Digimarc Corporation
Q2 2012 Earnings Call Transcript

Published: 27 Jul 2012

[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:]

Thank you. Good afternoon. Welcome to our conference call. Mike McConnell, our CFO, is with me. On the call today, we will review and discuss Q2 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 risks, assumptions, uncertainties and on 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. Mike will begin by commenting on our financial results. I will then discuss our execution strategy and outlook. Mike?

[Michael McConnell:]

Thanks, Bruce, and good afternoon, everyone. Our second quarter 2012 revenue decreased by 4% to $9.1 million from $9.5 million in the second quarter of last year. Our operating income dropped from $2.3 million to $1.9 million, reflecting the lower revenues and increased research and development investments. Net income for the quarter was $1.2 million or $0.17 per diluted share compared to $3.6 million or $0.50 per diluted share in the second quarter of 2011. The 2007 (sic) results included a $2.6 million income tax benefit resulting from reversal of a valuation allowance on the company's deferred tax assets. Except for the $2.6 million tax benefit in 2011, net income in 2012 would have been $0.03 per share higher than the prior year. The balance sheet remains in excellent shape with approximately $44 million of cash and securities and no debt. Looking further into Q2 results. The 4% revenue decline was primarily attributable to lower development services to the Nielsen joint ventures, which was suspended in the first quarter of 2012. Our gross margin was 83%, about a 0.5 point higher than the prior year, reflecting a greater mix of license revenues to the total. We experienced operating expenses at similar levels to 2011 with increased investments in R&D related to Digimarc Discover and our second wave of intellectual property. Operating income came in at 21% of revenues. Income taxes were 38% of pretax income. Our operating cash flow mirrored operating income at $1.9 million or 21% of revenues. And we purchased 54,000 shares of stock during the quarter at an average price of $25.86. Our financial performance, thus far, in 2012 is within the range of our expectations at the start of year. Finally, I'm pleased to note the Board of Directors of Digimarc has declared a cash dividend of $0.11 per share of the company's common stock, the dividends payable on August 24, 2012, to shareholders of record as of the close of business at August 10, 2012. For further discussion of our financial results, our business and financial models and risk and prospects for our business, please refer to the Form 10-Q for the quarter that we expect to file in the next few days. Bruce will now provide his comments on our outlook and execution of strategy.

[Bruce Davis:]

Thanks, Mike. It's mid-year and I'd like to take some time to recap where we are in relations to our expectations at the start of the year and give you some insight into our view about how relative markets are developing and what the implications of these developments are for our strategy. Here's an update on strategy execution regarding our key goals and objectives as we shared them with you at the start of the year. First of all, we were seeking to deliver profitable growth. One of the critical elements of this goal was to favorably resolve the Verance litigation, which we did in January, giving rise to substantial growth license revenues. Our government business is up double digits from last year as well. Commercial service revenues are down due to previously announced suspension of operation of our joint venture with Nielsen, which, although still a licensee, had also been a customer of ours for development services. We sought to continue profitable growth in our government business by providing excellent quality of service to our central bank customers, renewing our long-term contract with them and securing new government business in other areas. We were doing well with our central bank customers, and we expect the contract renewal with them to be signed before year end. Shortly after the end of the quarter, we closed a contact for a few hundred thousand dollars in a new government business not related to our work with central banks. There are several other opportunities still in the pipeline. Next in line is to lay a foundation for future financial success by doing 3 things

[Operator:]

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

[Walter Schenker:]

It's a general question and maybe you've answered this before, but I didn't know the answer. Now that you've been working with IV for a longer period of time, I realized once a year you get the report. You get to look at the report and you get to actually hire people to help review the report. But on an interim basis, do you get progress reports? Do you get notified if they add a licensee? Do you have some sense as to how they are doing more than, gee, things are going okay, great, bad or indifferent?

[Bruce Davis:]

We work with them everyday. And so we have continuous flow of information in both directions. We don't give any interim financial reports. We get only one report in March of each year, and so we've have stub report just for a couple of months of activity and then one full year so far.

[Walter Schenker:]

Okay, so if they were to sign a major licensing deal, you might be aware of it because of the interface you have on a regular basis, but you might not know the specifics of what that might generate or anything else?

