DIGIMARC CORP - 10-K - 20080229 - FORM
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
ý
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2007
OR
o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period
from to
Commission File Number 000-28317
DIGIMARC CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
94-3342784
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
9405 SW Gemini Drive, Beaverton, Oregon 97008
(Address of principal executive offices) (Zip Code)
(503) 469-4800
(Registrant's telephone number, including area code)
Securities
registered pursuant to Section 12(b) of the Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common Stock, $0.001 Par Value Per Share
The Nasdaq Global Market
Securities
registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes
o
No
ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes
o
No
ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes
ý
No
o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K.
o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large
accelerated filer
o
Accelerated filer
ý
Non-accelerated filer
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act). Yes
o
No
ý
The aggregate market value of common stock, par value $0.001 per share, held by non-affiliates of the registrant, based on the closing price for the
common stock on The Nasdaq Global Market on the last business day of the registrant's most recently completed fiscal second quarter (June 30, 2007), was approximately $208 million.
Shares of common stock beneficially held by each officer and director have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate
status is not necessarily a conclusive determination for any other purposes.
As
of January 31, 2008, there were 22,041,002 shares of the registrant's common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's proxy statement pursuant to Regulation 14A (the "Proxy Statement") for its 2008 annual meeting of stockholders are incorporated
by reference into Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K. The registrant intends to file the Proxy Statement not later than
120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
Table of Contents
PART I
Item 1.
Business
1
Item 1A.
Risk Factors
9
Item 1B.
Unresolved Staff Comments
9
Item 2.
Properties
9
Item 3.
Legal Proceedings
10
Item 4.
Submission of Matters to a Vote of Security Holders
11
PART II
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
12
Item 6.
Selected Financial Data
14
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
14
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
52
Item 8.
Financial Statements and Supplementary Data
53
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
53
Item 9A.
Controls and Procedures
53
Item 9B.
Other Information
55
PART III
Item 10.
Directors, Executive Officers and Corporate Governance
56
Item 11.
Executive Compensation
56
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
56
Item 13.
Certain Relationships and Related Transactions, and Director Independence
56
Item 14.
Principal Accounting Fees and Services
56
Item 15.
Exhibits and Financial Statement Schedules
57
SIGNATURES
58
EXHIBIT INDEX
PART I
The following discussion of Digimarc's business contains forward-looking statements relating to future events or the future financial
performance of Digimarc. 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 Annual Report on Form 10-K in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, under the caption "Safe Harbor Statement
under the Private Securities Litigation Reform Act of 1995."
Although we believe that the expectations reflected in our forward-looking statements are reasonable, we do not give any assurances that these expectations will
prove to be correct. These statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from
those described in our forward-looking statements, and we do not intend to update or revise any forward-looking statements as a result of new information, future events or otherwise. We urge you to
carefully review and consider the various disclosures we have made that attempt to advise interested parties of the factors which affect our business, including the disclosures made in Item 7,
Management's Discussion and Analysis of Financial Condition and Results of Operations, under the caption "Factors Affecting Forward Looking Statements" in this Annual Report on
Form 10-K, the audited consolidated financial statements and related notes included in this Annual Report on Form 10-K, and other reports and filings made with
the SEC.
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 Annual Report on Form 10-K.
This
Annual Report on Form 10-K includes trademarks and registered trademarks of Digimarc Corporation.
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:
•
Foster
large-scale adoption of media identification and management solutions licensed under Digimarc's intellectual property; and
•
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
1
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
2
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:
•
produce
driver licenses with digital portraits,
•
deploy
facial recognition and State-wide fingerprint matching in 1995 and 1996,
•
introduce
market leading security features, including digital watermarking, Kinegrams, and secure card materials,
•
produce
driver licenses in secure, networked central issuance factories,
•
offer
driver license renewal by Internet,
•
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
•
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
3
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
4
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:
•
deter
piracy and illegal use of movies, music and images;
•
protect
entertainment content from copyright infringement;
•
track
and monitor entertainment content for rights usage and licensing compliance;
•
monitor
advertisements to verify ad placement and measure return on investment;
•
enhance
information access, search and marketing capabilities related to media content; and
•
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
5
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.
6
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:
•
counterfeiting
and piracy deterrence,
•
media
management,
•
authentication
and monitoring,
•
linking
to networks and providing access to information,
•
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.
7
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
8
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.
ITEM 1A: RISK FACTORS
Certain risk factors that may affect our business, financial condition, results of operation and cash flows, or that may cause our actual results to vary from the
forward-looking statements contained in this Annual Report on Form 10-K are set forth in Item 7, Management's Discussion and Analysis of Financial Condition and Results of
Operations, under the caption "Factors Affecting Forward Looking Statements," in this Annual Report on Form 10-K.
ITEM 1B: UNRESOLVED STAFF COMMENTS
None.
ITEM 2: PROPERTIES
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. Information about our office leases is set forth below.
Square Feet
Expires
Beaverton, Oregon
46,000
August 2011
Burlington, Massachusetts
60,000
October 2010
Fort Wayne, Indiana
48,000
January 2010
We
also lease sales and support offices in multiple locations throughout the United States and internationally.
