ITEM 1: BUSINESS
Overview
Digimarc Corporation ("Digimarc," "our" or "we") is a leading supplier of
secure identity solutions and solutions for use in media identification and
management. Our solutions enable governments and businesses around the world to
enhance traffic safety and national security, combat identity theft and fraud,
facilitate the effectiveness of voter identification programs, improve the
management of media content, deter counterfeiting and piracy and support new
digital media distribution models that provide consumers with more choice and
access to media content. Our mission is two-fold:
º •
º Foster large-scale adoption of media identification and management
solutions licensed under Digimarc's intellectual property; and
º •
º Be the most desired profitable supplier of driver license issuance
systems.
We issue more than 60 million identification documents ("IDs") annually and
are the leading supplier of government-issued citizen IDs in North America,
including supplying systems that produce more than two-thirds of all driver
licenses issued in the United States. We are also a pioneer and leading owner of
intellectual property in a signal processing technology innovation known as
"digital watermarking" which allows imperceptible digital information to be
embedded in all forms of digitally designed, produced or distributed media
content, including personal identification documents, financial instruments,
photographs, movies, music, television, and product packages. The embedded data
within various types of media content can be detected and read by software or
hardware detectors in personal computers and other digital devices.
Digital watermarking is a strategic component of nearly all of our product
offerings. We provide media identification and management solutions based on
this and related technologies directly and
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through our licensees. Digital watermarking has already proven to be a powerful
element of document security, giving rise to our long-term relationship with a
consortium of Central Banks and many leading companies in the information
technology industry. We are working to achieve a similar success in secure
identity management systems. We anticipate that by the middle of 2008 more than
one out of two driver licenses being produced in the U.S. will carry digital
watermarks as a means to provide cross-jurisdictional machine authentication. In
addition, Digimarc and its licensees have successfully propagated digital
watermarking in music, movies, television broadcasts, images and printed
materials. Digital watermarks have been used in these applications to provide
improved 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 experiences.
Our principal administrative, marketing, research, and intellectual property
development facility is located in Beaverton, Oregon. Our secure ID systems
business is headquartered in Burlington, Massachusetts, and our logistics center
is in Fort Wayne, Indiana.
Our ID systems revenue is primarily generated pursuant to long-term
contracts with government ID issuers-primarily U.S. State government agencies
responsible for driver license issuance and national governments of a number of
countries. These customers rely on our systems design, integration and materials
science expertise, and proprietary technologies such as digital watermarking, to
implement issuance systems and processes that improve the security of identity
documents and banknotes.
Our media identification and management revenue is generated through
commercial and government applications of our digital watermarking and related
media identification and management technologies, primarily from patent and
technology license fees paid by business partners and our contracts with a
consortium of Central Banks and with The Nielsen Company. Our licensing program,
which is a core part of our media identification and management business, is
built upon our extensive patent portfolio, which contains 360 issued U.S.
patents, and numerous foreign patents, as of December 31, 2007. Private sector
media and entertainment industry customers use secure media identification and
management solutions from our business partners and us to identify, track,
manage and protect content as it is distributed and consumed-either digitally or
physically-and to enable new consumer applications to improve access to networks
and information from personal computers and mobile devices. We expect that
patent and technology licensing will continue to contribute most of our revenues
from non-government customers for the foreseeable future.
Financial information about geographic areas is incorporated by reference to
Note 4 of our consolidated financial statements.
History
Digimarc was incorporated in 1995. We were founded to commercialize a signal
processing innovation known as "digital watermarking." Digital watermarking is a
technology that allows our customers to infuse 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 this digital data enables a wide range of improvements in security
and media management, and new business models for distribution and consumption
of media content. We use digital watermarking as a differentiator in nearly all
of our product offerings to increase value to our customers.
Banknote counterfeit deterrence was the first commercially successful use of
digital watermarking. Digimarc, in cooperation with an international consortium
of Central Banks, developed a system to deter the use of digital technologies in
the unauthorized reproduction of banknotes. More recently, innovations based on
our digital watermarking technology and experience have been leveraged to create
new products to deter counterfeiting and tampering of driver licenses and other
government-issued
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secure credentials. In parallel, Digimarc's business partners, under patent or
technology license from Digimarc, are delivering digital watermarking solutions
to track and monitor the distribution of music, images, television and movies to
consumers.
