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Executives

Bruce Davis - Chairman and Chief Executive Officer

Michael McConnell - Chief Financial Officer and Treasurer

Analysts

William Gibson - Nollenberger Capital Partners

Andy Hargreaves - Pacific Crest Securities

Walter Schenker – Titan Capital

Adam Fischer - Burnham

Digimarc Corporation (DMRC) Q1 2009 Earnings Call May 4, 2009 10:00 AM ET

Operator

Welcome everyone to the Digimarc first quarter 2009 results conference call. (Operator Instructions) Mr. Davis, you may begin your conference.

Bruce Davis

Thank you. Good morning and welcome to our conference call. Michael McConnell, our CFO, is with me. We issued a press release earlier today announcing our first quarter 2009 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 our strategy and operations. This web cast will be archived in the Investor Relations section of our website.

Before we proceed, please note that during the course of this call we will be making forward-looking statements regarding management's opinions and expectations about Digimarc’s business, its markets and financial performance. These statements are subject to assumptions, risks, uncertainties and changes in circumstances. The 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 10Q filed on Friday and our earnings release posted on our website earlier today.

During the course of this conference call we will also refer to certain non-GAAP financial measures as defined by the SEC and Regulation G. Definitions of these non-GAAP financial measures and the reconciliations of these measures to their most directly comparable GAAP financial measures are included in the earnings release for the quarter.

Any assumptions we offer about future performance represent a point-in-time estimate. Given the current economic climate we believe it is prudent to embrace a very cautious posture toward assumptions and projections in general. We describe various assumptions and projections in this call with a limited purpose of giving you a sense of our planning assumptions and to assist analysts who solicit our views as one of their sources for modeling possible future performance. It is obviously very challenging for anyone to try to forecast the general economy and derivatively its impact on an individual business like ours. We expressly disclaim any obligation to revise or update any assumptions, projections or other forward-looking statements to reflect events or circumstances that may arise after the date of this conference call.

Mike will begin this update call by commenting on our financial results. I will then update our financial and product market outlooks, strategy and operating plans for the remainder of 2009. Mike?

Michael McConnell

Thanks Bruce. Good morning everyone. I will begin by reminding everyone of the base of accounting used presenting our historical financial results. The digital watermarking business that forms the basis of the current new Digimarc was spun out from old Digimarc last summer just prior to the sale of old Digimarc to L-1 Identity Solutions.

As explained previously in our calls and SEC filings, the basis of accounting used for the digital watermarking business prior to the spin-off and through August 1, 2008, is referred to as a carve-out of digital watermarking assets, liabilities and results of operations from the old Digimarc business that included our ID Systems operations that were sold to L-1. It is difficult to meaningfully compare the new to the old financial results due to the difference basis of accounting used in light of the spin off transaction. Please keep this in mind as we discuss changes in our results from our prior periods.

Q1 2009 results financial highlights included revenues of $4.4 million that were 13% lower year-over-year and primarily reflect some expected changes in revenue sources for terms of certain long-term contracts, a later than expected start of work on our federal defense contracts and to a certain extent lower royalties from some of our licensees.

Gross margin was 67% compared to 72% in Q1 2008 with a five point change due to mix where lower margin service revenues accounted for a greater part of the total and to a lesser extent the impact of a different basis of accounting for expenses I had mentioned earlier. Operating expenses increased from $3 million to $3.9 million primarily reflecting the change in basis of accounting between the two periods.

Our cash investments balance at March 31 was essentially unchanged at $46 million. The revenue backlog at the end of the quarter was $57 million reflecting the net impact of newly booked business and the normal burn off of backlog. For a further discussion of our results, our business and financial models and risks and prospects of our business I refer you to form 10Q that we filed last Friday, May 1st.

Looking forward we continue to be cautious that our discussion of financial assumptions and the context of the prevailing general economic conditions should continue to be viewed cautiously. With this in mind, we are not revising our prior assumptions in any significant ways. We expect Q2 revenues and financial results to be better than Q1 assuming the delayed federal contracts get underway soon. We are working on a number of interesting opportunities that could impact 2009 financial performance but the potential impact is too speculative to model at this point.

Leaving these opportunities aside, our baseline assumptions are that revenues should grow and earnings improve during the remainder of the year. We expect that 2009 operating expenses which include the majority of our $2.3 million stock compensation will be less than $15 million. Stock comp expense is allocated between both operating expenses and cost of revenues.

At these baseline levels and composition of revenues and expenses, we expect gross margin percent for the year to be in the mid 60’s, GAAP earnings to show a six-figure loss, adjusted EBITDA or earnings before interest, taxes, depreciation, amortization and stock compensation would be north of $1.5 million. Free cash flow, defined as operating cash flow less capital expenditures, will be positive after taking into account more than $1.3 million of capital expenditures the majority of which are expected to be related to capitalized patent costs. The primary explanation for the differences between adjusted EBITDA and free cash flow versus GAAP earnings being the $2.8 million of non-cash charges for stock compensation and depreciation.