9
ITEM 3: LEGAL PROCEEDINGS
Beginning in September 2004, three purported class action lawsuits were filed in the U.S. District Court for the District of Oregon against us and certain of our
current and former directors and officers on behalf of purchasers of our securities during the period April 17, 2002 to July 28, 2004. These lawsuits were later consolidated into one
action for all purposes. The amended complaint, which sought unspecified damages, asserted claims under the federal securities laws relating to the restatement of our financial statements for 2003 and
the first two quarters of 2004 and alleged that we issued false and misleading financial statements and issued misleading public statements about our operations and prospects. On August 4,
2006, the court granted our motion to dismiss the lawsuit with prejudice and entered judgment in our favor. Plaintiffs have filed a notice of appeal in the Ninth Circuit Court of Appeals. The appeal
was stayed pending the recent U.S. Supreme Court's determination in another case of issues relating to the Private Securities Litigation Reform Act, and briefing is scheduled to be completed by the
end of the year. We anticipate oral argument and a decision in 2008. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate timing or outcome of the
matter.
On
or about October 19, 2004, two purported shareholder derivative lawsuits were filed against certain of our officers and directors, naming us as a nominal defendant, in the
Superior Court of the State of California for the County of San Luis Obispo. These lawsuits were consolidated into one action for all purposes on March 14, 2005. This suit claims that certain
of these officers and directors breached their fiduciary duties to our shareholders and to us. The complaint is derivative in nature and does not seek relief from us. The Board of Directors appointed
an independent committee to investigate the claims asserted in this derivative lawsuit. On July 19, 2005, the court granted our motion to stay these consolidated actions in favor of a
shareholder derivative action to be filed by plaintiffs in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005, the California plaintiffs filed two new
derivative lawsuits in the United States District Court for the District of Oregon. On October 17, 2005, defendants filed a motion to dismiss these complaints for lack of subject matter
jurisdiction and failure to state a claim. In May of 2006, the Board committee, after completing
its investigation, concluded that pursuit of the allegations would not be in the best interests of Digimarc or its shareholders. On August 24, 2006, the court granted defendants' motion and
dismissed the lawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22, 2006. The briefs to the Ninth Circuit were completed in June, and we anticipate oral argument and a
decision in 2008. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate timing or outcome of the matter.
Beginning
in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for
the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of our initial public offering as defendants.
The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters
of our initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in our
initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of our stock in the after-market subsequent to our initial public offering.
Certain of its officers and directors and we are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5
of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters' alleged compensation arrangements and manipulative practices. The complaint seeks unspecified
damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a court order dated October 9, 2002, were dismissed from the litigation without
prejudice. Furthermore, in July 2002, other defendants in the consolidated cases and
10
we
filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated
actions, including us. The claims against us under Section 10(b), however, were dismissed. In June 2003, a committee of our board of directors conditionally approved a proposed partial
settlement with the plaintiffs in this matter. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. The settlement would have provided, among other things, a
release of us and of the individual defendants for the alleged wrongful conduct in the amended complaint in exchange for a guarantee from our insurers regarding recovery from the underwriter
defendants and other consideration from us regarding our underwriters, including agreeing to assign away, not assert, or release certain potential claims we may have against its underwriters. The
plaintiffs have continued to litigate against the underwriter defendants. The district court directed that the litigation proceed within a number of "focus cases" rather than in all of the 310 cases
that have been consolidated. Our case is not one of these focus cases. On October 13, 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed
that ruling, and on December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court's class certification decision. On April 6, 2007, the Second Circuit denied
plaintiffs' petition for rehearing. In light of the Second Circuit opinion, we have informed the district court that this settlement cannot be approved because the defined settlement class, like the
litigation class, cannot be certified. We cannot predict whether we will be able to renegotiate a settlement that complies with the Second Circuit's mandate. Due to the inherent uncertainties of
litigation, we cannot accurately predict the ultimate outcome of the matter.
On
October 10, 2007, a Digimarc shareholder filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted as lead
underwriters on our initial public offering. The complaint, which also named us as a nominal defendant but did not assert any claims against us, asserted claims against the underwriters under
Section 16(b) of the Securities Exchange Act of 1934 for recovery of alleged short-swing profits on trades of our stock.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
11
PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURTIES
Our common stock is traded on The Nasdaq Global Market under the symbol "DMRC." The closing price of our common stock on The Nasdaq Global Market was $8.26 as of
January 31, 2008. The following table lists the high and low sales prices of our common stock for the periods indicated, as reported by The Nasdaq Global Market.
Year Ended December 31,
2007
2006
High
Low
High
Low
First quarter
$
12.43
$
8.09
$
8.00
$
5.85
Second quarter
$
11.05
$
8.90
$
7.76
$
5.85
Third quarter
$
11.60
$
8.05
$
8.45
$
5.56
Fourth quarter
$
9.60
$
8.21
$
9.75
$
7.51
At
February 25, 2008, we had 487 stockholders of record of our common stock, as shown in the records of our transfer agent.