Following the events of September 11, 2001, we realized that our expertise
in security printing and digital imaging technologies and systems placed us in a
position to address both the digital threats to identity management credentials
and the environment and concerns of the issuers of these credentials. In late
2001, we acquired the Large Government Programs business unit of Polaroid
Corporation ("Polaroid"). The primary focus of this business is the production
of driver licenses and other IDs issued by government agencies. The acquired
assets included all relevant software, hardware, services, materials science and
distribution assets of Polaroid's government-issued photo identification
business.
In this strategic acquisition, we saw a unique opportunity to assist in
efforts to deter identity theft and fraud and thereby enhance transportation
safety and Homeland Security through the combination of a new layer of security
using our digital watermarking technology and Polaroid's expertise in secure ID
solutions. Based on Polaroid's history with secured ID issuance systems, the
resulting business has over 50 years of experience in the delivery and operation
of secure ID issuance systems, has produced more than 2 billion issued IDs, and
has guided customers through numerous major upgrades and technology migrations
in ID security. We are the leader in deploying new solutions to meet driver
license security and related service challenges. This includes being first to:
º •
º produce driver licenses with digital portraits,
º •
º deploy facial recognition and State-wide fingerprint matching in 1995
and 1996,
º •
º introduce market leading security features, including digital
watermarking, Kinegrams, and secure card materials,
º •
º produce driver licenses in secure, networked central issuance
factories,
º •
º offer driver license renewal by Internet,
º •
º offer comprehensive and modular secure driver license solutions to
address recently enacted Federal legislation, such as the Federal
legislation passed in May 2005 known as the REAL ID Act (the "REAL ID
Act"). The Real ID Act imposes certain Federal requirements for
State-issued driver licenses. These requirements are intended to
increase the security of driver licenses, require validation of
applicants prior to issuance, and mandate certain changes in business
processes relating to security and the sharing and storage of data,
and
º •
º offer an Enhanced Driver License (EDL) solution in response to a
recently enacted Federal law called the Western Hemisphere Travel
Initiative, which imposes new security requirements on North American
land and sea border crossings. We supplied production of the first
high security licenses in a pilot program in Washington State.
With increasing interest in issues surrounding Homeland Security, prevention
of identity theft and fraud, traffic safety, copyright and intellectual property
protection and establishment of new business models for digital distribution and
use of media content, Digimarc has evolved from a technology-driven early stage
company to an important supplier of critical infrastructure to government
agencies and a strategic business partner to solution providers supporting the
media and entertainment industry.
Customers and Business Partners
Our ID systems revenue is derived from long-term contracts with government
ID issuers, primarily State driver license issuers and governments of various
foreign countries and provinces.
Our media identification and management revenue is generated through
commercial and government applications of our digital watermarking, including a
long-term contract with a consortium
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of Central Banks. Our contract with the Central Bank consortium is in its tenth
year in 2008. The contract is in the final year of a 5-year extension and
provides for two additional 3-year extensions. The Central Bank consortium has
agreed to the first 3-year extension. Other digital watermarking-related revenue
is generated primarily from patent and technology license fees paid by business
partners providing media identification and management solutions to movie
studios and music labels, television broadcasters, creative professionals and
other customers around the world. Patent and technology licensing is expected to
continue to contribute most of the revenues from non-government customers for
the foreseeable future.
We must comply with and are affected by laws and regulations relating to the
award, administration and performance of government contracts. Government
contract laws and regulations affect how we do business with our customers and,
in some instances, impose added costs on our business.
In some instances, these laws and regulations impose terms or rights that
are more favorable to the government than those typically available to
commercial parties in negotiated transactions. For example, the government
agency may terminate any of our contracts and, in general, subcontracts, at its
convenience, as well as for default based on performance. Upon termination for
convenience of a fixed-price type contract, we normally are entitled to receive
the purchase price for delivered items, reimbursement for allowable costs for
work-in-process and an allowance for profit on the contract or adjustment for
loss if completion of performance would have resulted in a loss. Upon
termination for convenience of a cost reimbursement contract, we normally are
entitled to reimbursement of allowable costs plus a portion of the fee.
In addition, our government contracts typically span one or more base years
and multiple option years. The government agency generally has the right to not
exercise option periods and may not exercise an option period if the agency is
not satisfied with our performance on the contract.
Products and Services
We provide secure ID solutions to government agencies and media
identification and management solutions to commercial entities and government
customers.
Secure ID Systems
We issue more than 60 million IDs annually and are the leading supplier of
government-issued citizen IDs in North America, producing more than two-thirds
of all driver licenses issued in the U.S. We have also provided secure ID
solutions to approximately 25 foreign governments.
