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Executives

Bruce Davis - Chairman, Chief Executive Officer and President

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

Analysts

Walter Schenker

Paul D. Sonz - Paul D. Sonz Partners

Keith Maher - Singular Research

Digimarc (DMRC) Q3 2012 Earnings Call October 25, 2012 5:00 PM ET

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 Davis

Good afternoon. Thank you for participating in today's conference call. Welcome. Michael McConnell, our CFO, is with me. On our call today, we will review and discuss Q3 2012 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 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. 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 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.

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

Michael McConnell

Thanks, Bruce, and good afternoon, everyone. Revenues for the quarter was $8.9 million for 2012, an increase of 4% from $8.6 million in the third quarter of 2011. Our licensing revenues increased 16%, primarily due to increased revenues from Intellectual Ventures and Verance. Our service revenues were down 16%, mostly due to the suspension of the joint ventures with Nielsen in the first quarter.

Our gross margin increased 84% in the current quarter from a year ago and primarily due to a higher proportion of licensing revenues versus service revenue. Our operating income increased 11% to $1.6 million or 18% of revenues in the third quarter from $1.4 million or 17% of revenues in the same quarter a year ago. And the increase is primarily due to higher gross margin.

Our pretax income more than doubled to $1.6 million, due largely to the elimination of approximately $700,000 of Nielsen joint venture losses recorded in the year ago quarter that were not incurred this quarter due to the previously announced suspension of the joint venture operations with Nielsen.

Our income taxes were 39% of pretax income for the quarter compared to 17% in the prior year, with the 2012 results reflecting a more normalized tax rate after benefiting from utilization of NOLs and deferred tax assets in 2011.

Our net income increased by 57% to $1 million this quarter compared to $600,000 in the third quarter of last year. Our balance sheet remains in excellent shape with about $43 million of cash and market securities and no long-term debt.

Our operating cash flow was $1.3 million or 15% of revenues, and we purchased about 73,000 shares of common stock during the quarter at an average price of $23.44.

Our financial performance, thus far, in 2012 is within the range of our expectations at the start of the year. Note that the current year's licensing revenues reflect the $8 million past due royalty payment from Verance received in Q1 of this year, and the current year service revenues reflect approximately $1.8 million lower revenues from the Nielsen joint ventures.

Excluding the impact of the Nielsen joint ventures and the Verance items from our revenues, we see a 6% revenue growth year-to-date in 2012 versus 2011, and the primary contributors to this growth was in licensing from Intellectual Ventures and in our government services area.

And finally, I'm pleased to note that Digimarc's Board of Directors has declared a cash dividend of $0.11 per share of the company's common stock. The dividend is payable on November 20 to shareholders of record as of the close of business on November 6, 2012.

For a further discussion of our financial results and risks and prospects of our business, please refer to our Form 10-Q for the third quarter that we expect to file very soon.

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

Bruce Davis

Thanks, Mike. The level of activity on all fronts escalated in Q3. I'll touch on some of the highlights that are ripe for public disclosure.

First, I'm pleased to announce that we've agreed on a budget for 2013 with our Central Bank customers that anticipates approximately 14% revenue growth with higher gross margins.

Next, concerning Intellectual Ventures. And as you know, our agreement with IV provides a 20% profit participation after contractually authorized costs are deducted from revenues attributable to our portfolio. As previously discussed, we have received 2 profit participation reports from IV: one for the fourth quarter of 2010 and another for the calendar year 2011. The next report is due March 2013. The first 2 reports indicated that there was no profit for those periods.

In the earnings release call on April 26, we acknowledged that we had received our first full year report from IV. License revenues attributable to our portfolio were substantial but not sufficient to cover the $36 million of minimum guarantees and other IV costs associated with our portfolio. And that given this was our first full year report, we had spent considerable time with IV discussing questions and concerns about allocation of revenues and costs.

In our earnings release call on July 26, we remarked that following a series of informal discussions with IV, we had begun an audit process with the assistance of an expert professional services firm. We noted that, given the importance of this license agreement to our business, we believed it was incumbent upon us to conduct additional diligence on the reports and gain comfort that we had an adequate understanding of their continents before publicly characterizing the financial implications in more detail. The audit has not yet answered all of our inquiries. And we are continuing to discuss the results with IV, but we do not yet agree with the revenue or expense allocation methodology or results.

