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Digimarc (NASDAQ:DMRC)

Q3 2013 Earnings Call

October 30, 2013 5:00 pm ET

Executives

Bruce L. Davis - Chairman, Chief Executive Officer and President

Michael McConnell - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer

Analysts

William Gibson

Paul D. Sonz - Paul D. Sonz Partners

Operator

Good afternoon, and thank you for participating in today's conference call. Now, I will turn the call over to Bruce Davis, Chairman and CEO of Digimarc.

Bruce L. Davis

Thank you, and good afternoon. Welcome to our conference call. Mike McConnell, our CFO, is with me. On the call today, we'll review and discuss Q3 financial results, talk about significant business developments and market conditions and provide an update on our strategy and operations. The webcast will be archived in the Investor Relations section of our website.

Please note that during the course of this call, we'll be making certain forward-looking statements, including those regarding revenue recognition matters, results of operations, investments, initiatives and growth strategies. These statements are subject to many assumptions, risks, uncertainties and changes in circumstances.

Any assumptions we share about future performance represent a point-in-time estimate. 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. For more information about risk factors that may cause actual results to differ from expectations, please see the company’s filings with the SEC, including our latest Form 10-K.

As was previously announced, Mike is planning to retire soon. We expect this will be his final investor update. Mike has been with us for 9.5 years, around which time, he's done a terrific job of accounting for and protecting the company's financial assets. Our shareholder returns during Mike's tenure has been outstanding. He's been a strong and able leader and a respected member of senior management. We wish him all the best. Charles Beck, our Controller, is expected to be named as CFO by our board next week. He's been working on the transition for some time now, and we expect it to go smoothly. Charles is also with us on this call. Mike will begin by commenting on our financial results. And I'll then discuss our execution strategy and outlook. Mike?

Michael McConnell

Thanks for the kind words, Bruce. I'd like to take this time to thank you, our board, our executive team, employees and shareholders for the opportunity and pleasure to serve as Digimarc's CFO for the past 9.5 years. I expect many relationships that I've developed over these years will continue for some time. No doubt, the excited and sometimes challenging times will be my fondest memories, and I'll miss the excitement of the coming years as our vision materializes. As a former officer and regally [ph] large shareholder, I'll be watching the development closely and looking forward to celebrating the successes of the future.

Now on to the financial results. Our Q3 revenues were $7.4 million, up 17% lower than the same quarter a year ago, reflecting the end of a guaranteed minimum license payments from Intellectual Ventures in Q2. The year ago quarter included $3.2 million of license revenue from IV. Revenues from sources other than IV licenses increased 30% due to the Attributor acquisition in Q4 and growth in the revenues from the central banks and from patent licensees other than IV.

Operating results were pretty much in line with our expectations and reflect the previously discussed increases in investment and the growth initiatives, including development and marketing of Digimarc Discover and our Intuitive Computing Platform, adding audio watermarking and packaging and developing the second wave of patents, all in support of our vision of enabling computers, networks and other digital devices to see, hear, understand and respond to their surroundings.

Looking into more of the details of the Q3 2013 financial results, you'll see that gross margins were at 74%. 10% -- 10 points lower than a year ago, due to lower license revenues and an increase in subscription revenues from Guardian for e-books, acquired in December of last year. Operating expenses increased by 21 -- 28% over a year ago period, primarily due to the addition of the Attributor operations and increased investments in R&D and marketing. Our operating loss was $2 million and logically tracks with the lower revenues and the higher growth investments that we've made.

We utilized $1.5 million of cash, and our operations reflected the impact of this operating loss. The $1.3 million of capital investments we've made were higher than usual, with about $800,000 being associated with streamlining the data center infrastructure of Guardian for e-books. We expect this investment to provide significant efficiency going forward, with $200,000 or more reduced annual operating expenses. And finally, the balance sheet remains in excellent shape with more than $38 million of cash in securities and no debt.

We still expect operating results for 2013 to be as indicated in our prior call and mainly that revenues and profits will be down considerably from last year, primarily due to the combination of $8 million of past due royalty revenues forbearance that we received and recognized in Q1 of 2012 and expiration of the $3.4 million quarterly minimum license payments from Intellectual Ventures that we received in Q2 of this year. That was partially offset by growth in revenues from the acquisition of Attributor and from central banks, certain licensees and new customers and other areas of the business.

