Digimarc Corp (DMRC) 2008 Q1 法說會逐字稿

Good morning. My name is Ashley, and I will be your conference operator today. At this time I would like to welcome everyone to the Digimarc first quarter earnings call. All lines have been places on mute to prevent any background noise. After the speakers' remarks there will be a question and answer session. (OPERATOR INSTRUCTIONS)

Mr. Davis, you may begin your conference.

Good morning, and welcome to our Q1 2008 financial results conference call. Mike McConnell, our CFO, is with me on the phone. We issued a press release earlier today announcing our Q1 2008 financial results. The objectives of this call are to summarize and comment on these results, review significant business developments and market conditions, including the pending sale of our ID Systems business to L-1 Identity Solutions and provide an update on execution of our strategy for 2008. This webcast will be archived in the Investor Relations section of our website.

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 Digimarc's business, its markets and financial performance and the announced transaction with L-1 Identity Solutions, including the expected dilution as a result of anticipated option exercises in connection with the transaction that are based on our current understanding and expectations. These statements are subject to assumptions, risk, uncertainties and changes in circumstances, including assumptions about Digimarc and L-1 stock prices, methods of option exercise and option exercise behavior. 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 within the next few days 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 Regulation 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. The earnings release can be found on the homepage of our website.

Keep in mind that any guidance we offer represents a point-in-time estimate. We expressly disclaim any obligation to revise or update any guidance or any other forward-looking statements to reflect events or circumstances that may arise after the date of this call. Now, let's proceed.

These are indeed exciting times. During 2007 we made great progress in executing our strategic plan. Key financial measures of gross margin, EPS, adjusted EBITDA and cash flow all significantly improved from fiscal 2006 on a similar level with revenues, as we delivered more than $11 million of improvement in our bottom line and significantly better cash flow for the second year in a row, including nearly $19 million of adjusted EBITDA representing 17% of revenues. As the year ended, we announced an historic strategic licensing and services agreement with the Nielsen Company amidst many other signs of progress in the adoption of digital watermarking technology.

In the first quarter of 2008 we announced the pending sale of our ID Systems business to L-1 for approximately $250 million in cash and stock based on the value of L-1 common stock at the time of the announcement. Now in the first quarter of 2008, we reported record revenues with good growth in both ID Systems and Digital Watermarking.

Mike will begin this update call by commenting on the financial results for Q1 and the outlook for 2008, and I will return to provide updates on Nielsen, the sale of our ID Systems business, other aspects of execution of our 2008 annual operating strategy and plan. Mike?

Thanks, Bruce, and good morning, everyone. Our Q1 financial results were generally in line with prior guidance and significantly better than last year after excluding the impact of the cost related to the pending acquisition of our ID Systems business by L-1. More specifically, Q1 revenues were a record $30.6 million, 14 % higher than the prior year with the ID Systems revenues of $25.5 million, growing 9% over the prior year and Digital Watermarking revenues of $5.1 million growing 46% over prior year.

Gross margin for the quarter improved two points over the prior year to 39%, reflecting financial leverage in our operations supporting higher revenues. Operating expenses for the quarter, excluding the $1.1 million of acquisition-related cost, were $12.4 million compared to $11.4 million in the prior year. The increase in expenses is largely due to increased compensation costs associated with an accrual for bonuses where none were accrued in 2007, the cost-of-living salary increase for employees, other than executive officers, and higher stock compensation costs from higher accruals resulting from the adoption of FAS 123(R) in 2006.

The $0.06 per share loss included acquisition-related cost equal to $0.05 per share. The $0.01 loss prior to accounting for these costs was a $0.04 improvement over the $0.05 loss a year ago.

Adjusted EBITDA for the quarter, including the effects of $1.1 million in acquisition-related costs, was $3.9 million, compared to $3.5 million in the prior year. Capital expenditures for the quarter $3.6 million or $3 million lower than the prior year, reflecting a lower rate of investment as we neared completion of several large projects that began in 2006 and 2007.

