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Digimarc (NASDAQ:DMRC)

Q4 2013 Earnings Call

February 20, 2014 5:00 pm ET

Executives

Bruce L. Davis - Chairman and Chief Executive Officer

Charles Beck - Chief Financial Officer and Treasurer

Analysts

William Gibson

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. Mr. Davis, please proceed.

Bruce L. Davis

Thank you. Good afternoon. Welcome to our conference call. Charles Beck, our CFO, is with me. On the call today, we'll review and discuss our financial results for 2013 and the 2014 outlook, talk about significant business developments and market conditions, and provide an update on execution of strategy. This webcast will be archived in the Investor Relations section of our website.

Please note that during the call, we'll be making certain forward-looking statements, including those 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. Actual results may vary materially from those expressed or implied by such statements. 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.

Charles will begin by commenting on our 2013 financial results and 2014 outlook. I'll then discuss market conditions and execution strategy. Charles?

Charles Beck

Thanks, Bruce. And good afternoon, everyone. As discussed on prior quarterly calls, we expected 2013 operating results to be lower than 2012, due to lower revenues and increased investments in our business. Our actual results are in line with those expectations. Revenue decreased by 21%, from $44.4 million in 2012 to $35 million in 2013. Revenue was lower due to $8 million of past due royalties paid by Verance in January 2012 and $5.8 million lower license revenue from Intellectual Ventures as the quarterly minimum license fee payment ended in May 2013. These decreases were partially offset by a full year of revenue contribution from our Guardian for e-books business and higher revenues from the central banks.

Gross margin was 77% for the year, 8 points lower than prior year, reflecting the change in revenue mix I noted a moment ago. Operating expenses increased 25% over 2012 due to substantial investments in our growth initiatives, including the development and marketing of Digimarc Discover, the Digimarc Barcode, and our Intuitive Computing Platform, as well as continuing to develop and prepare for licensing of our second wave patent portfolio.

We've realize an income tax benefit for the year of $1.8 million. Our effective tax rate for 2013 was higher than our statutory tax rate due to income tax of federal R&D tax credits for 2012 and 2013 tax years that were extended in January 2013.

At the bottom line, we incurred a net loss for the year of $500,000 or $0.10 per diluted share versus net income of $8.3 million or $1.12 per diluted share in 2012.

Cash flow from operations was $3.5 million during the year. We invested $1.7 million in our IT infrastructure and facilities and $1.1 million in patent assets during the year. The balance sheet remains in excellent shape with $35 million of cash and securities and no debt.

For the fourth quarter of 2013, results were in line with our expectations. Revenue was $6.8 million versus $9.3 million in the fourth quarter of 2012, primarily due to the end of the quarterly minimum license fee payments from Intellectual Ventures. Operating expenses were up 43% over the same period due to increased investments in our growth initiatives. We incurred a net loss of $1.3 million or $0.19 per diluted share in the fourth quarter.

Our operating plan for 2014 includes the following financial assumptions: revenue will likely be lower than 2013 due to the end of quarterly license fee payments from Intellectual Ventures in May of last year and the Nielsen Company in January of this year. We expect expiration of these license payments to be partially offset by higher revenue from our Guardian products, higher Discover revenue from expansion into retail, and higher revenues from the central banks.

Although settlement of the arbitration with Intellectual Ventures improves the likelihood and potential amount of profit sharing from their licensing of our patents, we are not yet in a position to project when or whether we will receive such profit share. We expect gross margins to be around 70% based on an estimated revenue mix of 40% service, 30% subscription and 30% license.

2014 will be another investment year as we transition from R&D to market development and delivery to the Intuitive Computing Platform, Digimarc Discover, and the Digimarc Barcode. We will invest in selective research related to the Digimarc Barcode, our Intuitive Computing Platform and our virtual wallet solution for mobile payments, intellectual property development and monetization of our second wave patent portfolio, marketing of Digimarc Discover and the Digimarc Barcode for retailers and brand in support of the Shoppers Journey and faster checkout, and releasing new products and expanding market penetration of our Guardian antipiracy solutions.

