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DMRC > SEC Filings for DMRC > Form 10-Q on 3-May-2013All Recent SEC Filings

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Form 10-Q for DIGIMARC CORP


3-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included in this Quarterly Report on Form 10-Q under the caption "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995."

The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q. Readers are also urged to carefully review and consider the disclosures made in Part II, Item 1A (Risk Factors) of this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2012 filed on February 22, 2013 (the "2012 Annual Report") and in the audited consolidated financial statements and related notes included in our 2012 Annual Report, and other reports and filings made with the Securities and Exchange Commission ("SEC").

Unless the context otherwise requires, references in this Quarterly Report on Form 10-Q to "Digimarc," "we," "our" and "us" refer to Digimarc Corporation.

All dollar amounts are in thousands, unless otherwise noted. Percentages within the following tables may not foot due to rounding.

Digimarc Discover is a registered trademark of Digimarc Corporation. This Quarterly Report on Form 10-Q also includes trademarks and trade names owned by other parties, and all other such trademarks and trade names mentioned in this Quarterly Report on Form 10-Q are the property of their respective owners.

Overview

Digimarc Corporation enables governments and enterprises around the world to give digital identities to media and objects that computers can sense and recognize and to which they can react. Our technology provides the means to infuse persistent digital information, perceptible only to computers and digital devices, into all forms of media content. The unique digital identifier placed in media generally persists with it regardless of the distribution path and whether it is copied, manipulated or converted to a different format, and does not affect the quality of the content or the enjoyment or other traditional uses of it. Our technology permits computers and digital devices to quickly identify relevant data from vast amounts of media content.

Our technologies, and those of our licensees, span a range of media content, enabling our customers and those of our partners to:

Quickly and reliably identify and effectively manage music, movies, television programming, digital images, e-books, documents and other printed materials, especially in light of new non-linear distribution over the internet;

Deter counterfeiting of money, media and goods, and piracy of e-books, movies and music;

Support new digital media distribution models and methods to monetize media content;

Leverage the power of ubiquitous computing to instantly link consumers to a wealth of information and/or interactive experiences related to the media and objects they encounter each day;

Provide consumers with more choice and access to media content when, where and how they want it;

Enhance imagery and video by associating metadata or authenticating media content for government and commercial uses; and

Better secure identity documents to enhance national security and combat identity theft and fraud.

At the core of our intellectual property is a signal processing innovation known as "digital watermarking," which allows imperceptible digital information to be embedded in all forms of digitally designed, produced or distributed media content and some physical objects, including photographs, movies, music, television, personal identification documents, financial instruments, industrial parts and product packages. The digital information can be detected and read by a wide range of computers, mobile phones and other digital devices.

Digital watermarking allows our customers to embed digital data into any media content that is digitally processed at some point during its lifecycle. The technology can be applied to printed materials, video, audio, and images. The inclusion of these digital signals enables a wide range of improvements in security and media management, and new business models for distribution and consumption of media content. Over the years our technology and intellectual property portfolios have grown to encompass many related technologies.


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We provide solutions directly and through our licensees. Our proprietary technology has proven to be a powerful element of document security, giving rise to our long-term relationship with a consortium of central banks, which we refer to as the Central Banks, and many leading companies in the information technology industry. We and our licensees have successfully propagated digital watermarking in music, movies, television broadcasts, images and printed materials. Digital watermarks have been used in these applications to improve media rights and asset management, reduce piracy and counterfeiting losses, improve marketing programs, permit more efficient and effective distribution of valuable media content and enhance consumer entertainment and commercial experiences.

Our business has further expanded in e-commerce with our recent acquisition of Attributor Corporation ("Attributor") the global leader in protecting e-books from online piracy. Attributor's software and services protect book revenue and authors' rights by finding, reporting on, and assisting in removing pirated content found on the Internet. Online book piracy is a growing and global problem, and with emerging e-book standards and the growing popularity of iPads, Kindles and other e-readers, book piracy is expected to grow dramatically. Attributor is building a promising business in this high growth market, and possesses technical skills and market knowledge that will complement our existing organization.