Cash flow from operations was $8.6 million compared to $5.4 million in Q1 of 2007, reflecting higher revenues and improved receivables and inventory management and, to a lesser extent, a higher rate of non-cash charges for depreciation.

Our balance sheet strengthened, and cash and equivalents grew by more than $4 million to $37 million. Working capital now stands at more than $37 million with a current ratio of more than 3 to 1. We continue to operate free of long-term debt. Our long-term liabilities consist primarily of deferred revenue and some smaller amount of capital leases.

Our backlog is approaching record levels with a quarter-end balance of approximately $280 million. The $65 million backlog for Digital Watermarking accounted for nearly one-third of the total --I'm sorry, one-quarter of the total.

For further discussion of 2008 results, our business and financial models, and risk and prospects for our business, please see the Form 10-Q that we expect to file within the next few days.

Next I'll say a few words about our financial expectations for 2008. Regarding the financial guidance for the remainder of 2008, the most significant change since our last guidance relates to the pending sale of our ID Systems business. The legal and accounting costs associated with the transaction are expected to increase our operating expenses by several million dollars prior to the anticipated closing in the second half of the year. With regards to other aspects of financial performance, and assuming we continue to operate our entire business in an independent entity for the rest of 2008, we note that all areas of our business showed robust growth in 2001 (sic). As to the remainder of 2008, as noted in the prior call, we expect to gain clarity during the second quarter on a number of factors affecting near-term revenue growth.

We note that Digital Watermarking revenues grew 46% Q1 over the prior year. We anticipate continuing robust demand in this area. In the ID Systems area, recall that the primary catalyst for near-term growth in revenues is REAL ID-driven upgrades, in particular, the federal funding that is scheduled for release soon. As grant monies are awarded, we will have a better idea of the potential impact on 2008 ID System revenue growth rates.

Capital expenditures for the year are likely to be a bit higher than 2000 levels (sic ) at around $20 million. Actual spending may vary depending on possible delays in existing programs and the timing and type of orders received during the year. Excluding the impact of acquisition-related costs, we expect continuing improvement in our cash flow metrics with 2008 operating cash flow and adjusted EBITDA growing by more than 30% and 10%, respectively, over 2007 levels, with each measure expected to exceed $20 million and free cash flow growing to more than $5 million in 2008 from a deficit in the prior year -- free cash flow meaning operating cash flow, less capital expenditures.

Again, excluding the impact of acquisition-related costs and taking into effect -- into account the effects of non-cash charges for amortization of intangibles, depreciation and stock compensation, EPS for the year may range from a small loss to small profit, subject to the timing and mix of various aspects of revenue growth I explained a few moments ago and the rate of investments supporting higher revenues in future periods that we deem appropriate.

Absent any unavoidable delays in program deliveries, second quarter revenues are expected to be 5 to 10% higher than last year. We expect to show a small loss for the quarter, excluding merger-related costs. We plan to file a Form 10 Registration Statement to register the shares of the spun-off Digital Watermarking entity, which we refer to as New Digimarc, within four to six weeks. It will provide further details about the New Digimarc and its financial model. The Form 10 will include financial statements for the three years ended December 31, 2007 and the stub period for March 31, 2008, respectively.

Bruce will now provide an update of the pending sale of our ID Systems business to L-1 and our execution of strategy, then offer some closing remarks.

Thanks, Mike. On March 24 we announced we've entered into a definitive agreement with L-1 to sell our ID Systems business for $250 million in cash and stock based on the value of L-1's common stock at the time of the announcement. The transaction is expected to close in the second half of 2008, subject to regulatory and shareholder approvals. The boards of both companies have unanimously approved the merger agreement.