[Bruce Davis:]

I'm sorry, Walter. So the practice at IV has been to make public announcements of licenses, particularly large licenses. I don't know that there are any that they haven't. And so when those are announced, you see them as licensee then hypothesize what relevance our patents might have for your particular licensee. We have, in our agreement, a mechanism for determining participation that's based on the relevance of the patents to the license. And so that's what we don't know the answer to until we get the report, which is what part of what was received is allocated to us.

[Operator:]

[Operator Instructions] Your next question comes from Keith Maher of Singular Research.

[Keith Maher:]

I was wondering if you could talk a little bit about in the financial -- service revenues have been a bit lower than what they had been in the past few quarters. Is that -- and you mentioned Nielsen, is that primarily Nielsen that's driving that?

[Michael McConnell:]

Yes, Keith, this is Mike. The prime driver of that reduction was the joint ventures with Nielsen, where we suspended operations and there was no revenue in the second quarter. So you're right. You picked that up.

[Keith Maher:]

Okay. And is that also what's going on with the G&A? I mean I notice G&A is a bit lower than it had been in previous quarters as well.

[Michael McConnell:]

The G&A dropped. We settled the Verance matter in Q1 and so we had a large amount of litigation expenses in Q1. And so that dropped off obviously in Q2 and was down several hundred thousand dollars, so pretty much as planned for that.

[Keith Maher:]

And is that kind of more indicative of the level we should expect going forward?

[Michael McConnell:]

Well, from the Verance matter, which I think we ran about $500,000 or $600,000 in the first quarter, that's gone. We don't think our overall spending for the year is going to change much on a quarter-to-quarter basis, but we may have various initiatives we embark upon. But we don't see anything major material hitting the overall operating expenses.

[Keith Maher:]

Okay. And one balance sheet item, payables were down -- I don't know if that was, once again, something related to this kind of Nielsen or Verance or was that some sort of...

[Michael McConnell:]

Actually, it's quite a bit related to the Verance legal matter, that the push was heavy in the quarter so there were lots of accrued liabilities that all the bills came in right in the end of March and so all those bills were paid, but you're right. And also, I think we accrued our audit fee, which is heavy in the first quarter and that gets paid in the second quarter. So those types of things occur from time-to-time.

[Keith Maher:]

Okay, fair enough. And finally, just on the audit process with Intellectual Ventures, can we get any more color in terms of kind of the time frame as to when that would be wrapped up?

[Bruce Davis:]

This is Bruce. It's hard to tell. It's the first time that we've done it obviously and it's a complex report and relationship. So we're moving along as quickly as we can. As I said, Intellectual Ventures is cooperating, but we want to do a thorough job so that whatever we end up telling you guys we feel comfortable is reliable information.

[Operator:]

[Operator Instructions] Your next question comes from Paul Sonz of Sonz Partners.

[Paul D. Sonz:]

I have a question, Bruce. I listened to your description of -- sorry, the, I guess, the new direction you're taking with your research and development. That seems to me to be involved with location -- adding location in some way or helping people understand consumers' preferences in context of location. And I wondered if you could explain that a little bit more because, to be honest, I didn't really understand what you bring to the party.

[Bruce Davis:]

Okay. I had lot to say because I wanted to help everyone to understand what we're spending our time doing this year, which is a lot of R&D. The discussion about location, indoor location services, was to explain the addition to our second wave of patent portfolio with an acquisition of some patents from a company called Zulu Time. And it's not a new direction. It's just a continuation of the elaboration of the platform of the seeing-hearing device. And so the way in which this would play out, for example, would be when someone enters a retail establishment and they have their mobile device with them. One of the things that's not known today is how they traverse the store, how they shop, where they look, what they don't buy, how long they spend looking at things. Well, if you think about online retail, they know all those things. They capture every click that you do. They know how you shop. And so, if, for instance, you shop at Amazon, you know they're always suggesting things to you. Well, that's being recognizing increasingly as a huge, enduring disadvantage of physical retail. So the answer to that would be combining the ability for your mobile device to see what it's looking at and recognize it with knowing how you're moving around the store. So that's an example of how it's relevant. There are many other examples of how it's relevant, but that's one. Does that help?

[Paul D. Sonz:]

So in terms of -- so this would be a different technology than the watermarking?