We
have never declared or paid cash dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future
earnings, if any, to finance the future growth of our business.
The
following table sets forth information regarding purchases of our equity securities during the quarter ended December 31, 2007, all of which were shares subject to restricted
stock awards that we purchased to cover applicable tax withholding obligations when these awards vested.
Period
(a)
Total number of shares (or units) purchased
(b)
Average price paid per share (or unit)
(c)
Total number of shares (or units) purchased as part of publicly announced plans or programs
(d)
Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased under the plans or programs
Month 1
October 1, 2007 to October 31, 2007
3,175
$
8.95
—
—
Month 2
November 1, 2007 to November 30, 2007
—
—
—
—
Month 3
December 1, 2007 to December 31, 2007
21,272
$
8.82
—
—
Total
24,447
$
8.84
—
—
Information
regarding securities authorized for issuance under equity compensation plans is included in Part III, Item 12 of this Form 10-K.
12
STOCK PERFORMANCE GRAPH
The following graph compares the performance of our common stock with the performance of (i) the Nasdaq U.S. Index and (ii) a peer group selected by
us. The comparison assumes $100 was invested on December 31, 2002 in our common stock at the closing price on such date and in each of the other two indices at the closing price on such date
and assumes reinvestment of any dividends. We believe that the companies in the peer group are more comparable to us in terms of line-of-business, market capitalization,
revenues, and number of employees and, therefore, comprise a more appropriate peer group for purposes of comparing stock performance. The comparisons in the graph are based on historical data and are
not indicative of, nor intended to forecast, future performance of our common stock.
Comparison of Cumulative Five Year Total Return
Indexed Data
Years Ending December 31,
Company Name / Index
Base Period
2002
2003
2004
2005
2006
2007
Digimarc Corporation
100
$
117.28
$
82.19
$
52.03
$
77.51
$
77.78
Nasdaq U.S. Index
100
150.36
163.00
166.58
183.68
201.91
Peer Group
100
160.33
187.81
145.79
137.99
127.54
Companies included in the peer group index of the stock performance graph are as follows:
ACTIVIDENTITY CORP
ENTRUST INC
NIC INC
ALADDIN KNOWLEDGE SYS LTD
L-1 IDENTITY SOLUTIONS INC
RAE SYSTEMS INC
AMERICAN BK NT HOLOGRAPHICS
LASERCARD CORP
SCM MICROSYSTEMS INC
COGENT INC
MACROVISION CORP
TYLER TECHNOLOGIES INC
DTS INC
MEDIALINK WORLDWIDE INC
VERINT SYSTEMS INC
DYNAMICS RESEARCH CORP
NCI INC
(1)
The
peer group does not include two companies, CompuDyne and Safenet, from our 2006 peer group since they were acquired in 2007.
13
ITEM 6: SELECTED FINANCIAL DATA
The selected financial data set forth below should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial
statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," which are included
elsewhere in this report. The consolidated statement of operations and balance sheet data as of and for each of the five years in the period ended December 31, 2007, are derived from our
audited consolidated financial statements.
Year Ended December 31,
2007
2006
2005
2004
2003
(in 000'S, except per share data)
Consolidated Statement of Operations Data:
Revenue
$
109,764
$
104,247
$
101,053
$
92,947
$
85,591
Net income (loss)
$
(445
)
$
(11,740
)
$
(23,097
)
$
(9,022
)
$
175
Net income (loss) per share—basic
$
(0.02
)
$
(0.57
)
$
(1.13
)
$
(0.44
)
$
0.01
Net income (loss) per share—diluted
$
(0.02
)
$
(0.57
)
$
(1.13
)
$
(0.44
)
$
0.01
Weighted average shares—basic
20,982
20,649
20,485
20,326
18,572
Weighted average shares—diluted
20,982
20,649
20,485
20,326
19,351
Year Ended December 31,
2007
2006
2005
2004
2003
(in 000'S)
Consolidated Balance Sheet Data:
Total assets
$
142,023
$
134,631
$
140,239
$
163,287
$
161,153
Long-term obligations, net of current portion
8,462
6,230
3,009
3,104
2,006
ITEM 7: 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 Item 7, under the caption "Safe Harbor Statement under the Private Securities
Litigation Reform Act of 1995."
Although we believe that the expectations reflected in our forward-looking statements are reasonable, we do not give any assurances that these expectations will
prove to be correct. These statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from
those described in our forward-looking statements, and we do not intend to update or revise any forward-looking statements as a result of new information, future events or otherwise. We urge you to
carefully review and consider the various disclosures we have made that attempt to advise interested parties of the factors which affect our business, including the disclosures made under the caption
"Factors Affecting Forward Looking Statements" in this Item 7, the audited consolidated financial statements and related notes included in this Annual Report on Form 10-K,
and other reports and filings made with the SEC.
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 Annual Report on Form 10-K.
14
Overview
Digimarc is a leading supplier of secure identity management and media identification and management solutions. 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
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 foreign 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 applications of our digital watermarking and related technologies, primarily from patent and technology
license fees paid by business partners, and a contract with a consortium of Central Banks.