The legal structure of the transaction contemplates a spin-off of our Digital Watermarking business, and all cash held by Digimarc, including restricted cash, into a new publicly-held corporation immediately preceding the closing, followed by a merger of the remainder of Digimarc for the subsidiary of L-1. Shares issued in the spin-off will be distributed pro rata to Digimarc's stockholders. L-1 will invest $5 million in the New Digimarc, which will be known as Digimarc Corporation, remain headquartered in Beaverton, Oregon and is expected to retain the Digimarc stock symbol.

The fair market value of the shares issued in the spin-off, for tax and other purposes, is expected to be determined at or about the time of the closing on a basis consistent with normal and customary factors applied in such transactions. There will be further discussion of fair market value calculation and tax implications in the Form 10 Registration Statement that we will file with the SEC in the near future.

In addition to shares issued in the spin-off, Digimarc stockholders will receive an aggregate of $120 million in cash and up to $143.5 million of L-1 stock. The actual number of L-1 shares to be issued will depend on the average trading price for 20 trading days ending 5 days prior to closing. The number of L-1 shares will be fixed at approximately 10.3 million shares if the 20-day average is at or between $11 and $14 a share and at 11.3 million shares if the 20-day average is below $11. If the 20-day average is above $14, the number of shares to be issued to Digimarc stockholders will be adjusted so that the aggregate value of L-1 shares to be received in the merger will not exceed $143.5 million. The most recent closing share price of L-1 was $14.41.

The value received for each Digimarc share in connection with the spin-off and merger will be equal to the total of all consideration, meaning shares issued in the spin-off, L-1 shares, and cash, divided by the total Digimarc shares outstanding at closing. At March 31 there were approximately 22 million Digimarc shares outstanding. The number of shares outstanding at closing is likely to be significantly more than the current shares outstanding due to stock option exercises between now and then.

The merger agreement provides that all outstanding Digimarc stock options will accelerate and become exercisable immediately before the spin-off. Upon completion of the merger, all unexercised options will be cancelled. The number of shares that will be exercised is largely determined by our share price between now and the closing of the transaction. The decision whether to exercise will depend on whether the market price of the shares exceeds the exercise price of the options during that period. Options for several million shares may be exercised.

For an overview of the number of options outstanding at various exercised prices, see table F-28 in our Form 10-K dated February 29, 2008. A similar table, updated through March 31, will be presented in our Form 10-Q that we will file shortly.

Executive officers and members of the Board will not buy or sell any shares pending the close. At close, we expect them to exercise in the money options. Between now and the close, non-executive employees will be permitted to exercise options and buy and sell shares during normal trading windows. We expect that the dilution from stock option exercises will be in the range of 8 to 10%. The actual dilution will largely depend on fluctuations in the price of Digimarc shares between now and close.

With this summary of financial terms in mind, let's turn to an overview of the process between now and close. Work is underway on a number of tasks, including the following -- negotiation of various ancillary agreements, including a separation agreement for dividing assets and liabilities between the Digital Watermarking business and the ID Systems business, a transition services agreement and an intellectual property license, the Hart-Scott-Rodino filing with the U.S. Federal Trade Commission and the U.S. Department of Justice, the filing with the SEC of an S-4 Registration Statement by L-1 with respect to the shares that L-1 intends to issue in connection with the merger, which filing will include a proxy statement for the Digimarc special stockholder meeting, the filing with the FCC of a Form 10 Registration Statement by Digimarc, providing details of the spin-off of New Digimarc, including three years of audited financial statements for the Digital Watermarking business, and the Digimarc special shareholder meeting and vote.

L-1 will file with the SEC a registration statement on an S-4 to register the L-1 shares, which will include the proxy statement from Digimarc. That's expected to be filed within the next month. We'll also be filing a Form 10 Registration Statement. The Form 10 will include more detailed information about the spin-off, including the audited financial statements for the last three fiscal years. We currently plan to file this registration statement within four to six weeks. The statement explains the business and associated risks of the spin-off corporation, provides historical financial information about the Digital Watermarking business and information regarded expected composition and compensation of officers and directors, and registers the stock that will be distributed to the Digimarc shareholders. There is a review period for this filing as well.