[Bruce Davis:]

Yes, it's still signal processing. We use a little bit technical opinion-backed methodology to create a virtual clock in the subnet. And so when you walk into a space, there are a bunch of receivers and transmitters around and they sort of create a little closed network conceptually, where the various nodes of the network then can notice that you're moving around by judging what's going on with the signal. So it's quite consistent with our core competence, the signal processing, but it is not digital watermarking.

[Paul D. Sonz:]

Right. Now, would that -- does that require that stores would have to make a capital investment to have these -- to have the ability to pin your smartphone or whatever?

[Bruce Davis:]

Well, at this point in time, it's still R&D. It hasn't been implemented commercially yet, so it's precommercial. And our hope is that, actually, there'll be only a nominal investment required, if any, in order to deliver the services. But it's still a little too early to tell. But the main point with respect to indoor location is that it's a very hot area now in which many companies are investing in many different approaches, and the IP issues will get sorted out. And we think that our inventions may be useful to this field. And they are complementary to other features in our platform.

[Paul D. Sonz:]

The other features are obviously a person has to take a positive action. In this case, it might be -- would it be necessary to have people opt in on a conscious basis to be part of this or to allow this to happen?

[Bruce Davis:]

I think it's a good idea. I don't know if it's necessary, but that would be our intention for privacy purposes.

[Paul D. Sonz:]

Okay, right, right. Okay. In terms of, any -- I ask these questions every quarter, anything out there that looks interesting from -- on the M&A front? How -- are there lots of things available or not or...

[Bruce Davis:]

I wouldn't say there's a great deal of difference in supply or demand in the environment right now. There's always activity going on or things that are brought to our attention or that we explore. So it's status quo, I would say, in that regard.

[Paul D. Sonz:]

All right. And you've mentioned that you had a small contract, I think, of $200,000 or $300,000 from the government that was nonrelated to the central banks. Was this, in any way, part of that large subcontract that you had from the Defense department?

[Bruce Davis:]

No, it's not, and it's not a contract we had. It's contract we have. And so I'm pleased to report something other 0 is increasing. So yay, but we still have more opportunities in the funnel and larger opportunities, and we're still trying to close them. But we finally have some business going, which I'm happy to report.

[Paul D. Sonz:]

All right. One last question. In terms of the direction of the additional -- your Phase 2 intellectual property. That's not the right term, but your second group of patents that you're developing. One of the -- I remember you also talked about moving on a new methodology or something new in the audio recognition space. And I wondered -- I know you talked a little bit about that, but is there anything more you can say about the additional work you're doing in audio recognition?

[Bruce Davis:]

Nothing other than to recap again. It's a fairly complicated set of ideas today, so what we're doing is we're doing mobile optimized audio watermarking, which we believe is different in many ways from prior audio watermarking that was mainly done for what is called inline applications, that is, applications that don't involve a mobile device speaker picking up a signal and discerning what it's listening to. And the importance of that, we believe, is that fingerprinting, although doing a competent job of recognition, although not a great job or it's sort of, they're in the 67% range generally of recognition we find from what we've been able to study in the market. But it's good enough. What they can't do is to tell you where you heard it. And so this -- the new way of buying music is to hear something and purchase it immediately then there is no means for the distributor or the marketer to get credit. And so that model can't work very well for very long. And so what we think will happen, now that the value of recognizing music has been demonstrated, is that the new distribution, the marketing distribution models, will be built and I think they're going to be enduring. And in those, people will want to get credit, get paid for what they do and also have some influence on what happens once the music recognized. So we can do those 2 things and you can't do those with fingerprinting.

[Paul D. Sonz:]

Right. And so that would require that -- the market for that product, would that be new music and new releases where you could embed in the new release a watermark?

[Bruce Davis:]

No, no. Actually, it can be used with any music from any distribution source because the encoding will be done by the distribution source, by the radio station, okay? So all music, not just new music.

[Paul D. Sonz:]

So that could be -- so you get around the problem of not being originally in it. It can be just once it is distributed again, you can put it in, in that level.

[Bruce Davis:]

That's the idea, yes.

[Operator:]

Your next question comes from the line of Matthew Galinko of Sidoti & Company.