In North America, we generate most of our revenue through the issuance of
State driver licenses and other IDs on a fixed price per credential issued
basis. In North America, we are generally a prime contractor, providing full
issuance systems to Federal, State, and provincial departments of motor vehicles
or other government issuing authorities. These systems typically include
hardware (including specialized cameras, printers, personal computers and
servers), software, consumable supplies (such as ribbons, blank or preprinted
card materials and laminated and related consumables) and ongoing support
services. These systems may also involve software and/or hardware development,
integration services, and implementation services. When we provide a full
issuance system to a customer, we generally retain title to all equipment,
software and consumables associated with the system and are responsible for
maintaining the system over the contractual period.
Our strategy regarding the anticipated opportunities relating to the REAL ID
Act is to provide solutions that address the requirements of the REAL ID Act:
identity verification; document scanning and archiving; individual background
checking; data and image sharing; and migration to and production of REAL ID Act
compliant driver license documents. These solutions are available to
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customers as upgrades or complete issuance systems. Digimarc is currently
offering the States program management assistance to safely migrate to REAL ID
Act compliance.
In markets outside of North America, we generally provide driver license,
national identification and voter identification systems, services, and
components in partnership with local card producers, security printers, system
integrators and others. In these markets, we may serve as prime contractor or
sub-contractor, depending on the circumstances. As a sub-contractor, we
generally are responsible for delivering hardware, software, or consumables, and
some degree of integration services to the prime contractor; whereas as a prime
contractor, we are responsible for integrating all components of the system to
the customer's specifications.
Outside of North America, our revenues are typically generated from sales of
equipment, software and/or consumables to government agencies or their prime
contractors. These sales may occur at irregular intervals, can carry relatively
low margins and cause variations in quarterly revenue and gross profit trends.
We enter into low margin contracts and transactions from time to time to
maintain market presence and build relationships with customers and business
partners, and often transition to more profitable digital technologies over
time. Due to the nature of such international programs and customers, the timing
of these sales is less predictable than our service revenues provided by
domestic customers and, consequently, international sales can occur unevenly
during the course of a year.
Media Identification and Management
We license our technology and patents and otherwise foster development of
the market for media identification and management solutions through our
participation in industry activities and events, including our digital
watermarking technologies, for commercial as well as governmental uses. Our
licenses primarily involve use of our technology and patents in the media and
entertainment area, but also support industrial and commercial enterprise
applications as well as applications supporting Federal programs. We also have a
multi-year contract with an international consortium of Central Banks in which
we have been, since 1997, developing, deploying, supporting and continuing to
enhance a system to deter digital counterfeiting of currency using personal
computers and digital reprographics.
Commercial customers use secure media solutions from our business partners
and us to identify, track, manage and protect content as it is distributed and
consumed-either digitally or physically-and to enable new consumer applications
to access networks and information from personal computers and mobile devices.
Many movie studios, record labels, broadcasters, creative professionals and
other customers rely on digital watermarking as a cost-effective means to:
º •
º deter piracy and illegal use of movies, music and images;
º •
º protect entertainment content from copyright infringement;
º •
º track and monitor entertainment content for rights usage and licensing
compliance;
º •
º monitor advertisements to verify ad placement and measure return on
investment;
º •
º enhance information access, search and marketing capabilities related
to media content; and
º •
º enable fair and legitimate use of content by consumers.
Our business partners and customers include AquaMobile, Cinea, Inc., a
subsidiary of Dolby Laboratories, Inc., GCS Research LLC, MediaGrid, Microsoft
Corporation, Mobile Data Systems, Inc., The Nielsen Company, Royal Philips,
Signum Technologies Limited, Thomson Multimedia, S.A., USA Video, Verance
Corporation, Verimatrix, Inc. and VCP (an affiliate of VEIL Interactive
Technologies). Although each partner or customer addresses particular needs, as
a whole these partners and customers are propagating digital watermarking in
music, movies, images and television as a means to improve
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media rights and asset management, reduce piracy losses, improve marketing
programs, and provide more efficient and effective distribution of valuable
media content.
Technology and Intellectual Property
We use intellectual property ("IP") to differentiate its products and
technologies, mitigate infringement risk, and develop opportunities for
licensing. Licensing of our digital watermarking and related technologies is
supported by a broad patent portfolio covering a wide range of methods,
applications, and system architectures.
Most of our patents relate to various methods for embedding digital
information in video, audio, and images, whether the content is rendered in
analog or digital formats. The digital information is generally embedded by
making subtle modifications to the fundamental elements of the content itself,
generally at a signal processing level. The changes necessary to embed this
information are so subtle that they are generally not noticeable by people
during normal use. Because the message is carried by the content itself, it is
file-format independent. The message generally survives most normal compression,
edits, rotation, scaling, re-sampling, file-format transformations, copying,
scanning and printing. Our media identification and management patent portfolio
includes not only digital watermarking but innovations in pattern recognition
(sometimes referred to as "fingerprinting") and digital rights management (DRM)
applications.