Our patent portfolio contains a number of innovations in digital watermarking, pattern recognition (sometimes referred to as "fingerprinting"), digital rights management and related fields. To protect our significant efforts in creating our technology, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, we believe we have one of the world's most extensive patent portfolios in digital watermarking and related fields, with greater than 1,200 granted and pending U.S. and foreign filings as of March 31, 2013. We continue to develop and broaden our portfolio of patented technology in the fields of media identification and management technology and related applications and systems. We devote significant resources to developing and protecting our inventions and continuously seek to identify and evaluate potential licensees for our patents.

For a discussion of activities and costs related to our research and development, please read the sections titled "Research, development and engineering" under Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations."

Critical Accounting Policies and Estimates

Detailed information on our critical accounting policies and estimates are set forth in our 2012 Annual Report in Part II, Item 7 thereof ("Management's Discussion and Analysis of Financial Condition and Results of Operations"), under the caption "Critical Accounting Policies and Estimates," which is incorporated by reference into this Quarterly Report on Form 10-Q.

Results of Operations

The following table presents statements of operations data for the periods indicated as a percentage of total revenue. Unless otherwise indicated, all references in this Management's Discussion and Analysis of Financial Condition and Results of Operations to the three-month period relate to the three-month period ended March 31, 2013 and all changes discussed with respect to such period reflect changes compared to the three-month period ended March 31, 2012.

                                                   Three            Three
                                                  Months           Months
                                                   Ended            Ended
                                                 March 31,        March 31,
                                                   2013             2012
        Revenue:
        Service                                          29 %             18 %
        Subscription                                     14                2
        License                                          58               80

        Total revenue                                   100              100
        Cost of revenue:
        Service                                          14               10
        Subscription                                      6               -
        License                                           1               -

        Total cost of revenue                            21               11
        Gross profit                                     79               89
        Operating expenses:
        Sales and marketing                              12                6
        Research, development and engineering            27               12
        General and administrative                       21               16
        Intellectual property                             3                2

        Total operating expenses                         63               36


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                                              Three            Three
                                              Months          Months
                                              Ended            Ended
                                            March 31,        March 31,
                                               2013            2012
             Operating income                       16               54

             Net loss from joint ventures           -                (6 )
             Other income, net                      -                -

             Income before income taxes             16               48
             Provision for income taxes             (7 )            (18 )

             Net income                              9 %             29 %

Summary

In 2013, we started the year with Attributor fully engaged in our business operations. We expect to expand market penetration in the book publishing industry for deterrence of book piracy, while also continuing to increase investments in marketing and development of Digimarc Discover, bringing to market our packaging and audio offerings, and more directed research and associated hardware, software and intellectual property development.

Total revenue for the three-month period in 2013 decreased 40% to $10.2 million compared to the same period in 2012 primarily due to the $8.0 million past due royalties payment from Verance Corporation ("Verance") in the 2012 three-month period, partially offset by increased subscription revenue due to the inclusion of Attributor.

Total operating expenses for the three-month period in 2013 increased 6% to $6.5 million compared to the same period in 2012 primarily due to the impact of Attributor's operations and related acquisition and integration costs, partially offset by the reversal of the contingent merger consideration of $0.2 million related to the acquisition of Attributor.

Revenue



                                          Three              Three
                                         Months             Months
                                          Ended              Ended              Dollar             Percent
                                        March 31,          March 31,           Increase            Increase
                                          2013               2012             (Decrease)          (Decrease)
Revenue:
Service                                $     2,929        $     3,048        $       (119 )                (4 )%
Subscription                                 1,384                278               1,106                 398 %
License                                      5,930             13,720              (7,790 )               (57 )%

Total                                  $    10,243        $    17,046        $     (6,803 )               (40 )%

Revenue (as % of total revenue):
Service                                         29 %               18 %
Subscription                                    14 %                2 %
License                                         58 %               80 %

Total                                          100 %              100 %

Service. Service revenue consists primarily of software development and consulting services. The majority of service revenue arrangements are structured as time and materials consulting agreements, or fixed price consulting agreements. The majority of our service revenue is derived from contracts with the Central Banks, Intellectual Ventures ("IV"), and government agencies and contractors. The agreements range from several months to several years in length, and our longer term contracts are subject to work plans that are reviewed and agreed upon at least annually. These contracts generally provide for billing hours worked at predetermined rates and, to a lesser extent, for cost reimbursement for third party costs and services. Increases or decreases in the services provided under these contracts are generally subject to both volume and price changes. The volume of work is generally negotiated at least annually and can be modified as the customer's needs change. We also have provisions in our longer term contracts that allow for specific hourly rate price increases on an annual basis to account for cost of living variables. Contracts with other government agencies and contractors are generally shorter term in nature, less linear in billings and less predictable than our longer term contracts because the contracts with other government agencies are subject to government budgets and funding.