Bruce will now provide an update about our markets, strategy and operating plans for 2009 and beyond.

Bruce Davis

Thanks Mike. First quarter revenues were lower than in the comparable quarter of last year largely due to the impact of arbitrary variations in certain scheduled payments, temporary delays in beginning work on some military and defense contracts and to a lesser extent financial pressures on some of our licensees from the general economic situation.

The largest share of the shortfall came from delayed starts on our federal contracts for Smart Data and Weapons Security. We are working on alignment of essential parties and the mechanics of funds flows for these projects and hope to get underway soon. Continuing delays could dampen Q2 revenues but at this point we believe we will still achieve our 2009 work plans and budgets for these programs. We will give you an update in our next call.

Elsewhere we are executing our strategy generally according to plan, making good progress on our key objectives. As outlined in previous calls these objectives include successfully repositioning post spin off Digimarc in product and financial markets, exceeding our financial goals, providing excellent quality of service to the central banks and Nielsen, helping our other partners to deal with market challenges and grow their businesses and entering into additional significant business relationships.

As to the last point concerning growing our business through new and expanded relationships, we are working on a number of potentially significant opportunities but none are sufficiently definite to discuss yet. The board has approved a share purchase program authorizing the purchase of up to $5 million of our shares. At current price levels we believe our stock represents an attractive investment opportunity for the company. We believe we can continue to invest in the initiatives that are important to our future success as well as enhance the value of our company by repurchasing our stock under this program.

Under the program, shares may be repurchased from time to time in open market transactions at prevailing market prices or in privately negotiated purchases. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other environment and economic conditions. Repurchases under the program will be funded from available working capital. The program may be commenced, suspended or terminated at any time or from time to time at management’s discretion without prior notice.

In closing, we continue to perform in line with a relatively conservative operating plan as we mitigate risks posed by challenges and uncertainties associated with the global recession. This concludes our prepared remarks. Thank you very much for your interest and support. We will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from William Gibson - Nollenberger Capital Partners.

William Gibson - Nollenberger Capital Partners

One of the things I noticed you didn’t mention on the call was the possibility of acquiring additional technologies to add to your core technologies. Is that still something you are exploring?

Bruce Davis

It is. As I have said on previous calls I think that during the second half of the year there will be interesting opportunities presented to us for acquiring technologies or operating assets. I am sticking with that view. I think we are still heading downward on pricing and obviously we never control the timing of opportunities. They come when they come but I think there will be opportunities but I don’t know if it will make sense to take advantage of them or not but we are certainly open to considering them.

William Gibson - Nollenberger Capital Partners

One last semi-related question, I noticed in the 10Q on the R&D spending you mentioned digital fingerprinting, other identification technologies. Is that just exploring what may fit or what the competition is doing? What are you doing on that front?

Bruce Davis

We have been generalizing our R&D for many years now so that our content identification means include a portfolio of technologies including fingerprinting. So we actually have fingerprinting IT and a growing amount of it. We see that and certain kinds of applications, fingerprinting can do an adequate job of identification at a gross level and on other applications the combination of fingerprinting and watermarking will yield an optimal result. At this point in time we are still keeping a very close eye in R&D and marketing on that technology and there are many unknowns. Watermarking is a much better understood content identification technology so what you are seeing there is both work on development of technology and the assessment of technology.

Operator

The next question comes from Andy Hargreaves - Pacific Crest Securities.

Andy Hargreaves - Pacific Crest Securities

You just alluded to it I think but I was going to ask on R&D is some of the increase almost like contracted R&D with specific clients or specific to some of these opportunities that you are going after? Or is it more general stuff that you will just be pursuing?

Michael McConnell

We have a little bit of a couple of things. One is there have been added headcount that we talked about in prior calls that we had increased our headcount by about 10%, all of it in the engineering area. That was to address both increased volume of service work where they are billed out and also to enhance and explore existing and new opportunities.

Andy Hargreaves - Pacific Crest Securities

On some of these new opportunities can you give us any sense for what industries they are in or what type of opportunities they are? Is it similar to work you are already doing or is there anything that would be maybe a new application of the technology?

Bruce Davis

There are an increasing number of projects we are working on. You will see R&D spending higher going forward because of the hiring that we have done. We have added about ten people to the company this year, all engineers. We added them to work on expanded scope of some projects but also to work on new projects and in particular we have the two federal contracts where the work has been delayed a bit. The weapons security project is brand new. So those are the areas with the greatest concentration of new resources are applied.

Operator

The next question comes from Walter Schenker – Titan Capital.

Walter Schenker – Titan Capital

You made reference in your comments about a number of opportunities which could impact results for 2009 without delineating the magnitude of what the opportunities may be. Can you give us some color at least to what areas they might be in aside from saying watermarking?

Bruce Davis

That is hard to do where things are just not right. I’ll try to be a little more indicative here. The opportunities are primarily in the content identification space but in the commercial area rather than additional government work. We have a substantial amount of new government work this year and so we are concentrating our efforts on building new opportunities in the commercial space. So commercial content identification would be a little more precise.