To protect our significant efforts in creating these technologies, 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 the field of digital
watermarking, with 360 U.S. and over 80 foreign issued patents and more than 500
U.S. and foreign patent applications on file as of December 31, 2007 in the
areas of digital watermarking, secure identity management and related
technologies. Separately, we own registered trademarks in both the U.S. and
other countries and have applied for other trademarks. We continue to develop
and broaden our portfolio of patented technologies, including digital
watermarking and related applications and systems, and other technologies
related to secure ID systems. For ID systems-related technologies, the focus of
patent development has been in the areas of imaging and printing systems, card
architecture and materials, and security features. Some patents relate to future
product offerings or related technologies like smart cards, laser engraving and
alternative card systems.
Although we devote significant resources to developing and protecting our
technologies, and periodically evaluate potential competitors of our
technologies for infringement of our intellectual property rights, these
infringements may nonetheless go undetected or may arise in the future. We
expect that infringement claims may increase as companies become more concerned
with protecting their content from electronic copying.
Markets
Identification
We believe that the U.S. driver license market will continue to grow as a
result of (i) broadening use of the driver license as a secure credential beyond
its traditional role as evidence of competence to drive a motor vehicle;
(ii) technological innovation; (iii) desire among issuers to improve security
and efficiency; and (iv) new governmental regulations such as the REAL ID Act.
We anticipate that these regulations may result in substantial system upgrades
by our customers. Final rules under the REAL ID Act were published on
January 11, 2008. According to a February 8, 2008 report published by CNET
Networks, Inc., 30 States have stated they intend to comply with REAL ID or have
applied for and already received extensions. Five States, representing 5% of the
U.S. population, have passed anti-REAL ID laws; and 15 States believe they will
possibly comply.
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We believe that many aspects of our driver license issuance solutions have
value in other forms of credentials and secure personal identification systems.
As the global market for secure personal identification solutions develops, we
believe that our position as the leading supplier of government-issued citizen
IDs in North America and our extensive investments in research and development
provide a good foundation for participation in the global market for government
programs establishing the identities of citizens and issuing associated
credentials.
An example of such a potential opportunity is in the market for smart cards.
The Western Hemisphere Travel Initiative requires that all U.S. citizens
returning from outside the U.S. present either a passport, a new border PASS
Card or EDL, approved by the Department of Homeland Security. The Federal
government is requiring a Radio-frequency identification (RFID) chip in each
PASS Card or EDL. In other applications, the Federal government has been
advancing worker identification using smart cards. In response to these moves,
in 2006 we announced a smart card option for our secure driver license solution.
We began production of the first high security licenses in a pilot program in
Washington State. Interest in these new high tech licenses is spreading. The US
Secretary of Homeland Security is strongly encouraging Canadian provincial
governments to consider producing such licenses, which could be used in lieu of
a passport at the border. In parallel, a growing number of U.S. States,
including Arizona, New York, Texas, and Vermont, have expressed interest in
producing an EDL. In addition, we will continue to look for opportunities to
participate in smart card ID programs in Europe and other parts of the world
where smart cards are more widely used.
Media Identification and Management
Digital watermarking and related technologies are used in various media
identification and management products and solutions supporting a variety of
media objects, from movies and music, to banknotes and secure credentials. Each
media object enabled by our technology creates the potential for several
applications, such as:
º •
º counterfeiting and piracy deterrence,
º •
º media management,
º •
º authentication and monitoring,
º •
º linking to networks and providing access to information,
º •
º and enhanced services in support of mobile commerce.
We believe the market for such applications is in the early stages of
development and that existing solutions represent only a small portion of the
potential market for our products, services, and technologies.
Competition
Digimarc competes for government business with system integrators,
biometrics suppliers, security printers, card manufacturers, and smart card and
other security technology suppliers, including companies like L-1 Identity
Solutions, Inc. (formerly Viisage Technology, Inc.) (biometrics), Unisys
Corporation (system integration) and De La Rue plc (security printer). Each of
these companies is a supplier to U.S. driver license issuers. As U.S. driver
licenses gain utility as general credentials and the Federal government is
demanding higher security and a certain amount of standardization, competition
may increase. For instance, certain aspects of the REAL ID Act may expedite an
existing trend toward central issuance of driver licenses. Although we are
proficient at central issuance, the possible acceleration of this trend could
draw new competition from classic security printers such as Canadian Banknote
Company, Limited and Giesecke & Devrient GmbH.