IV and Digimarc have made significant progress in monetizing the portfolio, and we intend to continue to work together on further monetization. IV reported substantial licensing activity during the first 15 months of the agreement, resulting in $27 million of revenues recognized and received, and we estimate that there is an additional $23 million or more in revenues expected to be received by IV over the next 7 years for a total of more than $50 million attributable to monetization of the Digimarc portfolio during the first 15 months of licensing.

Under our agreement with Intellectual Ventures, profit participation is determined using revenues recognized and received. Offsetting costs include an accrual for the $36 million guarantee that is being paid quarterly to us. Given this, regardless of other costs, including those that are still subject to discussion and further inquiry, no profit has been generated. Proper treatment of revenue and expenses is critical to our profit participation and an important factor in assessing the likelihood and timing of profit participation, if any, after the guaranteed minimums expire.

Regardless of the outcome of the reporting issues, profit participation is speculative and dependent on numerous other factors, most notably the amounts and value of use of our inventions in the marketplace. We remain optimistic that market trends will foster adoption during the life of the patents.

We value our relationship with IV, and we believe we can work together effectively and share the profits. We hope our differences can be resolved sooner rather than later. Meanwhile, we will continue to work together to further monetize the portfolio. In this regard, numerous additional license prospects have been specifically identified, ranging from venture-funded companies to multibillion multinationals.

Regarding our publishing industry market development, we witnessed a tremendous increase in activity in Q3. Before getting into the numbers, I continue to caution that the market is young as is our involvement, and there's still a lot of ongoing experimentation so trying to extrapolate trend is risky. With this in mind, we note that distribution of our software platform is gaining ground, with more than 500,000 watermark detectors deployed globally via Digimarc Discover and numerous third-party branded applications. There was an increase in the number of countries in which there was some detector activity from 110 to 132.

Top territories included the U.S., Australia, U.K, Canada and Netherlands. The U.S. accounts for more than 70% of the total global activity. The majority of these estimates of detectors and detection involves scans [ph] from magazines. With relatively small amounts of activity outside the magazine industry, including in newspapers, books, stamps and marketing materials.

As you know, our market development focuses on the magazine business. Publishers purchased 750 watermarks in Q3, up over 80% from Q2. The number of connections from watermarks to network services by readers grew nearly 450% quarter-to-quarter to over 800,000. The principal payoffs for consumers are videos, coupons, sweepstakes and product information.

There were 80 Digimarc-enabled magazine issues during the quarter involving 24 magazines, including 12 magazines in the top 100 in circulation in the U.S., employing an average of 9 watermarks per issue. Seventeen Magazine, alone, employed nearly 250 watermarks in its back-to-school issue. Our customers included titles from all 3 major group publishers.

Last quarter, I noted we were engaged in joint R&D initiatives with a major network service provider, a Fortune 500 services brand, a radio station group owner and a major bar code equipment and services supplier. We believe we are in the final stages of negotiating a term sheet with the network service provider, defining major deliverables and business terms. Things seem to be going well.

Our radio-oriented activity is split along 2 paths. In one, we began discussing an R&D collaboration with a complementary service provider to provide a more complete solution for market trials involving the group station owner. In the second thread, we carried out nationwide tests of digitally watermarked ads in television as well as in radio. We believe we are making good progress with audio watermarking research and development and intend to explore various paths to commercialization in 2013.

On the packaging front, we did a successful proof of concept demonstration of watermark packages for increased throughput at checkout during the quarter. We're very excited about the prospects and are engaged in more extensive testing with a potential market development partner and beginning discussion of business terms for the proposed alliance.

We presented our 2013 operating plans with the board earlier this week. We have a robust agenda for next year, and I want to share some of that with you. Our key goals include the following. One, grow revenues and margins from our government work. Our new contract with the Central Bank customers lays the good foundation for those. Two, improve the likelihood and magnitude of our Intellectual Ventures profit share. Three, increase penetration in publishing. This includes effectively communicating the business model implications of Discover as we seek to change the basic business model of the publishing industry, get magazines to go beyond experimentation to routine use and achieve at least a tenfold increase in watermarks in magazines and grow the addressable market, as well by achieving routine use in more magazines, books and catalogs.