We expect the operating expenses to be higher than 2013, reflecting a full year at the higher run rate established in the second half of 2013.

We are projecting an income tax rate of around 40%, unless the federal R&D tax credit is extended for 2014 before the end of this year. We are not prepared to discuss the impact of the federal R&D tax credit, if expected [ph] at this time.

We expect that existing cash will be adequate to fund our operations, dividend payments will continue to be evaluated by the board each quarter as part of our ongoing assessment of optimum capital allocation.

Please keep in mind that these highlights of our financial assumptions and operating plan represents our current view of expected values based on our assessment of the most likely unfolding of events over the course of 2014. As is our general practice, we intend to update each quarter regard execution of our strategy, but do not plan to provide detailed guidance.

Speaking of dividends, I am pleased to note that the board has declared a quarterly cash dividend of $0.11 per share on the company's common stock, payable on March 10 to stockholders of record as of the close of business on March 3. For further discussion of our financial results, and risk and prospects for our business, please see the Form 10-K that we expect to file shortly.

Bruce will now provide his comments on market conditions and execution of our strategy.

Bruce L. Davis

Thanks, Charles. The year got off -- started with a bang at the National Retail Federation Show where we demonstrated the game-changing performance of our Digimarc Barcode by being the world record for checkout of 75 seconds for 50 items by an astounding 27 seconds. We demonstrated the Digimarc Barcode not only as a significant cost savings vehicle for retailers, but also as a key element to the comprehensive mobile-optimized Shopper's Journey that we have developed. Most of the top retailers in the world stopped by to learn about the Discover platform. We had engaging conversations with many of them, and already have had numerous follow-up discussions. Planning is underway with more than one such retailer for detailed testing and potential implementation of the Digimarc Barcode and other elements of the Discover platform.

Our focus is turning naturally to delivery. Now that we have provided the provocative demonstration of our capabilities, it's time to close sales and deliver. Our team did an outstanding job of preparation for the launch, and we'll apply that same conscientious effort to delivering our first customers.

In updating our strategic plan for 2014, we are working out sophisticated model to estimate the labor cost savings that we would expect to deliver the retailers by increasing the speed of checkout. The model was intended to better inform our pricing, resource allocations and understanding of the potential value of our business.

Our preliminary findings indicate a very large market opportunity. According to our latest Annual Report released by the U.S Commerce Department in 2013, total retail sales in 2011 were $4.7 trillion, including food, service and automotive. The global market is probably around $15 trillion. The initial focus of our model was on America's largest general merchandise and grocery retailers who are sometimes referred to as hypermarkets. These retailers generally have the highest volumes of scanning merchandise at checkout, and thus, withstand to gain the most in labor cost savings. Again, our estimates are preliminary, and subject to change as we get the model. But we believe that use of the Digimarc Barcode in consumer packaged goods is capable of delivering billions of dollars of savings annually to the retail industry, if fully deployed. In addition, we believe that our solution will increase customer satisfaction to quicker-assist checkout and easier self-checkout and increased mobile consumer engagement in a lot of stores, among other benefits not included in the model.

We're in the process of employing one of the world's largest management consulting firms with having involvement in the retail industry, hoping to employ them to invest the model. After further study with such expert consultants, in a sample of our business partners and prospective customers, I intend to publish the model to solicit comments and criticisms from all interested parties and to establishing a strong foundation for use of the model and driving our strategy and communicating to the industry the extraordinary benefits we expect to deliver.