Variability of Capitalized and Deferred Costs.
Our driver license and ID issuance programs generally require significant cost
to develop, build and deploy new systems. These new systems may be sold outright upon completion or used in generating recurring revenue in the future. Certain labor and other costs relating to these
new systems may be deferred and expensed upon completion, or capitalized and amortized over the life of the relevant contract, rather than expensed in the quarter in which they are incurred. We may
experience variability in our operating income, depending on the extent to which we are able to capitalize or defer these costs. If we are able to win new business, our capitalized or deferred costs
and operating income may increase as a result of an increased allocation of labor resources to capitalized or deferred items. On the other hand, if we experience delays or reductions in new business,
our capitalized or deferred costs may decrease, which may result in an increase in operating expenses for the relevant quarter and a decrease in operating income.
Depreciation.
Starting January 1, 2006, we changed our policy for depreciating fixed assets that were specifically
used to provide services under long-term contracts to the shorter of the original contract term plus 2.75 years or estimated useful life. Through December 31, 2005, we
depreciated these assets over the shorter of the original contract term or estimated useful life. This change in estimate was supported by an analysis we completed during the first quarter of 2006
which showed that historically 95% of contracts were extended beyond the original contract term, that the average contract had at least two contract extensions during its life and that these
extensions added an average of 2.75 years to the length of the contracts' original terms.
Since
contract-specific program assets are tracked on a contract basis, the finding that contracts are routinely extended beyond the original term and that these extensions are not
generally accompanied by significant incremental capital investment indicates that the useful life of contract-related assets is generally longer than the original term of the contract. Given these
findings, we concluded that it was appropriate to change the estimated useful lives of these assets for purposes of depreciation. In addition, the change in useful lives achieves a better matching of
the utility of these assets with the resulting revenues. For the year ended December 31, 2007, we performed an updated analysis on contract specific assets which resulted in no change to our
previous conclusions. We will continue to analyze the useful lives of contract specific assets in future periods. The financial impact of this change is discussed below in the Cost of Revenue.
Backlog.
Based on projected government-issued credential production volumes and other commitments we have for the periods
under contract with our respective customers, we anticipate our
15
current
contracts as of December 31, 2007 will generate approximately $225 million in revenue during the contractual terms of such contracts, currently up to seven years. 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 are firm but not yet funded, and government contracts awarded but not yet signed. Backlog as of December 31, 2006 was approximately $250 million. The decrease in
backlog reflects factors noted below.
Some
factors that lead to increased backlog are:
•
Competitive
bid wins,
•
Renewals
with current customers,
•
Add-on
sales to current customers, and
•
Contracts
with longer contractual periods replacing contracts with shorter contractual periods.
Some
factors that lead to decreased backlog are:
•
Recognition
of revenue associated with backlog currently in place,
•
Low
bid and award activity,
•
Contracts
with shorter contractual periods replacing contracts with longer contractual periods, and
•
The
revenue model utilized for a particular customer (e.g., a "price-per-card" model with a large associated backlog vs. a "hardware and
consumables" model with a small associated backlog).
The
mix of these factors, among others, dictates whether our backlog increases or decreases for any given period.
Over
the next year or so, we anticipate several states to request bids or negotiate extensions on their driver license issuance system programs. This period of expected high bid and
potential extension activity could lead to additional backlog if we are successful with our bids. Another example is our variable revenue model. From time to time we have sales to our customers that
are not characteristic of our price-per-card model, but instead included hardware and consumable sales. Although these types of revenue models are positive growth indicators
for our business, they can lead to lower reported backlog.
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.
Restructuring.
During the last half of 2005 and continuing during 2006, we restructured our operations to improve
productivity and reduce fixed costs. During the second quarter of 2006 we accelerated those activities significantly, resulting in a reduction of our workforce by nearly 20%. Overall, our workforce
was reduced by over 30% since mid 2005 until late 2006. Our actions included the redeployment and reallocation of resources to better align with our operating strategies.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the U.S. ("U.S. GAAP") requires us to
make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going
basis, we evaluate our estimates, including those related to bad debts, inventories, fixed assets, intangible assets, income taxes, restructuring, long-term service
16
contracts,
warranties, investments, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the
circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Certain
of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term service contracts,
impairments and estimation of useful lives of long-lived assets, inventory valuation, reserves for uncollectible accounts receivable, contingencies and litigation and stock-based
compensation. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:
Revenue recognition on long-term service contracts:
We recognize revenue on long-term identification and driver
license production contracts using primarily a price-per-card method. We use actual monthly volume amounts, if available, or we estimate the card production volume on a monthly
basis for certain of these contracts in order to recognize revenue earned during the period. In the case of estimates, when the actual production information becomes available, which is typically
within four weeks, we bill the customer accordingly and any differences from the estimates are recognized in the month the billing occurs. These amounts represent our best estimates of cards produced
and are based on historical trends, known events during the period, and discussions with contract representatives. Prior to publicly reporting results, our practice is to compare the actual production
volumes to estimated production volumes and adjust revenue amounts as necessary. Any estimated amounts are included in unbilled receivables on the balance sheet until the actual production information
is available and the billing occurs. Any estimation process involves inherent risk. We reduce the inherent risk relating to production estimation through our approval and monitoring processes related
to accounting estimates. We also evaluate contracts for multiple elements and account for these items under the appropriate accounting literature.