We also want to increase detector distribution. To do this, we intend to increase adoption of our platform and companion applications for magazines and product and service brands, deliver music discovery functionality as it has sufficient value to increase download to Digimarc Discover, in addition to those downloads for the current market leaders, Shazam and SoundHound. We want to forge effective partnerships with network operators to increase the distribution of the Digimarc Discover platform and leverage the sales and marketing resources of these operators to increase our market share and revenues. Fifth, we want to commercialize digital watermarking for music. This will require securing a reliable source of supply for fingerprint-based identification of music, integrating the fingerprinting and watermarking Discovery algorithms in our platform and marketing an integrated solution to artists' labels and other participants in music marketing and distribution.

Next, we want to build a virtual interface for at least one major service provider brand around the capabilities we bring to mobile devices. Specifically, making it work with the first customer that we are already engaged with, build a reference design for an industry solution, deliver the proof of concept to other service industries and articulate how this model applies to consumer packaged goods.

Then on to packaging. We intend to have a developed -- have a go-to-market plan and partner for the packaging business. Our long-term goal is to become the successor to conventional bar codes for much of the automatic data capture market, including retail checkout, and to demonstrate the extended value in consumer pre- and post-purchase benefits of digitally watermarked packaging and shop for marketing materials. We then intend to link our packaging and mobile intuitive interface work with our indoor location R&D.

All these developments flow into our patented, intuitive computing platform design. We will optimize patent claim capture embodying all these elements. Our goal is to have sufficient licensable IP to project significant new license income sources before we exit 2013. This process includes identifying target markets and companies, optimizing the portfolio in relation to these targets, expediting issuance of high-value claims and beginning the marketing and enforcement, if necessary.

We have an ambitious agenda for 2013. We continue to believe that seeing and hearing will become routine functions of mobile devices. This is, in our view, the natural successor to first-generation keyword search functionality popularized by Google. And as I noted in the last call, the developments that we are pioneering will foster more complete and engaging relationships between brands and their customers and prospects, providing customer intimacy, accountability and access to critical information about their shopping and consumption characteristics. This dovetails nicely with the growing desire of brands to tell stories of productivity and lifestyle enrichment in the new social networks and more effectively manage and deliver value-added brand experiences to their customers. It also fits well with new methods of integrated media marketing, providing consumers with greater flexibility and how, when, where to get their products and services and information and helps them make purchase decisions.

Social media channels are increasingly influencing consumer decisions and the shape of media experiences. There is a need to connect better to these decision support systems, that is obvious. The markets affected by improved seeing capabilities include -- in mobile devices, are large and diverse, including identification of documents, newspapers, magazines, direct mail, catalogs, sales and marketing collateral and packaging. These media can be recognized using a variety of techniques.

The hearing function applies primarily to TV and radio. Popular recognition means include audio fingerprinting and watermarking. The context in which things are seen and heard by mobile devices contains important clues as to the intent of the user, which factors into determining the optimal network services when an object is recognized. Currently, one of the most widely used elements of context is location. Location-based services are a well-established utility of mobile devices that are mostly limited to high-level directions to outdoor places and serving ads targeted by these location determinations. Providing precise indoor locations and form with other contextual data will deliver compelling user experiences and market research, and this is the next frontier.

Our R&D converges in the model of efficient and effective management of resources supplying the seeing, hearing device functionality. Multimodal recognition by mobile devices across multiple media types in a variety of contexts requires sophisticated resource management. We have been working on this for many years. We refer to this body of work as the intuitive computing platform. We have many patent-pending inventions in the space. Our first patent based on this work issued recently. We expect a large patent family to develop over the coming years, feeding our second-wave patent portfolio.

We don't anticipate significantly increasing our operating budget in order to accomplish our 2013 goals. We will focus on proving commercial value of our inventions and then delivering substantial additional licensable technology and patent assets, addressing numerous exciting advancements in media identification, management and enhancement. We have plenty of cash to fund growth, pay dividends and consider acquisitions.

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

Question-and-Answer Session

Operator

[Operator Instructions] You have a question from Walter Schenker of MAZ Partners.

Walter Schenker

Listening to a very long menu of things you're hoping to accomplish or move forward on in 2013. The first item, which is government you indicated, you gave us some indication of what at least the revenue implications might be. As you look down that list, which items should start to generate meaningful incremental revenue -- incremental -- meaningful to a whole company in 2013 [ph] incrementally and which are early still in development as you move forward and probably won't be showing up in 2013 in any meaningful way in the company's revenue? I mean, can you semi-prioritize or give us some feel for at least from a revenue standpoint, which are more significant?