[Matthew Galinko:]

Just -- first one is a quick follow-up on Paul's question on the government that you mentioned. Along those lines, can we expect a bit of uptick or material uptick in the service line sequentially into September quarter, or is that -- do you not expect that to be a significant piece of third quarter revenue?

[Michael McConnell:]

Yes, Matt. This is Mike. We expect it to generate some revenues from that along with our central bank revenue. Too early to tell if it's higher or lower, but I think it really goes towards our overall goal of capturing some government business here other than the central banks and that's good. So we'll have some revenue during the quarter.

[Matthew Galinko:]

And also I noticed a couple of weeks ago, Ikea came out with an app, just sort of talking about augmented reality or -- it seemed to be related to watermarking their annual catalog or catalog. Were you in any way involved with that? I didn't see any branding on it.

[Bruce Davis:]

No, we weren't. And there's a fair amount of confusion. I mentioned the chaos of the action codes. Augmented reality is presented in a confusing factions of the market because there are basically 2 pieces to it. One is recognizing something and the other is overlaying some graphics in between the mobile device and the object. So it often appears like a 3D kind of thing, right? Well, the way in which they recognize the object is independent of that experience, the viewer experience. However, all of the augmented reality proposed suppliers today appear to rely on image recognition to do that rather than watermarking or any other technology. They could use watermarking. So we actually don't need to compete with augmented reality, but they haven't yet embraced our technology of the triggering mechanism. So it's confusing for everyone.

[Matthew Galinko:]

All right. No, that helps clear it up, I think. I appreciate that. Last question for me. You talked about there being an eightfold increase in the number of reads that you've tracted, the Digimarc reader -- first of all, does that include any branded readers like the Sports Illustrated? And secondly, what is that in comparison to? Because I know last year, I think you released the Digimarc Discover, probably -- I think it was May or June. So -- but I guess apples-to-apples, what are we looking at?

[Bruce Davis:]

The increases appear to be quite significant. And I say appear to be because I don't want to be too firm on numbers when there's a lot of trial going on. So we're in our first year -- just finishing actually our first year here. And what we see is many fold increases in reads and in downloads. We only track downloads of the branded applications, the Digimarc Discover application and there are more than 20 branded applications using our technology. We don't track those downloads so far. So we don't really know how many downloads have been in total. But we know how many reads have been total. So the reads that I'm talking about are the reads by all of the applications.

[Operator:]

[Operator Instructions] Your next question comes from Adam Fisher of Samjo.

[Adam Fisher:]

A couple of questions. You talked about a bunch of new initiatives, a bunch of places we're making investments and where we have some partners that you talked about, the radio stations, the network service provider. Can you talk on a couple of different axes about kind of the size of the opportunity -- how you're prioritizing them in terms of the size of the opportunities, in terms of the investment we're making and maybe the partners are making with us and in terms of kind of the timing of when you expect both product releases or IPE releases and/or revenue over the next couple of years?

[Bruce Davis:]