After clearance by the SEC, Digimarc will provide notice of a special meeting of shareholders together with the proxy statement and Form 10. We expect to convene this special stockholder meeting about a month after the notice is sent to stockholders. L-1 and Digimarc contemplate completion of the spin-off and merger transaction promptly after the shareholder approval and receipt of any remaining regulatory approvals.

The combination of L-1 and Digimarc's ID Systems business will provide significant benefits to both companies and their customers, partners, and ID issuers and relying parties more generally worldwide. The transaction offers a clear investment path and a liquidity [event] for both value and growth investors in Digimarc. Our stockholders will receive stock in L-1 and New Digimarc, enabling them to continue investing in two terrific growth opportunities in identity management, which is expected to grow domestically due to federal legislation such as REAL ID and WIDI and globally, and in Digital Watermarking where the adoption of our technology is spreading through digital images, bank notes and secure credentials to television, movies, music, video games, ads, packaging and more. Financially this is an attractive transaction, unlocking unrecognized shareholder value in that the breakup value evidenced in this transaction provides a substantial premium to the trading and value of Digimarc stock immediately prior to the announcement.

We expect there to be many benefits for ID issuers, including a broader range of solutions, including central issue, over-the-counter and hybrid issuance production, a wider range of secure card materials, biometrics and data and document authentication solutions, and greater systems integration and expertise, extensive industry knowledge and experience of the combined teams, improved quality of service and program management resulting from combined call center and field service teams, increased competency across the entire organization for combined systems processes, staff experience, expertise and economies of scale, the development of innovative technologies resulting from a broader array of security products and features offered by the combined companies, improved ability to help issuers meet current and future legislative requirements, such as REAL ID, WIDI and other laws and regulations at the state and national levels.

With new legislative requirements and available federal funding, more companies are looking to meet our customers' requirements for complete credentialing systems that encompass enhanced IT systems. Our combined domain knowledge and solutions will help us meet these growing demands. We'll have enhanced responsiveness, delivery service and support, and better integration of applications, cameras, card production, secure card solutions, biometric technologies, applicant and document validation solutions.

Turning now to strategy execution, independent of the pending transaction, we had an excellent start to the new year in the first quarter. The second quarter could be quite interesting and informative and show continuing signs of progress. As I mentioned earlier, we believe that the federal government intends to grant $81 million to support REAL ID initiatives sometime late in the second quarter. Fourteen of our customers have submitted applications for funding. Regardless of the outcome of this grant process, our customers have many projects in the works. With $60 million of bookings in the first quarter alone, we anticipate a very busy year ahead for our ID Systems business.

As for the Watermarking business, we expect the Form 10 Registration Statement to provide details about the business and its prospects with historical financials and management's discussion about factors affecting financial performance. We believe that the Watermarking business as a stand-alone company will have a promising future.

After years of investment, and in incredibly hard work by our employees, and in teaching the market the virtues of digital watermarking, and in reshaping the Polaroid assets, we have reached the inflection points that we anticipated. The L-1 transaction is the consummation of a seven-year-long reshaping of the Polaroid assets into a high quality supplier and a highly valued asset. Through good strategy, wise investment and hard work, we turned the original $60 million investment into what we expect to be a significant return. After the closing we will focus all our energies on further realization of our vision for Digital Watermarking and delivering sustained, profitable growth for our shareholders.

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

(OPERATOR INSTRUCTIONS) Our first question is from Jeremy Grant with Stanford Group.

Hey. Good morning, gentlemen.

Hi, Jeremy.