Bruce Davis

Sure. The Central Bank business is the easiest to project because we have a budget, okay? And that's why I called that out specifically. We will continue to get license income from all of our existing license sources, all of whom can grow. And some of those are on a payment schedule, in essence, so are not likely to grow a lot. Others are more variable, could decline or grow. One of the significant expected growth areas is in Digimarc Discover, in the publishing industry. We also have a number of other initiatives that are too early to speculate as to 2013 revenue production, having to do with the various relationships that we're putting in place. And the last piece, of course, is Intellectual Ventures and whether there will be profit participation in the March reporting -- March 2013 report.

Walter Schenker

And then just one more question. On the -- since you brought it out, on the publishing industry and the use of Digimarc Discover, the per-application fee is very low but you're therefore expecting that, when we have this call a year from today, you'll be able to call out that operation as being a -- hopefully being a noticeable in the incremental growth of the business. That's a correct statement?

Bruce Davis

Yes, that's what we hope will be true, Walter. As we look at the early development of the market here, again, not done through enough early market development to not get too far ahead of the curve on trying to project how trends will go. Because they can go up, down and all around for while. But we think if we can get the publishing industry to appreciate the opportunity that our technology provides to the brands, that is to the entire brand of any publisher, not just to their print publication but to their digital editions as well. If they will understand that and they will go to routine use rather than experimental use, we actually think we'll begin making quite good money as early as next year. But there are a bunch ifs in there that we have to work our way through in order to get to the sustainable, large income stream. Now the activities that we have succeeded in delivering so far is a very, very small share of the addressable market. So looking at different metrics and market data available to us, we're somewhere ranging from less than 1% to between 1% and 2% penetrated, using different measures of market penetration. So if we could just get to, say, 10% or 15%, we would have a very nice business. So we're going to try to figure out how to get this past the experimental phase during the remainder of this year and going into '13. So that's the critical assumption on the publishing business.

Walter Schenker

Okay. And just -- and I'll get off. I would -- as a shareholder, I appreciate that you've been buying stock. And hopefully, you will continue to do it, since I think it will accrete pretty good value to us over time.

Operator

Your next question comes from Paul Sonz of Sonz Partners.

Paul D. Sonz - Paul D. Sonz Partners

The question I have is, Bruce, you talked about the revenues in the Intellectual Ventures deal. Are the revenues open to interpretation? Or have you settled on that -- is that the revenues numbers you gave us agreed upon now and that's settled and now you just moved on to talking about the allocation of expenses?

Bruce Davis

Let me see if I can give you a clear answer to that. So we gave you a couple of numbers. We gave you revenue recognized and received and then an estimate of additional revenue that hasn't yet been received. So the first part of that is reported revenue received. The second part is an estimate, our estimate, okay? Just to be clear about that. With respect to all aspects of the reports, our study and discussions are still under way. And so there could be some changes in any of the numbers that I've given you. I'm more confident about the revenue numbers than the expense numbers at this point in time, that's why I shared the revenue numbers. I think they're reasonable estimates.

Paul D. Sonz - Paul D. Sonz Partners

All right. And then the second revenue number you gave us, it represents revenue that, under no circumstances, would be considered to have been received this year but is subject to be -- to receipt over the next 4, 5, 6 years, whatever, I can't remember the number of years you gave me.

Bruce Davis

Yes. The way the profit participation is defined in our relationship, the revenues have to be both recognized and received to count. The expenses, however, particularly those associated with the money being paid to us, are accrued even before paid.

Paul D. Sonz - Paul D. Sonz Partners

Got it. I see, I see. In terms of the -- can you give us a sense of how meaningful the discrepancy is between yourself and IV?

Bruce Davis

No.

Operator

The next question comes from Keith Maher of Singular Research.

Keith Maher - Singular Research

Just letting you know, I got knocked off there at the start of the QA – the Q&A, so if I ask a question that's already been asked, just let me know and I can go back to the transcript. But with the -- starting just with regard to the work with the Central Bank, is this an expansion in the scope of the work? Or is it just increased pricing that's driving, I think you said, a 14% growth next year?

Bruce Davis

Yes, it's both.

Keith Maher - Singular Research

Okay. Could you talk -- I mean, could you divide it up or...

Bruce Davis

No, we don't want to get into that level of granularity on an individual contract.

Keith Maher - Singular Research

Okay. Okay. Okay, sure. Next, with -- on the Intellectual Ventures differences you're having. If you cannot amicably resolve this, I mean, would you need to go into -- would the next step, for example, be arbitration? I mean, I assume that might be in the contract. I mean, can you talk any about that? Or how you would resolve some of these differences?

