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Executives

Bruce Davis - Chairman and Chief Executive Officer

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

Analysts

Corey Barrett

Paul Sonz - Sonz Partners

Andrew Weiner - Burnham Asset Management

Bill Gibson - Nollenberger Capital

Kevin Hanrahan - KMH Capital Advisors

Digimarc (DMRC) Q1 2011 Earnings Call April 25, 2011 5:00 PM ET

Operator

Good afternoon, and thank you for participating in today's conference call. Now we'll turn the call over to Chairman and CEO of Digimarc, Mr. Bruce Davis. Sir, please proceed.

Bruce Davis

Thanks. Good afternoon, everyone, and welcome to our conference call. Mike McConnell, our CFO, is with me. The objectives of this call are to review and discuss first quarter financial results, talk about significant business developments and market conditions and provide an update on our strategy and operations. This webcast will be archived in the Investor Relations section of our website.

Please note that during the course of this call, we will make 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 offer 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 financial filings -- the company's filings with the SEC, including our latest Form 10-K.

Mike will begin by commenting on our financial results. I will then discuss outlook and execution strategy. Mike?

Michael McConnell

Thanks, Bruce, and good afternoon, everyone. This was our second consecutive profitable quarter and third out of the past 5 quarters. We also had positive operating cash flow in 4 out of the last 5 quarters. We continue to believe that we will grow our revenues, profitability and cash flow during the balance of 2011 and maintain a very strong balance sheet, currently with more than $30 million in cash and no debt.

Continuing with the execution of our strategic operating plan, we made significant investments in growth initiatives including the marketing of our intellectual property, our joint ventures with Nielsen, development of additional intellectual property and Digimarc Discover, all centered on our vision of enabling computers, networks and other digital devices to see, hear, understand and respond to their surroundings.

Our Q1 2011 financial highlights include revenues of $9.1 million that were 11% lower than prior year, a period which reflected a one-time payment of $4.5 million for an IP license from Arbitron to buy $600,000 of nonlinear service revenues from some of our governmental relationships. In the current quarter, revenues from existing and new customers grew by more than $4 million, including $3 million from our new relationship with Intellectual Ventures.

Gross margins of 82% were consistent with prior year results as our mix of license and service revenues remained relatively constant. Higher operating expenses reflect increased investments in new product initiatives and the unusual litigation costs; an operating profit of $1.4 million or 15% of revenues; a $700,000 capital contribution to our joint ventures with Nielsen, where our share of the net loss was $500,000; and $15.7 million of stock repurchases, the vast majority being related to the acquisition of more than 550,000 shares from 1 of our early strategic investors.

Bruce will now provide his comments on our outlook and execution of our strategy. Bruce?

Bruce Davis

Thanks, Mark. As I noted in the press release, we got off to a nice start for the year. Our operating performance was in line with our expectations, and we were pleased to be able to negotiate the purchase of a substantial number of shares from Philips in January.

The other big news in the quarter was commencement of a beta program for Digimarc Discover, a platform we're building to deliver on our vision to seeing/hearing mobile device as a cornerstone of pervasive intuitive computing.

Since the introduction of the beta program at Mobile World Congress in mid-February, many interesting opportunities have emerged from nearly 800 trial user accounts and direct involvement with numerous newspapers, magazines, brands and service providers around the world. Several smaller magazines have started using the platform in public trials. The beta program is scheduled to run until the end of May. It is intended to help us to refine our offering, study demand and prepare for active marketing in the second half of the year.

Meanwhile, we are beginning outbound marketing in newspaper and magazine industries. Marketing will ramp up throughout Q2 as we prepare for commercial launch. Early adoption by magazines and newspapers will have ancillary marketing benefits, educating in increasing awareness among consumers and advertisers and attracting attention from brands and their agencies.

As we are beginning commercialization of Digimarc Discover, we continue extensive research and development of subsequent phases, including basic performance enhancement, broadening and intervening various means of object recognition and innovating in higher order task for sensor fusion and inference.