I wanted to actually start off asking you a bit about Watermarking revenues this quarter. They were up, I think, a little over $5 million, which was quote a boost from what we've seen both the previous year and the previous quarter. And I wondered if you could talk a bit, one, about what drove this higher number, and two, if it's something that we should be thinking about on the analyst side about what this means for the rest of the year. I think your previous guidance was you expected Watermarking revenues to be about 30% over the '07 numbers, but if this $5 million continues as the run rate that would imply a bit of a higher number.

First, with regard to Q1 and what was going on there, we actually had good business across a number of different revenue sources for Digital Watermarking. We also, of course, had our first full quarter of involvement with Nielsen, and so we're quite comfortable with the prior guidance growth rate, and we think there's a good chance that we may exceed it significantly for the year.

Okay. So the prior guidance -- I mean, my calculations based on the '07 numbers was, I think, right around $17 million, so that would suggest that to hit the guidance you obviously have to slow down the Q1 phase, but you think -- you're saying there's a possibility there's upside to that $17 million number?

Yeah, there's a lot going on in the media business right now. It's a very exciting time. As you know, there are many, many companies now that have begun to focus on a different approach to managing media on the Internet. And so our Nielsen initiative is one among many initiatives in that area. Everyone's finally starting to understand that the notion that was prevalent in prior years of kind of shutting down the Internet is not feasible. And so if you can't shut it down, you have to learn to manage it better. And we think Nielsen is uniquely positioned as the global leader in market intelligence to help everyone to build business models in that environment, and that's really the nature of our project.

But because of the clear need and the massive scale of that need, we're seeing lots of people getting involved in the business too. So we believe we're going to have significant growth in our Watermarking revenues this year. And at this point we're not revising guidance, but I would express confidence in the guidance provided previously and note that there's a pretty good chance that we'll do better than what we said.

All right. Hey, are you able to break out with the Nielsen deal underway, how -- what -- I guess what kind of role that that played in bumping it to this much higher number in the Watermarking level this quarter? I know you don't get into specific deal terms, but was it a --

The Form 10, which we're working on and we'll file pretty soon, will actually have the kind of detail that you're looking for, Jeremy. And so, given that we have the statement in the works, I think it's probably best practice here to allow us to complete that work and to make that filing and then to discuss the contents of the filing generally with everyone.

Sure. If I could ask the question a different way, I think there was -- was it $60 million or $65 million in backlog, specifically from Watermarking?

That's right.

Sixty-five million. And what was -- I don't think we've broken those numbers out before in terms of total backlog. Can you discuss how much of that is new, quarter over quarter?

This is Mike, Jeremy. Let me cover a couple of things; a little clarity on the revenues. For the first time ever we've supplied a differentiation between services and products and subscriptions. Products and subscriptions for Watermarking is primarily licensing. And so that you have now comparative numbers for the quarter, and then that will be in the Form 10 as well for the prior three years. So that gives you some indication of where the growth is coming in, and it's in both services and licenses as well.

As to the backlog, we have not provided that. But obviously, with all of the contracts that we have, that has been growing. The Nielsen contract clearly had a substantial increase impact that we booked in Q4. This is the first quarter breakout. We'll be providing, on a go-forward basis, what that is every quarter. So you'll be able to see the comparatives.

Okay. I guess is there a way to talk about what the timeframe of the backlog being realized is or -- I'm trying to drill down here obviously with the acquisition announced of the ID Systems unit, to a certain extent there's a baked-in number between the cash and the value of L-1 stock you'll get. And it's pretty clear where the stock's been that the market is very much undervaluing, at least from my estimates, where the IP assets are in the surviving company. So in trying to drill down to the extent you can without the Form 10 being filed I think would be helpful for all of us to understand how to be explaining all of this.

I think the best advice for this is wait for the Form 10 because we'll give much more clarity on backlog and projected revenue streams for the year and so forth. And we hope to have that in the four to six week timeframe, so just be a little bit --

I think -- Jeremy, think of us as -- like we're doing an IPO. The Form 10 is a registration statement.