Revenue
from professional service arrangements is generally determined based on time and material or a cost plus a profit margin measure. Revenue for professional services is recognized as the
services are performed. Losses on contracts, if any, are provided for in the period in which the loss becomes determinable. Billing for services rendered generally occurs within one month following
when the services are provided. Revenue earned which has not been invoiced is classified as unbilled trade
receivables, which is included in the balance of trade accounts receivable, net in the consolidated balance sheets.
Impairments and estimation of useful lives of long-lived assets:
We periodically assess long-lived assets for
impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in accordance with the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets.
This statement requires that
long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If
such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is
determined based on discounted cash flows or appraised values, depending on the nature of the asset. Also, we periodically review the useful lives of long-lived assets whenever events or
changes in circumstances indicate that the useful life may have changed. If the estimated useful lives of such assets do change, we adjust the depreciation or amortization period to a shorter or
longer period, based on the circumstances identified.
17
Inventory valuation:
Inventory consists primarily of consumable supplies that are used in the production of driver licenses and products
held for resale to customers. We value inventory at the lower of cost or market value (which lower amount is the net realizable value). We reduce the value of our inventory for estimated obsolescence
or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market
conditions are less favorable than those projected by management, additional inventory write-downs may be required.
Reserves for uncollectible accounts receivable:
We maintain allowances for doubtful accounts for estimated losses resulting from the
inability of our customers to make required payments. We determine the allowance based on historical write-off experience and current information. We review, and adjust when appropriate,
our allowance for doubtful accounts on at least a quarterly basis. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.
Contingencies and litigation:
We periodically evaluate all pending or threatened contingencies or commitments, if any, that are reasonably
likely to have a material adverse effect on our operations or financial position. We assess the probability of an adverse outcome and determine if it is remote, reasonably possible or probable as
defined in accordance with the provisions of SFAS No. 5,
Accounting for Contingencies
. If information available prior to the issuance of our
financial statements indicates
that it is probable that an asset has been impaired or a liability has been incurred at the date of our financial statements, and the amount of the loss, or the range of probable loss can be
reasonably estimated, then such loss is accrued and charged to operations. If no accrual is made for a loss contingency because one or both of the conditions pursuant to SFAS No. 5 are not met,
but the probability of an adverse outcome is at least reasonably possible, we will disclose the nature of the contingency and provide an estimate of the possible loss or range of loss, or state that
such an estimate cannot be made.
Stock-based compensation:
We account for stock-based compensation in accordance with SFAS No. 123(R),
Share-Based Payment (Revised 2004)
, which requires the measurement and recognition of compensation for all stock-based awards made to employees and
directors including stock options and employee stock purchases under a stock purchase plan based on estimated fair values. We use the Black-Scholes option pricing model as our method of valuation for
stock-based awards. Our determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a
number of highly complex and subjective variables. These variables include, but are not limited, to the expected life of the award, our expected stock price, volatility over the term of the award and
actual and projected exercise behaviors. Although the fair value of stock-based awards is determined in accordance with SFAS 123(R), the Black-Scholes option pricing model requires the input of
highly subjective assumptions, and other reasonable assumptions could provide differing results. The fair value of restricted stock awards granted is based on the fair market value of our common stock
on the date of the grant (measurement date), and is being recognized over the vesting period of the related restricted stock using the straight-line method. The fair value of performance
vesting share awards granted is based on a Monte Carlo valuation model that resulted in a factor applied to the fair market value of our common stock on the date of the grant (measurement date), and
is being recognized over the derived service period using the straight-line method.
18
Results of Operations
The following table presents our consolidated statement of operations data for the periods indicated as a percentage of total revenue.
Year Ended December 31,
2007
2006
2005
Revenue:
Service
82
%
82
%
84
%
Product and subscription
18
18
16
Total revenue
100
100
100
Cost of revenue:
Service
55
58
61
Product and subscription
7
8
7
Total cost of revenue
62
66
68
Gross profit
38
34
32
Operating expenses:
Sales and marketing
15
15
16
Research, development and engineering
6
10
13
General and administrative
14
16
21
Amortization of intangibles
2
2
4
Intellectual property
2
2
2
Restructuring charges
—
1
—
Total operating expenses
39
46
56
Operating income (loss)
(1
)
(12
)
(24
)
Other income (expense), net
1
1
1
Income (loss) before provision for income taxes
—
(11
)
(23
)
Provision for income taxes
—
—
—
Net income (loss)
—
%
(11
)%
(23
)%
Our
total revenue for the year ended December 31, 2007 was $109.8 million, or 5% higher as compared to $104.2 million for the prior year. We reported a substantially
reduced loss for the year of $(0.4) million, an improvement of $11.3 million from 2006. We believe this dramatic improvement in earnings, driven both by increased revenue and reduced expenses,
is the result of realizing the financial leverage caused by the restructuring efforts begun in 2005 and carried through 2006.