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The possibility of including smart card technologies in driver licenses is
generating a great deal of public debate. The smart card industry is generally
driven by European chip manufacturers such as Infineon Technologies AG and
Gemalto NV. While successful in bank cards, mobile phone SIMs and phone cards,
smart cards have only recently begun to gain distribution as government-issued
credentials. The U.S. government is a strong advocate. Federal identity
standards are embracing smart cards for the military, transportation workers,
and government employees and contractors, and new "ePassports" will carry a
portrait in an on-book chip. Despite considerable investment by the Federal
government, we believe no States have attempted or even piloted smart card
driver licenses, except for the EDL card we recently deployed in Washington
State. We understand that in recent years, at least two States have expressly
considered and rejected smart card driver licenses. Emerging border control and
Federal traveler programs are considering smart card concepts, but have not
gained traction and face privacy issues. We anticipate we will be prepared to
support requirements from customers for smart card technology if, and when, such
requirements arise.
We are seeing increased interest in the U.S. ID market from large systems
integrators such as Electronic Data Systems Corporation, IBM Global Services,
Accenture, and Bearing Point, as well as other ID and security suppliers such as
Canadian Banknote and DataCard Corporation. Smaller application providers are
also emerging as point-product competition, including Saber and Archon. In 2007,
we implemented our first EDL pilot approved by the Department of Homeland
Security in the State of Washington for land and sea border crossing. While to
date there are no other known companies offering complete EDL solutions, we
anticipate the primary competition for the EDL will be the PASS Card, which
General Dynamics Corporation is contracted to provide.
Internationally, we supply credentialing systems, components or supplies to
numerous foreign governments, including four Canadian provinces, Latvia, Mexico,
Ghana and Russia. Competition in international markets, like in the U.S., comes
from security printers, card producers, biometric companies and systems
integrators, such as Sagem Telecommunications, S.A., De La Rue plc, Gemalto NV,
Fujitsu Siemens Computers, Wincor Nixdorf International GmbH, Unisys
Corporation, and Hewlett Packard Company.
In media identification and management, our business partners and we
generally compete with application-specific alternative technologies for the
security budget of the producers and distributors of the media objects. These
alternatives include technologies and solutions based on encryption or on
pattern recognition. We anticipate that our competitive position within certain
markets may be affected by factors such as reluctance to adopt new technologies
and, positively or negatively, by changes in government regulations.
Seasonality
We have observed seasonality in our U.S. driver license issuance revenues,
with larger revenues in the second and third quarter of the year, and generally
lower revenues in the first and fourth quarters. The fourth quarter is usually
the seasonally lowest quarter each year. We use the straight line method of
depreciation and amortization for program-related assets. The combination of the
seasonality of our revenues and straight line depreciation and amortization can
cause significant variations in quarterly gross margin trends, generally
increasing margins in the second and third quarters when our issuance revenues
are higher and decreasing margins in the first and fourth quarters when our
issuance revenues are typically lower, while having a neutral effect on a yearly
basis.
Backlog
Backlog as of December 31, 2007 was approximately $225 million. We expect
more than $90 million of this amount to be recognized as revenue during 2008.
This amount includes production volumes reasonably expected to be achieved under
currently effective contracts, government orders that
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are firm but not yet funded, and government contracts awarded but not yet
signed. Backlog as of December 31, 2006 was approximately $250 million.
There is no assurance that our backlog will result in actual revenue in any
particular period, because the orders, awards and contracts included in our
backlog may be subject to modification, cancellation or suspension. We may not
realize revenue on certain contracts, orders or awards included in our backlog
or the timing of such recognition may change.
Employees
At December 31, 2007, we had 424 full-time employees, including 60 in sales,
marketing, technical support and customer support; 89 in research, development
and engineering; 84 in finance, administration, information technology and
legal; and 191 in field operations, manufacturing and supply chain. We also had
38 contract workers, primarily utilized in our international manufacturing
operations at December 31, 2007. Our future success will depend, in part, on our
ability to continue to attract, retain and motivate highly qualified technical
and management personnel, for whom competition is intense. Our employees are not
covered by any collective bargaining agreement, and we have never experienced a
work stoppage. We believe that our relations with our employees are good.
Available Information
We make available through our website at www.digimarc.com our Annual Reports
on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and
amendments to these and other reports filed or furnished by us pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as
reasonably practicable after we file such materials with the Securities and
Exchange Commission.
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