Walter Schenker – Titan Capital

Since questions beget questions, new government work is outside of the currency areas?

Bruce Davis

Yes, in fact we have announced one continuing program and one new program outside the currency areas. The continuing program is called Smart Data and that is a development activity intended to improve the reliability of battlefield intelligence being generated by UAV’s. The second project which is brand new this year is called Weapons Security and it is a confidential project that we can’t say a whole lot more about but we are involved in enhancing the security for high value military installations.

Walter Schenker – Titan Capital

In the commercial area, I should take that to mean it would be…I should take anything to mean it would be largely media related or media meaning audio/video type stuff as opposed to print?

Bruce Davis

No, actually the opportunities we are looking at span all of our range of interest in that area. Audio, video, images and print. It is a surprisingly interesting, fluid environment as we are looking at opportunities. There is a lot going on in the market in general but it is sufficiently volatile, ambiguous and so forth that I don’t want to wind anybody up on what might be able to get done. It is largely given the climate that we are in. The climate creates opportunities but it creates a lot of volatility. So what looks like an opportunity may not be there the next day. Or one that wasn’t there today might be there tomorrow which looks more attractive than the one we are working on. So there are a lot of people who are very vigorously looking for changes in the business models and business opportunities and that may create opportunities for us. As we said in our script, and we have said in the last several calls, we have a conservative, well articulated operating plan this year. We are performing well against it but we have sufficient capital so that we can consider new opportunities and we are looking carefully at many different opportunities. As I said there is sufficient volatility that if I was to try and speculate today on something we were working on that might happen I might decide tomorrow there is a different and better opportunity. We will just wait until we have got a deal in hand and we will make a general public announcement and then we will be happy to talk about why we are doing what we are doing and what the consequences of that action are. I don’t want to speculate too much because of volatility.

Walter Schenker – Titan Capital

I will finish up with a comment about what you just said. The company periodically announces technology changes, partnerships, etc. and one way to find out if it is significant is to call you or Mike. A second way would be if in fact there has been sort of a request, if something is meaningful as it would affect current year revenues or earnings in some way indicated in the text? I can’t figure out when you make these announcements which ones mean a lot and which ones don’t mean a lot at least within a reasonable timeframe.

Bruce Davis

We will take that suggestion to heart and we will be as informative as we can be.

Operator

The next question comes from Adam Fischer – Burnham.

Adam Fischer - Burnham

Maybe I missed it, so maybe you can give some color around it. Has Nielsen talked about the timeline of the Media Manager project in any greater detail than we have heard up until this point?

Bruce Davis

No.

Adam Fischer - Burnham

Sorry. That was a no?

Bruce Davis

No. They haven’t as far as I know.

Adam Fischer - Burnham

On the bank note business, the work we do with the Consortium of Central Banks, you have talked in the past about additional opportunities there. Are we working against some of those? Can you talk maybe a little bit about that?

Bruce Davis

Well, that is one of the areas of potential expansion and the issues there are not so much volatility but the difficulty in predicting in advance when opportunities will mature. So we now are in our 12th year and in working with the central banks we have done a great job there. We have become increasingly known in the security printing market place but it is a very mature market with a relatively small supply chain and a number of dominant suppliers. We talk a lot with people in that business about opportunities but again I think it is best to wait until something is solid before talking about what we might be able to get done there. I do believe there are opportunities in that space. I don’t think there are any that I am aware of that would impact our 2009 results. So if anything did come up it would be longer term.

Adam Fischer - Burnham

On the same topic, secure printing; there have been a lot of kind of documents and leaks from the Obama administration. Is there a potential for us to kind of help them secure those documents so they can better secure the information flow?

Michael McConnell

We could. That is actually an application that we have offered to the various entities over the years. Both those who are in the document production business and those who create the documents using those tools. There is just not sufficient interest it seems to drive a broad scale market with reasonable financial return. It is an application we think we could do. We just can’t find a noteworthy customer for it. Would love to have the government sign up for that. There are many things in Defense and Intelligence and National Security that we think we could help on that we are not yet working on. We are pleased to have some new work here in 2009 but we think it is just scratching the surface of the kinds of things we would do. With the changes in administration, in fact I can only speculate at some aspects of our delay because of the way in which the government security markets work. The change in administration here has been pretty profound. It will take the Obama administration awhile to get their feet on the ground with respect to the management of national security programs I believe.

We will see how things develop with the administration. Obviously all of the attention of Congress has been on the economic crisis so they are really not very focused on anything else and I believe President Obama is probably in the same place.

Operator

There are no further questions at this time.

Bruce Davis

Thanks everyone for joining us on the call today. We will carry on. We look forward to talking to you at the end of this quarter. I believe we have one more question that has just come up. Let’s go ahead and take the question. It looks like it went away. Thanks again. We will talk to you next quarter.

Operator

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

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