Oh, yeah. No, I get all that. I'm just trying to figure out what --

It's only going to talk about the Watermarking business, so it's going to answer all these questions, and we'd prefer to answer them in that document rather than to answer them a few weeks ahead of time informally.

Okay. Hey, let me just shift real quick to Hart-Scott-Rodino, the initial application has been filed, is my understanding?

That's right.

Okay. And so we're looking at probably a mid-May piece of news as to whether we get to go anywhere beyond the 30-day review?

Not necessarily. The process is not as cut and dried as that might imply. So we're going to work with the government here to allow them to do a proper investigation or reach the right conclusion. And we'll take whatever time they feel is necessary to do that.

Okay. So I guess if you can walk me through the process a little bit, my understanding is there's an initial 30-day review, and then if they're interested in looking deeper, they'll signal that they want to look beyond the 30 days. Or is there a little bit more of a nuanced description of it?

There are -- there's more flexibility in the process than that would imply in that the filers may voluntarily waive that 30 days. If they need a little more time, in lieu of doing a second request, they could merely talk to the filer about extending their filing.

Okay. So this would be something -- I'm familiar with this from, like, the CIFIUS process, for example, for foreign acquisitions where you can consistently re-file and sort of restart the 30-day clock in an effort to not force an answer. So that can continue to slide.

Yes. That's the alternative. Right.

Okay. And that allows more of a negotiation as opposed to sort of forcing a firm deadline.

That's right.

I have a couple of other questions, but let me drop back in the queue and let someone others in. Thanks.

Okay. Thanks, Jeremy.

Our next question is from Bill Gibson with Nollenberger.

Hi. Bruce, I know you recently announced several new licenses on Digital Watermarking, aside from Nielsen, relatively small. So this is going to be a two-pronged question. Can we expect more of those announcements in the next six months? And then two, are there potentially bigger announcements from some of the companies that, at this point, may benefit from theft of media on the Internet?

Well, I won't embrace your specific timeframe of six months, but I would note that our basic business strategy is intellectual property license, and so we'll continue to license lots of people, I hope, and have that be a good flow. We're looking at a range of business partners, as you'll see what you'll refer to as some of the smaller players. We're knitting together business partners that can support an ecosystem to build the kinds of applications that watermarking can enable.

So we're big players wanting to play. I think there's a pretty good understanding in the marketplace that it's a good idea to have a business relationship with us, and we're quite open to that. But we also greatly value our entrepreneurial business partners and the investments that they're making in the development of technology and markets. So we like to see a mix, and we're hoping that some of our entrepreneurial partners will score big. And that's really explicit in our business model. It's the financial leverage that we seek in the model. So those smaller players actually can have quite a big effect if they're successful, and obviously the larger players generate a more predictable and larger revenue stream in the early stages.

Good. Thanks, Bruce.

Yes.

Our next question is from Andy Hargreaves with Pacific Crest.

Hi, guys.

Hi.

Can you give us a sense for how much Nielsen actually represented in the quarter?

Nope.

Will that be in the Form 10 in terms of being a 10% customer?

Probably.

Can you maybe break out whether or not Blu-ray was a meaningful portion of the growth there or has that not really kicked in yet?

Not yet. No. And let me reiterate something I didn't call out specifically earlier, update here. In our last call I said that I thought there'd be some potential for some greater visibility in Q2, one of the points related to federal grant money. I do think our prediction, at least as far as we can tell right now, was well founded, so Q2 could be quite interesting with respect to the federal grant money.

The other point really is to Blu-ray and whether we'd be able to figure out if the final license is coming together by Q2. I still hope that will be true. I don't know yet. It's obviously not been publicly announced, so we're keeping our fingers crossed that it will be. Once the license is final then we'll be able to generate a better sense of what the income flow will look like and the ramping of the income flow. But right now they're still operating under the interim license, as far as we know.

Okay. And the only other question I have, at least related to that, is that there seemed to be a restatement upward of the Q1 Watermarking revenue from last year. Did I read that right? It seems like it was different than what we had seen before.