It's really tough to do. I understand what you're looking for. Again, we don't give financial guidance. But I mentioned a few different partnerships that we have going. They're all early stage, so we don't quite know how they will play out. And as you know, our business model -- there are many ways in which the revenues can be recognized, generated and recognized. And so we're not in the position to forecast the outcomes. But we think all of them provide significant financial opportunities. So I'll try to characterize things a bit in terms of what I listed in my prepared remarks. So in terms of major network service provider, what we would get there is distribution, right, and that would help a great deal in our value proposition, everybody that we work with. So that would have a multiplier effect on everything we do because we have much larger distribution than we have today via our downloaded app. In terms of the reference to a Fortune 500 services brand, we're trying to work with them to build an industry solution for the industry that they happen to be in, which if we were successful, we would then market to everybody else in that business or line of business. But we'd also lay a foundation for our work in the bar code area in that we would be working on integrated marketing. And the integrated marketing would include not only printed materials outside of magazines and newspapers and so forth but also audio, both audio for television audio for radio. So what we're doing with them is collaborating to try to demonstrate the entire platform, that is the seeing-hearing device, facilitating customer acquisition of satisfaction across the entire range of their offerings. I mentioned the radio station group owner, not the radio station. So we're actually working with a group and what we're doing there is doing the commercial feasibility study for the audio watermarking work that we've been doing for the last 1.5 years or so. So we're at the final stage of R&D to determine the commercial viability of our work and that should be fielded quite soon. And then the last relationship I mentioned was with the bar code equipment and services supplier and there, as you know from prior conversations, we're not messing around with small ideas. We're hypothesizing that we might be able to do provide a superior transaction processing methodology to the state-of-the-art conventional bar code. If we pull that up, that would be enormous. But not will not happen in the next x number of quarters. And in addition to the improvement in transaction processing, we have all the other stuff you might be expecting us to talk about, which is the marketing advantages, both pre and post, using digital watermarking versus conventional bar codes in the private data channels for brands and so forth. And what we've been observing as really consistent with our strategy and reinforces our confidence is that for a while here, the -- what I'll call the legacy brands -- hadn't quite understood the impact that the digital intermediaries were having. And Apple has demonstrated very well to them how they can be disenfranchised in the music business. But now we're seeing Amazon becoming increasingly aggressive. Google, moving more into the helping people to find things they might want to buy it. And eBay and others taking more customer relationship aspects away from the brands. And the brands are getting very frustrated about it. And justifiably so, because it's going to hurt their ability to maintain their margins if they don't have the kind of brand relationship they had historically. In conjunction with that, all of the legacy brands recognize why the digital intermediaries have been taking business from them, which is that they have a better understanding of their customers. And so they're trying to figure out how to emulate online off-line and that's where I think both our seeing-hearing aspects of our platform and location-based services for indoor are important elements of beginning to develop analytics that help the physical retailers and the package goods and all the others who want to reduce the power of the digital intermediaries to have an ability to try to do that. So it's a very exciting time in the market right now. It seems to be coming together in a way that there are a number of supporting elements through this transformation that our technologies should be relevant for.

[Adam Fisher:]

And can you just talk again about how you're prioritizing the initiatives internally, how you're allocating R&D resources, how you're allocating your time and management of time to pursue the opportunities?

[Bruce Davis:]

Yes, I can give a shot at that. It's not something where there is a consistent daily, weekly or monthly allocation as you might imagine things ebb and flow. But we first focused a number of years ago on 2 things, back in 2008, after the sale of ID systems. We wanted to get our print-to-web technology improved. And we've done a marvelous job with that. I think it's really excellent now and I think everyone agrees. It performs very well. In parallel, we began laying down the general foundation for the platform into which that would fit and that we call the intuitive computing platform. And so we just got our first issuance a short time ago of a patent related to that. And the intuitive computing platform work was about resource management, assuming that there wasn't a single way to see or single way to hear, and that seeing and hearing would be used in conjunction with other sensor data and other user data and device data and network data and so forth and location data. How do you manage resources in a resource-constrained environment. So it's very important seminal work on efficient platform design. So we started work on one element with the platform and we started on the general foundation of the platform several years ago, all of that building on the work of the last 15 years. As we studied the existing audio watermarking technologies, we determined that none of them seem to perform to the standard that we want it to have for mobile recognition of audio from television and music. And so we invested significantly in that over the course of the last 1.5 years or so. It's been the priority in R&D, okay? With that work now nearing a point where we believe we can have a commercially feasible offering, many of those resources have shifted over into the bar code work. In parallel to that, we acquired resources associated with the location-based services, both of which, as you can discern, apply to physical retail. We've been augmenting our marketing resources to deal effectively with bringing these things together into integrated marketing solutions. That's where one of those partners that I alluded to comes into play. So I would say that the allocation today is -- depends on the different phases of development of the R&D. So our basic researches of location in bar code replacement, our most mature implementations is in the print-to-web area. We continue to develop the efficient platform model and actually implement it in addition to continuing to refine our theories about how it should be structured. And we are working on the integration of these things into the system, which then test those assumptions, but also bring to bear these new deliverables from R&D. So I hope that helps. I can't tell you it's 20%, less 30% that and so forth.

[Operator:]

[Operator Instructions] This concludes the allotted time for the question-and-answer session for today's call. I will now turn the floor back over to management for any closing remarks.

[Bruce Davis:]

All right. Thanks very much, everyone. We appreciate your support. We'll look forward to giving you an update at the end of this quarter. And in the meantime, you can trust that we're working very hard in all of the initiatives I have described, and that, in our view, it's a very interesting and exciting time in the market to be doing this. Thanks very much.

[Operator:]

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