19
Years Ended December 31, 2007 and 2006
Revenue
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Revenue:
Service
$
89,623
$
85,681
$
3,942
5
%
Product and subscription
20,141
18,566
1,575
8
%
Total
$
109,764
$
104,247
$
5,517
5
%
Revenue (as % of total revenue):
Service
82
%
82
%
Product and subscription
18
%
18
%
Total
100
%
100
%
Service.
Service revenue consists primarily of:
•
card
production on a price-per-card basis,
•
software
development and consulting services, and
•
hardware
and software maintenance.
The
majority of service revenue arrangements are typically structured as price-per-card product agreements, time and materials consulting agreements, or fixed
price consulting agreements.
The
increase in service revenue was due primarily to increased revenue from our Mexican operations following a production hiatus associated with the 2006 national elections in that
country and the commencement of services to additional provinces under our Atlantic Canada contract. These increases were offset by lower production volumes from Haiti's one-time voter
identification project completed in the first quarter of fiscal year 2006, lower revenue from Latvia as a result of a non-recurring transaction in 2006, and lower revenues from various
states from a combination of price and volume mix.
Product and subscription.
Product revenue consists primarily of the sale of equipment, software licenses and consumables
related to identification card production systems that are variable in nature and occur from time to time. Subscription revenue consists primarily of royalty revenue from our intellectual property
licenses and the sale of our web-based subscriptions related to various software products, both of which are more recurring in nature. Revenues from our licensing products have minimal
associated costs and are nearly all margin.
The
increase in product and subscription revenue was due primarily to a net increase in variable sales, add-ons and upgrades, to various domestic and international customers
and additional payments from certain cash basis customers where billings were made in the prior year but collected in 2007. Offsetting these increases was lower revenue from the United Kingdom
contract that ended in the second quarter of 2007.
20
Revenue by Geography
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Revenue by geography:
Domestic
$
87,610
$
83,161
$
4,449
5
%
International
22,154
21,086
1,068
5
%
Total
$
109,764
$
104,247
$
5,517
5
%
Revenue (as % of total revenue):
Domestic
80
%
80
%
International
20
%
20
%
Total
100
%
100
%
The
increase in domestic revenue was due primarily to variable sales and additional cash payments as discussed above, offset by lower revenues from a combination of price and volume mix
from various states.
The
increase in international revenue was due primarily to increased revenue from Mexico and Canada as discussed above. These increases were offset by lower revenue from the United
Kingdom contract, lower production volumes as a result of Haiti's one-time voter identification project,
which ended in fiscal year 2006, and lower revenue from Latvia due to a non-recurring transaction in fiscal year 2006.
Revenue by Source
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Revenue by source:
Media identification and management
$
13,211
$
11,071
$
2,140
19
%
Identification
96,553
93,176
3,377
4
%
Total
$
109,764
$
104,247
$
5,517
5
%
Revenue (as % of total revenue):
Media identification and management
12
%
11
%
Identification
88
%
89
%
Total
100
%
100
%
The
increase in media identification and management revenue was due primarily to additional license revenues from our cash based customers where billings were made in 2006 and collected
in 2007 and higher service revenue from our Central Bank and Nielsen contracts.
The
increase in identification revenue was due primarily to service and product sales to various domestic and international customers as discussed above.
21
Cost of Revenue
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Cost of Revenue:
Service
$
59,941
$
60,817
$
(876
)
(1
)%
Product and subscription
8,087
7,952
135
2
%
Total
$
68,028
$
68,769
$
(741
)
(1
)%
Cost of Revenue (as % of related revenue components):
Service
67
%
71
%
Product and subscription
40
%
43
%
Service.
Cost of service revenue primarily includes:
•
costs
of consumables used in delivering a service,
•
compensation,
benefits and related costs of software developers, quality assurance personnel, product managers and field operations personnel,
•
payment
to outside contractors,
•
depreciation
charges for machinery, equipment, software and capitalized labor,
•
deployment
costs used specifically for service delivery,
•
provisions
for obsolete and excess inventories,
•
travel
costs directly attributable to service and development contracts,
•
stock-based
compensation expense, and
•
charges
for infrastructure and centralized costs.
The
decrease in cost of service revenue was due primarily to the following:
•
decreased
employee compensation-related expenses for salaries, benefits, recruiting costs and incentive plans aggregating $1.9 million as part of the restructuring
initiative,
•
decreased
accrued benefits of $0.5 million due to no corporate incentive bonus earned or accrued across all cost areas in 2007, offset by
•
increased
depreciation expense of $1.1 million related to programs completed in the second half of 2006 or in fiscal year 2007, and
•
increased
allocated infrastructure and centralized costs of $0.4 million primarily due to the redeployment of resources to program activities as part of our
restructuring initiative during the prior year.
Product and subscription.
Cost of product and subscription revenue primarily includes costs of equipment and consumables
related to our ID production systems, as well as Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers.