During Q2, we plan to introduce music recognition in 1D barcode and QR code reading, progressing toward the creation of the universal reader that uses various technologies to identify the content consumers want to experience further. As you know, our ultimate goal is to enable mobile devices generally to see, hear, understand and respond with optimized network services when instructed by users to look or listen.

In other positive news, several major movie studios have initiated early video-on-demand release with DIRECTV giving the consumers earlier access to movies even if they are still being shown in theaters. Digital watermarking has been featured prominently in announcements of the new services as a key element to the security model for this new consumer opportunity.

As various news reports indicate, the licensing program in Intellectual Ventures has been heating up. We take this as a good sign. In parallel, our development activities in media and mobile markets continue to teach the value of the portfolio to an increasingly large audience.

In the government sector, things are going well as we expect to enjoy good growth in 2011 both in our international anti-counterfeiting program and the U.S. Federal market.

It's been quite an interesting day for our Media-Sync joint venture with Nielsen. We announced recently that The Weather Channel has become its second customer, joining ABC, that uses Media-Sync to enhance Grey's Anatomy.

There are many signs of transformation in the television-viewing experience along the lines we have anticipated. More engaging, more social television paradigm is developing rapidly with many suppliers jockeying for position. Earlier today, we learned that Yahoo! has acquired 1 of these companies IntoNow. We also learned that Walker Digital has filed a patent infringement suit against us based on the Media-Sync offering. Having just learned of both these developments, we don't have much more to add for the time being. Things are obviously heating up.

Overall, we're executing well on our strategy and anticipate a very exciting and rewarding year ahead. In closing, I'd like to thank our partners, clients, employees for their continued support and commitment to Digimarc's progress for making our vision a reality. Now we'll open the floor to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Corey Barrett of Pacific Crest.

Corey Barrett

I just wanted to first ask if there's any new developments that you'd be able to talk to with regards to the Verance matter?

Bruce Davis

There is. The -- there was a hearing in a Delaware action last week, I believe, about a week ago, on Wednesday. And I learned just a few minutes ago that the transcript from that hearing is available on PACER. And for anyone who's not familiar with PACER, it's an internet-based service where you can find legal pleadings or litigation documents.

Corey Barrett

Okay, perfect. And then I was hoping you’d talk or provide a bit more color on the Discover beta and just sort of what kind of traction you're getting there. You commented that you're seeing encouraging response. So is there anything you can add there?

Bruce Davis

Well, as I noted, we just had about 800 trial users sign up on the Online Services Portal, and we have ongoing involvement with a number of publishers and potential service organizations around the world. So there's a ton of stuff going on. It is, in fact, behaving like a beta. That is although there's tons of stuff going on, which we are yet to target, and we don't yet have the contracts. And so we're beginning outbound marketing, and we will be beginning charging at 1st of June. And we're looking forward to a very interesting second half of the year as we begin the commercial rollout. We do have some people paying us right now, but the dollars are pretty small. Among the opportunities, there's a lot -- there are a lot of very interesting, very exciting opportunities, but I got to see if I can bring them home into contracts, revenue-bearing contracts in the latter half of the year.

Corey Barrett

Perfect. And then can you quantify the breakdown of your IV-related revenue between the licensing fee, the $36 million licensing fee over 3 years and on top of that, what's coming from your 20% share of profits?

Michael McConnell

This is Mike. We had about $3 million this quarter from our IV relationship. And about just under $2.8 million came from the license, and the rest came from the services revenue.

Bruce Davis

And there's no profit participation yet, Corey. None was expected.

Corey Barrett

Okay, perfect. And then lastly, could you just talk about your share repurchase plans for Q2 and the rest of the year?

Bruce Davis

Yes. We have authorization granted by the board to continue to do buybacks on a discretionary basis. There's $3 million in the authorization. So we'll continue to monitor the market and determine when and if additional purchases ought to be made.

Corey Barrett

Okay. Thank you. That's all I have.

Michael McConnell

All right.

Operator

Your next question comes from Kevin Hanrahan of KMH Capital Advisors.

Kevin Hanrahan - KMH Capital Advisors

Thanks for having the call. I wanted to ask about the buyback, following up on what Mr. Barrett was just talking about. Did you repurchase any shares during Q1 aside from the shares you bought back from Philips?