Bruce Davis

Yes. I don't want to forecast the failure of our discussions here. We'll go where we need to go in order to get to a fair result. At this point in time, we're continuing to have meaningful discussions with our colleagues there, and we hope to work out a way in which we can maximize the profit from the portfolio and share reasonably in it. And I think that's certainly our goal, and I believe they share that. We just have some different views on how the accounting is -- has been done and some continuing uncertainty regarding some of the items. So we're working that through, and we'll see where it ends up. I don't know where it will end up just yet, but I'm optimistic.

Keith Maher - Singular Research

Okay, fair enough. And finally, you were talking about the operating budget next year, kind of not needing to increase that. Is R&D separate from that? Or were you just talking about SG&A in the operating budget?

Bruce Davis

It's total budget. Even though I outlined an ambitious and sophisticated agenda for 2013, much of what we're doing in '13 is bringing together the elements of the platform into what we hope will be valuable demonstrations of capability and expanded license opportunities. And so nothing of what we're talking about there is new to '13. But rather than working on the pieces, as we've been working on the pieces in prior years, we're more focused on bringing those pieces together in '13, both at a development level and a marketing level.

Operator

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

Unknown Analyst

Bruce, I had a question about the IV relationship, but not similar to the other ones we've heard. When you announced that deal about 2 years ago, and I was in your office I think the next day, you were talking at that time about service contracts. As -- hopefully, the patent portfolio would generate more license deals, but no one would know how to implement them better than Digimarc. So can you tell us, in addition to those numbers you mentioned, I think $27 million and $23 million to be recognized over time, do you have any service revenues yet that have been generated from the IV deal?

Bruce Davis

You're talking about providing implementation services to licensees.

Unknown Analyst

Yes, that's right. Yes.

Bruce Davis

Yes. That hasn't played out yet, and it was an assumption that I had, including the other relationships. I'm still not sure it's a failed assumption, it just hasn't happened yet. So there are some indications that it may prove to be a good one but may take a little more time. And this goes to another point that I've tried to make and I hope everyone appreciates, is that, whatever our complexities in our relationship with Intellectual Ventures may be, the key to our mutual success is generating greater adoption of our technology. And so the big players are still heading in the right direction but not there yet. So that would explain why I'd say what I would do with respect to potential implementation services. But I'm still hoping the big guys are going to get onboard pretty soon. And when they do, I hope they'll come to us for help. We'll be happy to give it to them. But when you look around, there are lots of good leading indicators, seem to be indicating that the big players are moving in the right direction. Particularly, for instance, Yahoo!'s conference call earlier in the week said focus on mobile, a lot of criticisms from the financial community about Facebook and Google not having robust mobile strategies. I remain firmly convinced that the future of Discovery with the mobile device is not typing in keywords with your thumbs. I know that's not the answer. And I believe we have a lot of invention that is relevant to the right answer and a lot of patent coverage over it. So I think it's all going to work out, but it's really a question of the pace of development in the market that we can't influence. So we just got to ride along and make sure that we're there and in a good shape to get our fair share when it comes.

Unknown Analyst

So no service revenue for implementation yet. Would you think there might be a small amount next year?

Bruce Davis

There's actually not none.

Unknown Analyst

Or do you think it might take longer?

Bruce Davis

There's actually not none. There's some, but it's not material.

Unknown Analyst

Not material, okay. And If I can ask Mike a question, Mike, you said you brought back 73,000 shares during Q3. Can you break that down for us and tell us how many were bought back on the open market versus how many were bought back for a tax thing for shares that might have been sold by insiders.

Michael McConnell

Yes. I think I have that information here. The shares in the open market were about 13,000, and the remaining was for the tax -- primarily the tax swap for options and shares from employees.

Unknown Analyst

So about 60,000 shares for the employees.

Michael McConnell

Yes, correct.

Operator

This concludes the allotted time for today's question-and-answer session. I would now like to turn the floor back over to Mr. Davis for any closing remarks.

Bruce Davis

Thank you very much. And thank you to everyone who participated in the call. We appreciate your involvement in the company and look forward to updating you again in about 3 or 4 months, a little bit longer here because it will be end of the year. So we'll talk to you in February. Thank you.

Operator

Thank you. This concludes your conference. You may now disconnect.

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