite confident what he said was incorrect.

Okay. Thanks. I probably have a couple other questions but I'll drop in the queue and let some others get some in. Thanks.

(OPERATOR INSTRUCTIONS) Your next question comes from the line of Nick Andrewes with Lazard.

Hey, guys. Good morning. Can you guys give us some little more details on what's going on over at the DHS and where the guidelines are at? Are they back at the OMB or are they back at the DHS and what's the cause for the delay?

I tell you, Nick, it's like musical chairs at times it seems. As DHS had told everyone, including us, they had sent the regulations to OMB and were to have them published in October. And something happened somewhere along the lines where they apparently retracted them to do something different with them and then appear from the latest public statements of DHS officials to have not given them back to OMB yet. And that's where the February sort of rumor date comes from in that if they gave them back soon then by law OMB would have until February to respond, but then they said in the same context that they didn't think it would take that long for them to respond.

So it's really very hard to tell what's going on and it's somewhat symptomatic of the state of the federal government right now. The Bush administration and the Congress appear to be at war and there's just -- it's very difficult to predict day-to-day the flow of such things.

As our script noted, the public's fully in favor of this. There were a number of states who are anxious to move forward with upgrades consistent with the federal regulation and they just can't get the rules out of Homeland Security. So it's very, very frustrating for us and our customers but it will get resolved and I believe it will get resolved in a way that moves the nation forward to a greater security.

Okay. Great. And is the delays going to cause a delay in states issuing hybrid cars as well?

It doesn't seem that way. In fact, that's the bright spot in the delays and ambiguities of REAL ID. The enhanced driver's license, which is a compliance document for another relatively unrelated law known as Western Hemisphere Travel Initiative, is being now correlated explicitly by a number of our customers and potential customers and by Homeland Security, saying that in the process of upgrading the system to support the delivery of an optional chip-based driver license to be used for land border crossing in North America, they believe that the states will naturally move toward REAL ID compliance. And the enhanced driver license has generated very little controversy outside of the technology circles where the smart card lobby would like to try to convince DHS to embrace their technology rather than EPC gen 2 chip technology that has been chosen by the Homeland Security.

So it's really, it's a vehicle for moving forward with REAL ID compliance and it's also very exciting development in the market because it elaborates the product strategy of our customers creating greater opportunities for us and expanding margins in the marketplace. So it's a very positive development and doesn't appear to carry the baggage of the REAL ID ambiguities very much, other than to maybe be a means of effectuating the intent of REAL ID once the regulations are finalized.

Great. Can you guys talk a little bit about national opportunities? I know that L1 was talking about some national ID programs going on in South America and I was just wondering about what's going on internationally from your standpoint and a little bit more about the opportunities there?

We had some good successes during 2007 with the Russian upgrade and with Mozambique and Tanzania customer wins. We're pursuing a number of targeted opportunities overseas, some of which are quite large and some of which are the same ones that L1 is talking about in their call. They're not competing with us on all of the opportunities that we are seeking but on some of them.

And as I've said in the past, the global market offers some extraordinary opportunities in a single win, having a nine-figure contract in some cases. And so we prefer not to wind everybody up about those things before we can claim victory and so we have a different style than some of our competitors in that regard. But that doesn't mean that we're not actively involved and that we don't intend to win. We're just going to deliver the goods and then discuss what we've won rather than hypothesize about when and how such things will be decided.

Great. Is there any change in the competitive environment out there, you know, obviously, you guys compete against L1 in the U.S., but anybody else trying to get into the market?

It is pretty stable. It's basically us and L1 in the domestic driver license business. There are a few other companies that are interested in participating but they don't seem to be getting much traction.

And just lastly, I know Georgia, the RFP was due today. Is that right?

The response to the RFP?

Yes.

I'm not certain that today is the due date. Those dates change from time to time so I'd rather not comment on that. You could perhaps check with Georgia.

Is California going to bid?

California is out to bid.

Is that happening?

Yes, California went out to bid almost two years ago.

Yes.

And they've been through nine revisions of the RFP since then and so that process continues, it's quite a lengthy process. And again, it's up to them how to continue the process and if to continue the process going forward. So I again, prefer not to try to predict what's they're going to do. It's very hard to discern with them having total discretion. We do value them as a customer. We do a great job for them.

They have intended there's some -- a final RFP bid due sometime in the near future.

They have but they've said that in the past and then changed their minds is my point. Those dates are not reliable is really the key point I'm trying to make. I could give you dates that I know if they were public dates but they wouldn't be worth much because they can change at the customer's sole discretion.

Got it. And anything going on in Mexico from the voter ID?

Business is good in Mexico. We're doing a cracker jack job there. We've got an excellent pair of factories, great employees there, good product and nice volumes.

Any indication that they'll go back out to bid again?

They may. They're, as any issuer, they have the legal right to go to bid when and if they choose and if the procurement regulations, or procurement authorities, indicate that an agency should go to bid in any jurisdiction, sometimes they go to bid even though the agency might not be inclined to do it.

But they haven't indicated anything yet.

Well, again, we don't comment on confidential statements of intention or rumors or things of that sort about the bidding process because they tend to mostly be unreliable.

Thanks, guys.

(OPERATOR INSTRUCTIONS) You have a follow-up question from the line of Jeremy Grant with Stanford Group.

Thanks. Just a couple more. Wanted to touch base on the Washington state pilot with Witi. I think they were looking at early next year, January, February, as a timeline to kick that off. Is that still what we're seeing?

That's right. Yes. Yes, that's the schedule.

And then shifting over a little bit to the watermarking side on your IP portfolio. I saw the release this morning as well as the whole article in the IEEE magazine about your patent portfolio now moving up to number five from number nine in terms of value which, obviously, has got to be a positive sign that somebody on the outside is looking at this and saying, hey, this is a great thing.

I think one of the challenges for us analysts has always been to try and actually sort out exactly when that gets monetized and how much it is and, obviously, I know that's a question you can't easily answer either. Are there any updates you can provide around that space, you know, as to how folks should be looking at this?

I can offer a bit more help in that respect. Mike and I have been working on trying to find ways to tell more about the nature at least of the revenues associated with our business, if not more of the financial metrics, and we hope that by year-end and in the context of providing '08 guidance that we will be able to give you some indication of the split of revenues and trends between ID and watermarking.

We anticipate until the REAL ID regs are published and/or there are significant international developments that the growth rate for ID will be in the mid single digits as it has been. Watermarking has been enjoying higher growth rates. We anticipate significant double-digit growth in '07 and higher rates of growth in '08 at this point in time. And again, we'll put more meat on the bones when we talk again next, I hope. I think we'll be able to do that.

Okay. Thanks.

(OPERATOR INSTRUCTIONS) Gentlemen, there are no further questions at this time.

All right. Thanks very much. We'll look forward to catching up with you in a month or so. Sometime in December, we hope to schedule a call to provide 2008 guidance and we'll look forward to speaking to you all again then. Thank you very much.

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.