22
The
increase in cost of product and subscription revenue was due primarily to the following:
•
increased
product costs to domestic and international customers related to increased sales, partially offset by
•
decreased
product costs as a result of the end of the United Kingdom contract that ended in the second quarter of 2007.
The
costs components included in our cost of revenue are comprised of three categories as described below:
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Cost of revenue:
Variable
$
31,281
$
29,145
$
2,136
7
%
Fixed field support and manufacturing
25,044
28,972
(3,928
)
(14
)%
Program depreciation
11,703
10,652
1,051
10
%
Total
$
68,028
$
68,769
$
(741
)
(1
)%
Cost of revenue (as % of total revenue):
Variable
28
%
28
%
Fixed field support and manufacturing
23
%
28
%
Program depreciation
11
%
10
%
Total
62
%
66
%
Variable.
Variable costs include:
•
price
of materials to produce an identification card,
•
direct
costs of hardware and software, and related labor, delivered to customers, and
•
other
costs that are variable in nature.
While
the variable cost as a percentage of revenue remained the same, the increase in variable costs is primarily due to increased costs associated with increased variable sales as
discussed above and somewhat offset by improved margins related to higher yields in the manufacturing process.
Fixed field support and manufacturing.
Fixed field support and manufacturing costs include:
•
field
operations and support costs,
•
manufacturing
costs,
•
supply
chain costs, and
•
charges
for infrastructure and centralized costs.
The
decrease in support costs was primarily due to costs associated with our focus on improving certain programs in early 2006 that resulted in fewer expenditures capitalized to the
balance sheet and temporarily increased fixed support expenses, as discussed in cost of service revenue above, excluding program depreciation. After improving the efficiencies in these programs, our
fixed costs returned to more normal levels, and reflected various significant cost reductions and operating efficiencies that were initiated over the prior two years, thus gaining financial leverage.
Program depreciation.
Program depreciation primarily consists of amortization and depreciation of costs incurred during the
delivery process, where such costs are capitalized and then amortized or
23
depreciated
over the useful lives of the assets to which the costs relate. Costs capitalized during the delivery process typically include equipment, purchased software, capitalized labor for software
development and implementation and travel.
The
increase in program depreciation was primarily due to delivery of new and upgraded programs in 2007, including our Atlantic Canada, Indiana and Oregon programs.
Gross Profit
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Gross Profit:
Service
$
29,682
$
24,864
$
4,818
19
%
Product and subscription
12,054
10,614
1,440
14
%
Total
$
41,736
$
35,478
$
6,333
18
%
Gross Profit (as % of related revenue components):
Service
33
%
29
%
Product and subscription
60
%
57
%
Total
38
%
34
%
The
changes in gross profit as a percentage of revenue, for both the revenue components and overall gross profit, for the year ended December 31, 2007 as compared to the year
ended December 31, 2006 were primarily due to commensurate changes in revenues and costs of revenues, as described above. In particular, the increase in gross profit reflects significant
financial leverage improvement in the field support and manufacturing areas.
Operating Expenses
Sales and marketing
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Sales and marketing
$
16,615
$
16,355
$
260
2
%
Sales and marketing (as % of total revenue)
15
%
15
%
Sales
and marketing expenses consist primarily of:
•
compensation,
benefits and related costs of sales and marketing employees, product managers and sales engineers,
•
travel
and market research costs, and costs associated with marketing programs, such as trade shows, public relations and new product launches,
•
stock-based
compensation expense, and
•
charges
for infrastructure and centralized costs.
24
The
increase in sales and marketing expenses was due primarily to the following:
•
increased
professional fees and marketing costs of $0.4 million in connection with business initiatives relating to the REAL ID Act,
•
increased
travel related expenses of $0.3 million related to increased international opportunities, offset by
•
decreased
accrued benefits of $0.4 million due to no corporate incentive bonus earned or accrued in 2007.
We
anticipate that we will continue to invest in sales and marketing at current or higher levels.
Research, development and engineering
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Research, development and engineering
$
7,323
$
10,269
$
(2,946
)
(29
)%
Research, development and engineering (as % of total revenue)
6
%
10
%
Research,
development and engineering expenses consist primarily of:
•
compensation,
benefits and related costs of software developers and quality assurance personnel,
•
payments
to outside contractors,
•
the
purchase of materials and services for product development, primarily in the card systems area,
•
stock-based
compensation expense, and
•
charges
for infrastructure and centralized costs.
The
decrease in research, development and engineering expenses was due primarily to headcount reductions and other restructure related initiatives, no corporate incentive bonus earned or
accrued in 2007 and increased resource allocation to capital projects.
We
anticipate that we will continue to invest in research, development and engineering expenses at current or above levels in the near term to support certain ongoing product
initiatives, and expect to moderate spending in the longer term.
General and administrative
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
General and administrative
$
15,609
$
17,484
$
(1,875
)
(11
)%
General and administrative (as % of total revenue)
14
%
16
%
General
and administrative expenses consist primarily of:
•
compensation,
benefits and related costs of executive, finance and administrative personnel,
•
legal,
human resources and other professional fees,
25
•
stock-based
compensation expense, and
•
charges
for infrastructure and centralized costs.