Our marketing development strategy continues to target world leaders in large-format value grocery retailers. Based on our impressive showing at NRS, we may be able to move fairly quickly to implementation with one or more Tier 1 retailers outside the top 10 to provide compelling demonstrations of our value proposition that will facilitate negotiations with the world leaders. While we're pursuing adoption of our platform for use at every marketing touch point throughout the entire shopper's journey, our primary focus is on establishing a strong foothold for the Digimarc Barcode at point of sale. We are recommending that the packaging enablement begin with the retailers' private label and brands. Private labels are an important and growing segment of the sales of most major retailers. As a point of reference, the consulting firm, Deloitte Consulting, estimated about private label sales accounted for 18% of American consumer goods dollar sales in 2011.

The enabling of private labels in conjunction with the purchase of image-based scanning equipment from on Data Logic will provide opportunities to objectively demonstrate the financial and other benefits of Digimarc Barcode at point of sale. Data Logic is the world leader in automatic data capture and offers a state-of-art solutions with fixed-position retail scanners, handheld scanners and mobile computers.

We expect initial shipments of Digimarc-enhanced scanners to begin in Q2. We are also encouraging retailers to integrate our software into their consumer applications for mobile devices to enable the full shopper's journey optimization across all their media. Once the financial impact of faster checkout is validated, we expect retailers to encourage the national brand suppliers to adopt the Digimarc Barcode as well. Demonstration by retailers of the effectiveness of Digimarc Discover in enhancing consumer engagement should provide additional justification for suppliers to become Digimarc customers. We've implemented low-friction, highly scalable customer acquisition and service model that includes online registration, purchasing and management of codes and associated network services. The encoding of packaging and other materials will be available in 2 ways: under a service bureau model, or a self-service via an online portal that can either be accessed directly or through free plug-ins through the Adobe Creative Suite of cloud services.

We have published pricing for the Digimarc Barcode that is consistent in structured an amount with what retailers and brands pay for traditional barcodes. Once we've bettered our industry value delivery model and we've demonstrated performance and actual implementations, we anticipate adjusting our pricing to a value-based approach.

Subscription in service areas of our business should also grow. According to a recently published study of mobile activation in magazines during 2013, Digimarc's share of that market doubled from 6% to 12%. Mobile activations increased nearly 250% over the prior year. The primary competition is QR codes and image recognition. The number of QR codes actually declined for the first time since reported and tracking mobile activations in 2010. I believe we are clearly a functionally superior activation means. As in traditional barcodes, we can do what they can do better.

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

The integration of the Attributor acquisition has been completed successfully, and we're now realizing the benefits of organizational integration and technology transfer. Our resulting business continues to grow with this Guardian antipiracy solution for publishers in North America, Europe and Japan. We're rolling in watermark based security to enhance the competitive differentiation that foster further growth.

We've completed another successful year of work with the central banks. We entered the second year of our contract extension that runs through 2024. Our work with central banks provide several strategic advantages to the company. In addition to building a strong positive reputation in the IT and printing industries, we've assembled a very talented staff with diverse skills that make valued contributions across other development initiatives.

Our R&D and IP development remain prolific. The retained portfolio continues to grow at a rapid rate. 82 patents were issued in 2013, with a majority of those issuances feeding our second wave, which has now grown to 77 issued patents. We filed over 100 patent applications last year, bringing the year-end total second wave patents pending to 344. The subject matter of innovations in the new filings include multispectral imaging, image processing for automated medical diagnosis, virtual wallet and mobile payments, low-power ambient audio signal detection and advances in watermarking in support of various retail initiatives among other things.

One area of R&D that has experienced a spike in interest from potential customers is the Digimarc Virtual Payment Card. Although this is still at the R&D stage and we've not yet demonstrated commercial feasibility, we're receiving an increasing amount of requests for technical disclosures in light of the rapid and significant shifts that are ongoing in the mobile payments market. The Digimarc Virtual Payment Card is intended to round out our overall Shopper's Journey value proposition to the retail industry by providing an intuitive branded mobile payments and coupons redemption interface at point of sale.