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The decrease in service revenue for the three-month period was due primarily to the suspension of operations in the joint ventures, partially offset by new government related work and the favorable impact of our new agreement with the Central Banks.

Subscription. Subscription revenue includes subscriptions for products and services, is more recurring in nature, is generally paid in advance and recognized over the term of the subscription.

The increase in subscription revenue for the three-month period was due primarily to the inclusion of Attributor.

License. License revenue originates primarily from licensing our technology and patents where we receive royalties as our income stream. The majority of license revenue is derived from contracts with IV, Nielsen, Civolution and Verance. Revenue from our licensed products have minimal associated direct costs, and thus are highly profitable.

The decrease in license revenue for the three-month period was primarily the result of the $8.0 million past due royalties payment from Verance in the first quarter of 2012, partially offset by the increased quarterly license payment from IV.

Revenue by Geography



                                          Three              Three
                                         Months             Months
                                          Ended              Ended              Dollar             Percent
                                        March 31,          March 31,           Increase            Increase
                                          2013               2012             (Decrease)          (Decrease)
Revenue by geography:
Domestic                               $     6,125        $    13,571        $     (7,446 )               (55 )%
International                                4,118              3,475                 643                  19 %

Total                                  $    10,243        $    17,046        $     (6,803 )               (40 )%

Revenue (as % of total revenue):
Domestic                                        60 %               80 %
International                                   40 %               20 %

Total                                          100 %              100 %

The decrease in domestic revenue for the three-month period was primarily the result of the $8.0 million past due royalties payment from Verance in the first quarter of 2012 and the suspension of operations in the joint ventures, partially offset by the inclusion of Attributor, increased quarterly license payment from IV and new government related work in the first quarter of 2013.

The increase in international revenue for the three-month period was due primarily to the inclusion of Attributor and the favorable impact of our new agreement with the Central Banks.

We anticipate a decrease in revenue for the full year 2013 compared to 2012 primarily due to the receipt of the $8.0 million past due royalties payment from Verance in January 2012, and the end of quarterly license payments from IV in May 2013; partially offset by a full year of revenue from Attributor operations and revenue growth in our existing customers and from new customers as we continue to expand the marketing and monetization of our intellectual property portfolio.

Cost of Revenue

Service. Cost of service revenue primarily includes costs that are allocated from research, development and engineering, sales and marketing and intellectual property that relate directly to performing services under our customer contracts, and, to a lesser extent, direct costs of program delivery for both personnel and operating expenses. Allocated costs include:

compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of our software developers, quality assurance personnel, product managers, business development managers and other personnel where we bill our customers for time and materials costs;

payments to outside contractors that are billed to customers;

charges for equipment directly used by customers;

depreciation and other charges for machinery, equipment and software directly used by customers;


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travel costs directly attributable to service and development contracts; and

charges for infrastructure and centralized costs of facilities and information technology.

Subscription. Cost of subscription revenue primarily includes:

compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of operations personnel and the cost of contractors to provide Attributor's subscription service;

Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers; and

charges for infrastructure and centralized costs of facilities and information technology.

License. Cost of license revenue primarily includes:

patent or software license costs for any patents licensed from third parties where the party receives a portion of royalties or license revenue received by Digimarc;

charges for infrastructure and centralized costs of facilities and information technology; and

amortization of capitalized patent costs and patent maintenance fees.