I don't think we had -- this is Mike. I don't think we had disclosed Watermarking revenues in the prior year.

In the quarter?

In the quarter.

Yeah, I don't think we gave a quarter a year ago because we just started toward the end of '07 talking about Watermarking revenue as separate from ID revenues.

The Form 10 will show the four quarters -- it will actually show five quarters. It'll show that all four quarters of '07 and the stub period for '08 of the revenue breakout.

Okay. Thanks, guys.

Yeah. The Form 10 we expect will be quite informative because revenue sources that were not material under the existing business here will become material for the watermarking spin-off, and so there'll be a lot more visibility responding to the kinds of questions that you're raising here, I'd expect.

Our next question is from the line of Irwin Silverberg with Burnham Asset Management.

I wonder, will you apply to the IRS for tax-free treatment on the spin-off of the watermarking business?

Mike, do you want to respond to that?

We'll have all that information on the tax side in the filings. Our approach -- I think we talked about this being a taxable transaction in the original release, and until we get all the filings complete that's kind of where we stand today.

Thanks.

Our next question is a follow-up question from the line of Jeremy Grant with Stanford Group.

Thanks. Hey, just a couple more questions. One, I think you mentioned overall bookings were very strong in Q1, particularly coming out of the driver's license space. And I guess what I'm trying to dig into a little bit is we sort of talked about a couple things that could be a catalyst for that market to pick up again. The first is obviously federal grant money coming out, which everybody loves, and that's sort of the easy one.

But the other is just the fact that the shackles are maybe off the states now to make some upgrades that they've been holding back on for a couple of years just because you finally actually have some REAL ID regulations that are out there that show them the path they're supposed to be on. And I was wondering if you could talk a bit about whether that latter factor has been a catalyst in the interim in some of the state activity.

Yes. The states are now moving forward with programs that have been impeded by the ambiguity of REAL ID, and so we are seeing what we have predicted, which is a substantial pick up in business, independent of any federal funding due to greater clarity about the direction of federal regulation. And so when I talk about the grants in Q2, I'm talking about sort of blowing the covers off if we happen to score there. Even if that gets delayed, even if it doesn't happen, even if we don't get much of the money, we are quite comfortable with our plan, and we see our customers moving forward at a much better pace of upgrades than for the past three years. But if we can get a piece of that early money, it's really going to be very meaningful to our business.

So that's how we look at that situation. We're not saying, "Geez, we hope there's some grant money, and that will give us some growth. We're expecting good growth regardless, but if we get the grant money then that gets layered on top. As we've talked about in the past, we've taken a kind of contingent approach to this, making sure that we're ready with resource plans to accommodate incremental spending driven by federal grant money. But we have not been sitting here waiting for it and depending on it in our basic operating plan. We see good demand from our customers, independent of that money.

Good to know. Question on OpEx. I think Mike mentioned though most of it was due to higher compensation and that both the R&D number as well as the G&A number were up a little bit above what we were expecting things to come in. Is there anything more -- is there actually more money being spent in either of those areas that's outside of comp. that we should be forecasting going forward? I guess the other question is are these numbers good ones to expect for the rest of the year, assuming the Company stays in one piece?

Well, first, all of the areas were hit with comp., all of the OpEx areas, even in the area of cost of goods sold. That's number one, so that's part of the reason for the upside. In addition, the compensation generally was higher in Q1 this year [versus] last year because our annual focal point adjustments are [like the]...April 1 of every year.

And other items impacting that -- Q1 is always a little bit higher in the finance and legal because of all the audit and 10-K filing that goes on in that timeframe, and so it drops a little bit. If you look at the trend over the last couple of years you'll see that Q4 and Q1 are kind of high in that area, and Q2 and Q3 are more normalized.