Profitability is also affected by the increased investments in R&D, marketing and intellectual property development. The increased investments relate to marketing development of Digimarc Discover as we look to expand our offering to larger enterprises and broader markets, particularly in retail in support of the Shopper's Journey, commercializing our consumer packaging and audio watermarking solutions, directed research in a number of areas, and including the Intuitive Computing Platform and mobile payments, developing our second wave of patent portfolio and associated monetization programs and improving operational efficiency of Attributor, now known as Digimarc Guardian and expanding its associated products and services.

Consistent with our prior discussions, the combination of lower revenues and increased investments is likely to lead to a GAAP loss for the year. Nevertheless, we expect positive operating cash flow for 2013. There were no open market share repurchases during the quarter, and the board approved the cash dividend of $0.11 per share, payable on November 12,2013, to shareholders of record at of the close of business on November 4, 2013.

For a further discussion of our financial results and risks and prospects for our business, please see the Form 10-Q that we expect to file shortly. Bruce will now provide his comments on our execution strategy and our outlook.

Bruce L. Davis

Thanks, Mike. On the financial front, the addition of Attributor and growth in other areas was not enough to offset the expiration of minimum payments for IV. There were no substantive developments in our arbitration with Intellectual Ventures during the third quarter. Process is moving along consistent with the dispute resolution provisions of our license agreement. We will keep you apprised of any material developments. We continue to make good progress in executing our strategy to invent and deliver directly into our licensing, a common platform that connects prospects and customers to brands across the full experience of the Shopper's Journey. We intend to launch the platform at the NRF annual show in January. We are intently focused on the lunch. Preparations are going well.

We anticipated in the -- or participated in the American Magazine Media Conference in New York City last week. It was a terrific event, where we received great visibility and access to senior executives of major publications and group publishers. Contemporaneously with the event, we announced new clients and new features for our Digimarc Discover publishing platform that is centered on enabling shopping for magazine print editions. Our key take away from the event is that the industry appears to be moving in the right direction, appreciating that print and digital operations should be managed and coordinated to build maximum brand equity with audiences. We were also reassured by industry data that print continues to dominate the distribution and private models of publishers, and that the publishing community understands the vital role that they play in the Shopper's Journey.

The use of Digimarc Discover and publishing now extends from magazines to catalogs, brochures, direct mail and books. We estimate that over 3 million consumer mobile devices have applications equipped with our platform. There have been over 2 million activations from more than 4,000 services and 300 issues so far this year. Coupons, recipes and sweepstakes are the most popular consumer payoffs. The U.S. accounts for the lion's share of activity.

Our R&D and IP development are prolific. The retained portfolio continues to grow at a rapid rate. 64 patents have issued thus far this year, with 31 of the 64 feeding our second wave portfolio, which has now grown to 66 issued patents. Third quarter issuances include innovations in second screen television, Intuitive Computing Platform and mobile content recognition and search. We have filed over 100 patent applications thus far this year, with 33 applications in the third quarter alone, bringing the total second wave patents pending to 340. Topics included in the new files include multispectral imaging, image processing for automated medical diagnosis and machine learning, among other things. We have not made much progress since our last call with the significant potential licensee, who we believe is using some of our patented second wave inventions. We are considering various options for moving things forward.

Preparations continue for the National Retail Federation BIG show in January, where we plan to demonstrate the full mobile optimized Shopper's Journey that we have developed. The show is in New York's Javits Center on January 13 and 14. And you happen to be in the area, we invite you to stop by.

That's it for our prepared remarks for today and now, we'll open up the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from Bill Gibson with Legend Merchant.

William Gibson

Bruce, what would you hope to accomplish at the NRF Show, maybe from minimum expectation to maximum?