Michael McConnell

We did. We purchased about 16,000, 17,000 shares under the buyback program.

Kevin Hanrahan - KMH Capital Advisors

Separate from the Philips transaction, which was kind of like a negotiated deal?

Michael McConnell

Right.

Kevin Hanrahan - KMH Capital Advisors

Right. So can you tell us how many total dollars you spent in Q1? Maybe...

Michael McConnell

We spent $15.7 million.

Kevin Hanrahan - KMH Capital Advisors

On share buyback. Okay. That's great. And then I have a question for Bruce about Shazam, if you can give us an update about -- so I think the last thing that happened there is you're kind of trying to reconcile or settle your differences. So if there's anything you can tell us about that, what's going on with the Shazam litigation.

Bruce Davis

Yes, there's not much more I can give you, Kevin, at this point. We're continuing to figure out what the optimal relationships are in the music discovery business. As you know, there are a number of firms doing similar things there. We may partner with 1 or more of them in some fashion. All of them would be subject to marketing from Intellectual Ventures in the event that we don't partner with them, and so we're still in that stage of trying to figure out what makes sense.

Kevin Hanrahan - KMH Capital Advisors

Would you say that -- is Digimarc negotiating with Shazam, trying to come to a settlement or the IV be taking the lead on that?

Bruce Davis

IV now has the rights, license rights necessary for -- in our view, for Shazam.

Kevin Hanrahan - KMH Capital Advisors

For those marketing opportunities?

Bruce Davis

Yes. What our role is in the mix here, besides providing advice and assistance to Intellectual Ventures, is trying to determine if something more than the simple license agreement makes sense with 1 or more of the companies in the space.

Kevin Hanrahan - KMH Capital Advisors

Okay. Thanks so much, Bruce.

Bruce Davis

You bet.

Operator

Your next question comes from Paul Sonz of Paul D. Sonz Partners.

Paul Sonz - Sonz Partners

I have 3 questions. One is, Bruce, did you talk about -- did you say earlier on in this call that you were going to introduce a music recognition program?

Bruce Davis

I did. That would imply some progress, and I was just talking about it with Kevin.

Paul Sonz - Sonz Partners

Okay. All right. And so I assume that that's all you're going to have to say about it. We'll just wait to hear -- wait for future events to be disclosed or something.

Bruce Davis

That's right.

Paul Sonz - Sonz Partners

Okay. You also said something in your succinct style about -- that you were putting together a program that was going to merge various types of identification programs, which would be barcode and other different ways of identifying things. Could you say a little bit more about that?

Bruce Davis

Sure. Our vision and strategy for Digimarc Discover is that the reader application, the software that goes in the mobile device will take advantage of all the various ways that have been developed and continue to be developed to identify objects in -- I call them objects and scenes but images and sounds. And so we're adding music recognition and barcode and QR code reading in Q2 to the platform so that the consumer experience is optimized. We believe watermarking is a very important means of identifying such objects but not the only means, and in some circumstances, alternatives may be helpful. And so we're integrating the alternative means of recognition into the platform.

Paul Sonz - Sonz Partners

What is the -- you said QR. What is that? Is that the 1 that sort of looks like a Rorschach inkblot test?

Bruce Davis

That's the 1.

Paul Sonz - Sonz Partners

That's the 1. Okay. All right. Excellent. And then you talked about that Yahoo!, just this morning, bought someone's company. And how does that relate to Digimarc?

Bruce Davis

They bought a company called IntoNow. And IntoNow has developed the means to recognize television programs by looking, generating and matching fingerprints of the audio stream for television programs.

Paul Sonz - Sonz Partners

And that would fall -- do you have...

Bruce Davis

So the Media-Sync realm of things.

Paul Sonz - Sonz Partners

Do you have a relationship with that company already?

Bruce Davis

They're our competitor.

Paul Sonz - Sonz Partners

I see. They're a competitor, oh. And so would this be -- would you view this as good news or bad news?