I think, Jeremy, to add a little more color, the executive salaries stayed where they were, but all the non-executive salaries were increased according to a budget of a little less than 4%, which is kind of consistent with what we can discern in relevant labor markets is appropriate increase. And last year we accrued no bonus because we were not meeting our objectives, and this year we are, and thus, there's a bonus accrual in there that wasn't there last year.

And then we have this artifact, if you like, of the stock compensation being included in our income statements that is causing some apparent growth without any actual growth. Then the last element is that business is good, and we have increased our resources in the front end of the business in anticipation of business continuing to grow. So that gives you a little more color on the Q1 rates and expectations about how OpEx will go throughout the year.

And then the transaction-related expenses were quite heavy in Q1. We would expect Q2 would be pretty heavy too. And then either the deal's closed or it's continuing on. If it's continuing on then we would expect those incremental expenses to decrease in size a bit in subsequent quarters.

Was any -- I haven't looked at the numbers. Was any significant new grants of options issued in this quarter that we got to be watching on the dilution calculations?

It's Mike. Yeah, nothing other than our normal annual grants and reviews.

Okay. So nothing unusual. Okay. All right. That's about all I have. Sounds good.

Okay.

(OPERATOR INSTRUCTIONS) Our next question is from the line of Kevin [Hanrahan] with KMH Capital Advisors.

Congratulations on the record revenues in Q1. Can you hear me okay?

Yeah. I can hear you just fine. Thank you, Kevin.

I wondered since the enhanced driver's license program kicked off in Q1 in the state of Washington, I don't know if you can talk a little bit about that, and if you're seeing continued interest from other states in that program or a similar program?

The State of Washington's program is going great. They're very happy, and the citizens seem to be embracing the product opportunity as a convenient, low-cost means of providing a border crossing credential.

There are many other states interested in the enhanced driver license, and we hope that many, if not all of them, will choose to do business with us on that product given that we were first to market with a successful implementation. So we're working on it. There is expressed demand in a number of states, and we're active in wherever we see an opportunity, and we'll hope we can deliver some incremental business there during the year.

Okay. And then, a second question -- I saw a comment that you made, I think, to an Oregon business journal, local paper there talking about the headcount at the two businesses and what it would look like, assuming the sale of the ID business to L-1 went through. Can you give us an update on this call what the employee headcount would look like at Digimarc at New Digimarc after, assuming the deal does close?

You may have been reading some speculation by the business journal. I don't recall talking to them about this subject. But in response to your question, we are in the planning process for New Digimarc and the Form 10 work that's being done in terms of historical modeling is really a critical foundation for understanding the expected financial performance of that business as it's spun-out. And the headcount and the compensation strategy for that business will be derived, if you like, from our objectives to make that a successful business. So, we haven't come up with a staffing plan yet for it specific, but as we approach the close, we will have quite a clear idea of what we're going to do there.

Okay. Well, let me ask that maybe slightly differently. If you -- you've already contemplated selling the ID business to L-1. Would it be fair to say that most of your ID employees would go over and continue in that division under L-1's ownership?

According to the terms of the merger agreement, the ID employees will go to L-1. Then L-1 will make a judgment about what their proper staffing needs are. The ID business then will be properly staffed, and then there will probably be some employees who will not have an opportunity in either business, but we've not quantified that nor identified the, what we call, shared services allocation of the employees specifically. So, if they're ID employees, they go to L-1. If they're Watermark employees, they go to new Digimarc, and then there are shared services employees who go one place or the other or neither. So, we've not made those judgments yet.

Okay, thanks, Bruce.

Yep.

And there are no further questions at this time. Do you have any closing remarks?

Want to thank everyone for their participation, and as we've noted here, we're off to an excellent start on the year and quite enthusiastic about the business potential. We're delighted about the interest by L-1. We think they're a terrific company and that our assets will fit very well into their strategy and make a significant contribution to their success.

So thank you all, and we look forward to talking to you again in a quarter or so.

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