The timing and amount of license income to expect in 2014 is, as always, difficult to handicap. As most of you know, any profit sharing from IV licensing during 2014 would be reported and accounted for in 2015. We expect to receive a report from IV in March regarding 2013 licensing, and do not have a basis for projecting whether there will be any profit sharing reported there. Otherwise, licensing revenues for 2014 will be due to continuing royalties from existing licensees and any new license income we might derive from second wave marketing.

Recent market developments are very encouraging for licensing of the first and second waves. We are starting a number of announcements concerning use of audio and visual signaling to automate tasks and to power new experiences. See for instance Google's recent acquisition of SlickLogin and MTT's recent announcement of the potential launch of an augmented second screen service for television using digital watermarking in 2015. But it's not the only company linking television to smartphones, as accompanying press reports indicated, Fujitsu, Mitsubishi Electric and Dentsu are also developing similar services for linking TV programs and commercials with smartphones. Obviously, we've not done detailed IP analysis for these statements and not intended to imply any legal conclusions at all.

We are assessing such opportunities with a firm of IP experts that we have hired to assist us in developing and implementing the monetization strategy for our second wave patents. They will provide guidance on identifying the best potential licensees, pricing of our license rights and structuring of transactions. While working with these experts, we have begun marketing our second wave patents, and we'll report on any material developments as they occur.

That's it for our prepared remarks. Now we'll open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Bill Gibson.

William Gibson

Hi, Bruce. What catches my attention is the patent filings for virtual wallet and mobile payments, and you talked about increasing request. How do you feel about any technical hurdles from here? Is it just blocking and tackling that you think you can overcome them, or is there a timeline there?

Bruce L. Davis

No and no. The mobile payments marketplace is still in its infancy. It's not been very successful life to-date until the Starbucks initiative. And so Starbucks Chairman reported that -- and CEO reported in the last quarter that a substantial portion of their sales were now done from mobile devices using custom barcodes. And so that's the first time that mobile payments have kicked in and been successful. That has -- that lack of success has caused a great deal of controversy and tumultuous activity in the space. And so there are a number of different models that are being promoted and tested, and that needs to get resolved and settled down for us to participate and be winner. What we're providing is a relatively small piece of the overall puzzle. It's the user interface and the ideal here is that, as retail moves to imaging, our consumers could have a very comfortable, familiar presentation of the card that they're accustomed to presenting from the trusted brand they are accustomed to relying upon to pay for the transaction. And so that's what we want to license. So we want to license a software enablement of the communications protocol that's based on presenting your card to the point-of-sale imager in a way that will be well accepted by consumers. And we think that addresses a number of challenges that have not been adequately addressed thus far in the market. But my guess is that it will take a while to sort out. I don't anticipate this being a material contributor to our business in 2014, and I can't make any of assurance about it ever contributing, because it's really just at the R&D stage. What he wanted to note was that we let prospective customers know about this work and they all get really excited. But we don't quite know what that means yet.

William Gibson

It seems like there is a trend that's coming. And then just one little follow-up. You mentioned hiring some IP experts to help market second wave patents. Is there any way that help IV in marketing the first wave, or do you get involved in that, speed up their licensing?

Bruce L. Davis

We do routinely help them. And since the resolution of the arbitration, our relationship has improved considerably. In terms of the working relationships, everyone is quite comfortable now and we're doing a lot of mutual consultation about how to improve the licensing of the patents that have been exclusively licensed to IV.

Operator

[Operator Instructions] There are currently no further phone questions.

Bruce L. Davis

All right. Thanks very much, everyone.

Operator

I would now like to turn the call back over to Bruce Davis. Sir, please proceed.

Bruce L. Davis

Well, I will conclude the call then, and look forward to catching with you again next quarter or sometime in the interim. Thanks very much, everyone, for your support.

Operator

This concludes today's call. Thank you, ladies and gentlemen, for joining us today for our presentation. You may now disconnect.

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