Bruce Davis

I view it as good news and in a number of ways. One is that it's obvious that Yahoo! thinks that this has the potential to be something quite big. Rumor has it they paid a fancy sum for a brand new start-up. And as you know, we've been working on this for quite a long time. We believe that we, meaning us and Intellectual Ventures, may have relevant IP. So the more, the merrier. And the big companies involved, we think, is generally, strategically a good thing for us. It's inspirational because of the obvious competitive capability that Yahoo! has, so it's going to cause us to make sure that we're making our best efforts at all times in the Media-Sync venture. And I don't know how this all plays out in the end, but I think that we and our technology and our IP end up in the endgame whatever that may be. But it's encouraging to see the investment going into the category and the increasing scale of the participants.

Paul Sonz - Sonz Partners

In terms of its -- the way that they accomplish the interaction with the television, does that -- is that separate from the way that you do it? Or is there a potential for an intellectual property dispute here?

Bruce Davis

Yes, I'm not going to try to characterize any infringement risk here on the phone. That's the work we do in private and present to appropriate potential licensees as the case may be.

Paul Sonz - Sonz Partners

All right. One last question. You talked about growth in revenue from government, and you talked about federal. And I didn't know whether that would include stuff with the Department of Defense or whether that's separate.

Bruce Davis

Yes. As you know, I don't like to try to forecast this area of the business very much, because it's too difficult to do that. But it does look like we're going to get some business out of that area, and so we may have some good news to report a little later on. But again, it's subject to all my usual caveats on the federal business.

Paul Sonz - Sonz Partners

All right. Well, good. Excellent. It's really -- it's very encouraging to hear a progress in so many fronts. Thank you very much.

Bruce Davis

You're welcome, Paul.

Operator

[Operator Instructions] You have a question from Bill Gibson of Anderson Strudwick.

Bill Gibson - Nollenberger Capital

Bruce, you went over the Yahoo! acquisition and then the lawsuit real quick. Who -- what was the lawsuit that followed the acquisition?

Bruce Davis

Yes, I went over them real quick, because I just learned about them. So I'm basically telling you what I know. There is a company called Walker Digital, and its founder is Jay Walker, who was the founder of Priceline. And Walker Digital is in the innovation business. They're a bit like us in their basic business approach. And they alleged that the Media-Sync platform or some attributes of it infringed on a patent that they own. So they sued us for patent infringement.

Bill Gibson - Nollenberger Capital

Okay, good. Thank you.

Bruce Davis

Yes.

Operator

[Operator Instructions] Your question comes from Andrew Weiner of Burnham.

Andrew Weiner - Burnham Asset Management

Bruce, I just want to clarify something, I realize you haven't had a full chance on the suit. Did they sue the joint venture? Or did they sue Digimarc itself?

Bruce Davis

They sued everybody. They sued Digimarc, Nielsen, Disney, The Weather Channel, Apple and the 2 joint ventures.

Andrew Weiner - Burnham Asset Management

Okay. And do you have any more color on the nature of the patent claims? Is it around content identification? Is it a business process?

Bruce Davis

Well, the complaint is available on PACER, I believe, and I just got it a couple of hours ago, and like I said, it alleges infringement of 1 patent. And I won't try to characterize what the patent says, because that will be inappropriate given we're in litigation, but you can read it. You can easily find the patent once you get the complaint and take a look at it.

Andrew Weiner - Burnham Asset Management

Secondly, Mike, you made a comment in the prepared remarks that if you were to exclude the one-time payment from Arbitron as well as some unusual -- sort of unusually high level of service activity around the central bank contract, that existing sort of ongoing revenue streams increased $4 million year-over-year.

Michael McConnell

That's correct.

Andrew Weiner - Burnham Asset Management

I assume that is a number that's net of whatever reduction we receive from Verance.

Michael McConnell

Actually, Verance is a 10% customer this quarter, so that Verance would have had an increase over the prior year.

Andrew Weiner - Burnham Asset Management

Okay. And is that still based upon them paying what they feel is the right number?

Michael McConnell

That's their calculation of the worth, correct.

Bruce Davis

Yes. Andrew, I can help a little bit on this 1. The number we're recording is actual cash received from those guys.