Bruce L. Davis

Yes. It's a -- the big show for the retail industry. There are generally about 30,000 attendees, including all of the largest mass merchants in the world who are our targets. So we'd like them all to come by the booth and see firsthand what we have, and our understanding, we've visited one show, this is our product exhibition, is that the big retailers sometimes come along in a gang and ask for a demo. We hope to see as many of the top retailers as possible there. We'll be open for business. We will be ready for anyone to buy what they want to buy, but we believe what's most likely to happen in a successful scenario is that they ask us to come out and talk with them at their locations and to describe how they could implement the system. So a reasonable expectation, or a reasonable range of expectations might be anywhere from lots of people are interested and say, "come have some meetings" to someone who says "let's get going." And what we'll be able to announce is probably too speculative to try to characterize right now, it kind of depends on how things go. But we'll be as informative as we can be after the show about how we felt something has went. And my understanding is a fair number of investors are thinking they may stop by because it is in New York City and convenient, at least, for the East Coast investment community.

William Gibson

Good. And a second unrelated question, you had a press release recently on an agreement with U.S. Bank Corp. and Monetize? And I just want to understand what you're trying to accomplish there, or what the role each plays, and how watermarking works in?

Bruce L. Davis

Okay, sure. Yes, the press release was about some work that U.S. Bank and Monetize and us are doing on implementation of the Discover platform in a banking-enabled application. And so think of it as Digimarc Discover was kind of a payments emphasis, and U.S. Bank has been working with us for a long time now, for many years, making sure that they understand the technology, running lots of tests. And they're, I believe, getting ready for implementation. Monetize is a company that helps banks to make their services available in the mobile environment. So I don't want to put a label on them because I don't think they put a label on themselves, but something like a system integrator concept for mobile. So that's what that was about. U.S. Bank and Digimarc have a broader relationship as well, as we hope that they'll be one of the early implementers of the virtual brand interface for their Shopper's Journey, as it relates to banking.

William Gibson

Okay. And let me wish you the best, Mike.

Michael McConnell

Thank you, Bill.

Operator

Your next question is from Paul Sonz with Sonz Partners.

Paul D. Sonz - Paul D. Sonz Partners

Bruce, in the last call, you talked about that you had certain development marketing deadlines that you hope to meet by the end of the year, and to have everything fully functional by year-end. Have you been able to accomplish that?

Bruce L. Davis

Yes, I think we're in pretty good shape. We still got a couple of months to go before year end, so there's obviously some things that aren't done that we expect to be done. We might not make it. But right now, everything looks good, and so we're looking forward to a very nice presentation at the show.

Paul D. Sonz - Paul D. Sonz Partners

Good. A follow-up to that is, you talked about that you had integrated into one company, you said, a checkout scanner and that you were hoping to add others. Any -- where does that process stand?

Bruce L. Davis

Well, when I -- I said that I wasn't meaning to imply, if you took it that way, that we'd have more at the show. That wasn't my intention. We're trying to get the other vendors up and running -- major vendors. We're also trying to figure out how to deliver a development environment for smaller vendors that is more self-service because we do want this to be a global phenomenon, and we do expect that there'll be major changes in the industry because of the shift in technology from lasers to imaging. And so we don't want to serve only the largest, but we want to start there, mainly because of our scale.

Paul D. Sonz - Paul D. Sonz Partners

Right. So this is to try and get as many people with image scanners to work with you, as many of those possible. And how -- over what period of time do you feel that the industry is going to switch from the laser scanners to the image scanners?

Bruce L. Davis

Well, the average duty cycle for a laser scanner is 6 to 8 years. The duty cycles for imagers haven't been established yet. So we might guess that they'd be -- it could be shorter or longer, depending on the delivery level of innovation of the industry. But maybe a little longer. And so many of the vendors have image or products that they're getting ready to introduce in the show. There will probably a certain number we've met at the National Retail Federation show. And so our understanding is that many of the customers are testing out those products and trying to make a judgment about what degree of future proofing they want to do in their next CapEx purchases. And obviously, if they go with laser, then they're looking at the possible obsolescence. And if they're looking at imagers, they're looking at brand new products. So I don't know yet how they're going to go. I think we're going to have better visibility on that early next year, after the show. And what we're hoping to have happened, just so I can tie together your 2 questions here, is that if we had a really good show, I would expect that we'll get much greater attention from the other scanner vendors, and that even if we're -- do very well, on the high-end of expectations, the retailers may tell those vendors that they need to have our stuff in their products, which will be wonderful. So that's how we expect this to flow as about the impetus to work with us across the industry will hopefully flow from a successful demonstration in New York.