Gross Profit



                                          Three              Three
                                         Months             Months
                                          Ended              Ended              Dollar             Percent
                                        March 31,          March 31,           Increase            Increase
                                          2013               2012             (Decrease)          (Decrease)
Gross Profit:
Service                                $     1,526        $     1,351        $        175                  13 %
Subscription                                   749                231                 518                 224 %
License                                      5,834             13,654              (7,820 )               (57 )%

Total                                  $     8,109        $    15,236        $     (7,127 )               (47 )%

Gross Profit (as % of related
revenue components):
Service                                         52 %               44 %
Subscription                                    54 %               83 %
License                                         98 %               99 %
Total                                           79 %               89 %

The decrease in total gross profit and total gross profit as a percentage of revenue for the three-month period was due primarily to the receipt of the $8.0 million past due royalties payment from Verance in the first quarter of 2012.

The increase in service gross profit as a percentage of service revenue for the three-month period resulted primarily from service mix and favorable impact of our new agreement with the Central Banks. The decrease in subscription gross profit as a percentage of subscription revenue for the three-month period resulted primarily from the inclusion of Attributor, which has a higher cost component than other subscriptions.

Operating Expenses

We allocate certain costs of sales and marketing, research, development and engineering and intellectual property to cost of service revenue when they relate directly to our customer contracts.

We record all remaining, or "residual," costs as sales and marketing costs, research, development and engineering, general and administrative, and intellectual property expenses.

We expect operating expenses for the full year 2013 to be higher than 2012, primarily due to a full year of Attributor's operations which is estimated to include $1.3 million of non-cash charges for amortization of acquired intangibles and stock compensation expense. In addition, we plan to increase spending in engineering, sales and marketing to accelerate our product development initiatives and our sales and marketing growth initiatives.


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Sales and marketing

                                             Three              Three
                                            Months             Months
                                             Ended              Ended
                                           March 31,          March 31,          Dollar          Percent
                                             2013               2012            Increase         Increase
Sales and marketing                       $     1,277        $     1,007        $     270               27 %
Sales and marketing (as % of total
revenue)                                           12 %                6 %

Sales and marketing expenses consist primarily of:

compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of sales and marketing employees and product managers;

travel and market research costs, and costs associated with marketing programs, such as trade shows, public relations and new product launches;

professional services and outside contractors for product and marketing initiatives; and

charges for infrastructure and centralized costs of facilities and information technology.

The increase in sales and marketing expenses for the three-month period resulted primarily from the inclusion of Attributor which resulted in higher headcount and compensation-related expenses of $0.2 million and amortization of acquired intangibles of $0.1 million.

We anticipate through 2013 that we will incur sales and marketing costs at higher levels due to the inclusion of Attributor and our efforts to accelerate our sales and marketing growth initiatives.

Research, development and engineering

                                             Three              Three
                                            Months             Months
                                             Ended              Ended
                                           March 31,          March 31,          Dollar          Percent
                                             2013               2012            Increase         Increase
Research, development and engineering     $     2,725        $     1,998        $     727               36 %
Research, development and engineering
(as % of total revenue)                            27 %               12 %

Research, development and engineering expenses arise primarily from three areas that support our business model:

Fundamental Research:

investigation of new watermarking algorithms to increase robustness and/or computational efficiency;

mobile device usage models and imaging sub-systems in camera-phones;

industry conference participation and authorship of papers for industry journals;

survey and study of human and computer interaction models with a focus on mobile devices and modeling of intent;

development of new intellectual property, including documentation of claims and production of supporting diagrams and materials;

research in fingerprinting and other content identification technologies; and

metadata ranking algorithms for match internet file content against reference database.

Platform Development:

tuning and optimization of implementation models to improve resistance to non-malicious attacks and routine transformations, such as JPEG, cropping and printing;

mobile platform creation to leverage device specific capabilities (e.g., instruction sets and Graphics Processing Units ("GPUs");

big data analytics transformation and metrics aggregation engine;

data-driven internet crawling infrastructure with policy-driven feedback loop; and

assembly of master book publishing catalog based on aggregation and reconciliation of multiple public data sources.


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Product Development:

maintaining the Online Services Portal to provide campaign management and routing services for the Digimarc Discover platform;

maintaining the web-hosted image watermark embedder in support of Digimarc Discover platform;

iterative development and release of the Digimarc Discover application for the iTunes and Android marketplaces;

real-time analytics portal to support anti-piracy services for the . . .

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