Andrew Weiner - Burnham Asset Management

Okay. Okay, next question I had was if you could talk a little bit more about our sort of intuitive computing efforts. Or when you talked about sort of Digimarc Discover per se, I know our focus has been on the publishers. However, what we're doing very much overlaps with some of the large search engine providers and a variety of other mobile commerce, advertising, marketing players. Is Intellectual Ventures pursuing strategic relationships of that nature and we’re looking to go only directly to publishers per se? Or are we involved at all in trying to accelerate adoption of our technology across a broader range of sort of channels, if you will?

Bruce Davis

We're involved across the board. Intellectual Ventures is, as I noted, generally appear to be ramping up their licensing work, which is a good thing. And we understand that they are actively marketing our portfolio, and we're helping them wherever we can. And we're also trying to increasingly demonstrate the value of our technology across the range of markets that we target, which helps them indirectly. And then their work hopefully helps us indirectly by providing awareness and where appropriate, freedom to operate for some of the potential implementers. So everything seems to be going along fine. It's obvious that there's a lot going on in our general product market area, so I'm very encouraged. I don't -- I haven't lost any enthusiasm at all. It's a pretty complex landscape, and we're navigating our way through it here, but it does seem like our vision of the market is well founded.

Andrew Weiner - Burnham Asset Management

And I mean and we -- and I've seen that as well. I guess what I'm also trying to understand is like if you take like an IntoNow for getting the actual application but seems to sort of this idea of media identifications through the use of a fingerprint and then linking it to information via network or [indiscernible] that was -- some of the IP that we've talked about owning and that there's been numerous examples of companies not just in sort of the Media-Sync-like application but in what I'll call sort of the Digimarc -- more directly aligned with Digimarc Discover. Is Intellectual Ventures going to be taking the lead in determining where to pursue legal action or try to enforce the intellectual property? How much say do we have in that? Where are we in the sort of market development? Because there seems to be an incredible amount of activity in businesses being acquired, funded, et cetera around this.

Bruce Davis

Yes, they have the legal right to exercise discretion. The practice has been and I expect to continue to be that we collaborate in identifying targets and developing marketing plans. So we're working together on these things, and yes, there's a lot going on.

Andrew Weiner - Burnham Asset Management

Thank you.

Bruce Davis

Yes. And also, I would just add for everyone's benefit that some of our retained assets, which we believe will mature into issued patents over the next few years, are relevant to this general space as well.

Operator

You have a follow-up question from Paul Sonz of Paul D. Sonz Partners.

Paul Sonz - Sonz Partners

A question on Verance. I was not aware that they were continuing to make payments. Is there any estimate you can give us as to the difference between what they paid and what you think you should have been paid for the quarter?

Bruce Davis

No. No, they are trying to keep pretty tight wraps on everything based on the confidentiality provisions of our license.

Paul Sonz - Sonz Partners

And so they basically have written you a check and said this is what we think is fair?

Bruce Davis

No, no. They just made their quarterly payment under the license that we have. They alleged that they're continuing to perform, and thus, they're paying what they think they should pay, and we have a disagreement about that. But they continue to pay, because they continue to allege they're operating under the license.

Paul Sonz - Sonz Partners

I see, and...

Bruce Davis

So it's just the quarterly payment. There wasn't any settlement of any kind. There was just the quarterly payment that they felt they should be making.

Paul Sonz - Sonz Partners

Yes, I understand. And is that a variable? Does that vary from quarter-to-quarter depending on what they see in their internal numbers? Or is it just a flat rate that they're paying?

Bruce Davis

It's a royalty.

Paul Sonz - Sonz Partners

Okay. All right. Thank you very much.

Bruce Davis

You're welcome.

Operator

At this time, there are no further questions. I will now turn the floor back over to Mr. Davis for any closing remarks.

Bruce Davis

All right. Thanks, everyone, for dialing up. It looks like it's going to be quite a year. We're working hard and optimistic about our outcomes. So I look forward to talking to you again in another quarter and let you know how we're progressing. Thanks very much.

Operator

Thank you. This concludes today's conference. You may now disconnect.

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