Paul D. Sonz - Paul D. Sonz Partners

Let me ask a question, just so I understand. That in order -- once people started adapting image scanners, making that available for Digimarc products, is that a software change or is there anything in the hardware that has to be done specifically to use the Digimarc Discover product?

Bruce L. Davis

As far as we know, it's software-only. We haven't surveyed all of the products, obviously, so it could be something that we don't know. But as far as we know, it should be software-only. We believe all of the products will be field upgradable that will still be -- have a network connection just like the software upgrades that you receive in hardware products of your own. And our preference, of course, would be to have our firmware in the product when it ships. So it’s a feature of the product.

Paul D. Sonz - Paul D. Sonz Partners

Last question. You talked in the last call about having real good cost out in the little brochures that they've sent out, and that you were hoping to develop relationships with other big box retailers, and I guess, that's the way to call them. Is there any progress in developing relationships with other large retailers?

Bruce L. Davis

Yes, but nothing announceable yet.

Paul D. Sonz - Paul D. Sonz Partners

Okay, all right. Well, that's all for me. And Mike, I've enjoyed dealing with you immensely, and best of luck.

Michael McConnell

Thanks, Paul.

Operator

[Operator Instructions] Your next question comes from Kevin Hanrahan [ph] with KMH Capital Advisors.

Unknown Analyst

Mike, I had a question about the tax rate. It looks like you had a negative tax rate in Q3, is that correct?

Michael McConnell

That's correct. Actually, the tax rate is a positive rate, but it's applied to a loss. And the rate is very, very high because of the cumulative impact of the R&D credits that came through this year. So it's kind of a difficult one to track, but it's the manner of the way the accounting profession applies these types of things when you have losses.

Bruce L. Davis

And Kevin, this is Bruce. I'd add to Mike's answer there, that apparently, we have a long discussion of this in the 10-Q. Right, Mike?

Michael McConnell

There's a little discussion in the 10-Q about it. But it follows pretty standard tax accounting when you have loss issue, you apply the rate to the loss and then when you have a year that's unique with the R&D credits, that applies further. And this year, of course, it's kind of a double whammy because in 2013, we get the 2012 credits that we were not allowed to book into last year's P&L because they were inactive until January, so you hit 2 years of credit. So that even makes it even more out of whack from what one might expect.

Unknown Analyst

Okay. So will that recur in Q4 or not? And how should we think about 2014? Because in the past, I had you paying taxes, and this quarter you had a benefit.

Michael McConnell

Yes. Well, given that we expect a GAAP loss for the year, that we'd likely have, you might say, a negative tax provision for the year. So there'd be some additional numbers, maybe, to what you've seen this quarter as well. Going forward, it all depends upon the R&D credits right now, that expires this year. If it's not next year, that has an impact. If it's instituted again, they may be more normalized. But a normal tax rate for us would be 35% to 40%, in that range, would be general. And apply to either a positive or a negative result.

Unknown Analyst

Right, right. Mike, can I ask you about the buyback. I heard you say you had no -- you bought back no shares. Was the window open? In other words, could you have bought back, or was there some material info that prevented you from being in the market?

Michael McConnell

Well, our program was open. We did buy about 8,000 shares under our normal employee purchase program. But in the open market, there were none. It's open, we evaluated and we'll continue to address that going forward, but we chose not to buy any this quarter.

Paul D. Sonz - Paul D. Sonz Partners

Okay. And best of luck in your retirement.

Michael McConnell

Thank you, Kevin.

Operator

There are currently no further phone questions.

Bruce L. Davis

All right. I want to thank everyone for participating in the call. We look forward to catching up with you in the next quarterly call and seeing some of you in between now and then, either at the show or on the road. Thanks, everyone. Bye.

Operator

Again, thank you for your participation in today's call. This concludes today's conference. You may now disconnect.

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