The
decrease in general and administrative expenses was due primarily to the following:
•
decreased
audit, consulting and legal fees of $0.8 million due to improved efficiencies in our operations, including less reliance on outside consultants,
•
decreased
accrued benefits of $0.8 million due no corporate incentive bonus earned or accrued in 2007,
•
decreased
allocated infrastructure and centralized costs of $0.6 million, offset by
•
increased
stock-based compensation expense of $0.6 million primarily related to restricted stock.
We
anticipate that we will continue to incur general and administrative expenses at or above current levels in the near term while continuing to examine means to gain efficiencies to
reduce general and administrative spending as a percentage of revenue in the longer term.
Amortization of intangible assets
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Amortization of intangibles
$
1,992
$
2,171
$
(179
)
(8
)%
Amortization of intangibles (as % of total revenue)
2
%
2
%
We
account for intangible assets resulting from acquisitions in accordance with Financial Accounting Standards Board ("FASB") Statement Nos. 141,
Business
Combinations
and 142,
Goodwill and Other Intangible Assets
. These statements require the recording of intangible assets under
purchase accounting rules, and require the amortization of such intangible assets over their expected useful life. As a result, in December 2001, we recorded $29.5 million of intangible assets
related to the acquisition of certain assets and certain liabilities from Polaroid and affiliates. These intangible assets were set up to amortize over an average of a 12-year period,
representing the expected useful life. Changes in contract status and customer relationships may lengthen or shorten the expected useful life of such intangible assets, or cause an impairment charge
related to the intangible asset, so some variability is expected to exist related to intangibles depending on internal and external factors.
The
slight decrease in amortization of intangible assets was due primarily do extended amortization periods from contract extensions with several domestic customers and to a lesser
point, the impact of reaching full amortization of values associated with some international contracts during 2007.
The
estimated amortization of intangibles over the next five years is as follows:
2008
2009
2010
2011
2012
(in 000'S)
Amortization of intangibles
$
1,598
$
1,501
$
1,501
$
1,501
$
1,501
26
Intellectual property
Year Ended December 31
Dollar Increase (Decrease)
Percent Increase (Decrease)
2007
2006
(in 000'S)
Intellectual property
$
1,836
$
1,774
$
62
3
%
Intellectual property (as % of total revenue)
2
%
2
%
Intellectual
property costs primarily consist of:
•
compensation,
benefits and related costs of attorneys and legal assistants,
•
costs
associated with documenting, applying for, maintaining patents and trademarks,
•
stock-based
compensation expense, and
•
charges
for infrastructure and centralized costs.
Intellectual
property expense remained relatively consistent from year to year. We anticipate that we will continue to invest in intellectual property expenses at current levels or
slightly higher.
Stock-based compensation.
Stock-based compensation includes expense charges for all stock-based awards to certain officers,
employees and directors. Such awards include option grants, restricted stock awards, and shares expected to be purchased under an employee stock purchase plan. We account for stock-based compensation
in accordance with SFAS 123(R), which requires the measurement and recognition of compensation for all stock-based awards made to certain officers, employees and directors including stock
options and employee stock purchases under a stock purchase plan based on estimated fair values. SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion ("APB")
No. 25,
Accounting for Stock Issued to Employees,
for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission
issued Staff Accounting Bulletin ("SAB") No. 107 relating to the application of SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).
We
adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of
our 2006 fiscal year. In accordance with the modified prospective transition method, our consolidated financial statements for periods prior to fiscal year 2006 have not been restated to reflect this
change. Stock-based compensation recognized in the year ended December 31, 2007 and 2006 is based on the value of the portion of the stock-based award that will vest during the period, adjusted
for expected forfeitures. Stock-based compensation recognized in our consolidated financial statements in the year ended December 31, 2007 and 2006 includes compensation cost for stock-based
awards granted prior to, but not fully vested as of, December 31, 2005 and stock-based awards granted subsequent to December 31, 2005. The compensation cost for awards granted prior to
January 1, 2006 is based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 while awards granted on or after January 1, 2006 follow the
provisions of SFAS 123(R) to determine the grant date fair value and compensation cost. Compensation cost for all stock-based awards is recognized using the straight-line method.
Upon
adoption of SFAS 123(R), we continued to use the Black-Scholes option pricing model as its method of valuation for stock-based awards. Our determination of the fair value of
stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These
variables include, but are not limited to the expected life of the award, our expected stock price volatility over the term of the award and actual and projected exercise behaviors. Although the fair
value of stock-based awards is determined in accordance with SFAS 123(R) and SAB 107, the Black-Scholes option pricing model
27
requires
the input of highly subjective assumptions, and other reasonable assumptions could provide differing results. The fair value of restricted stock awards granted is based on the fair market
value of our common stock on the date of the grant (measurement date), and is being recognized over the vesting period of the related restricted stock using the straight-line method. The
fair value of performance vesting share awards granted is based on a Monte Carlo valuation model that resulted in a factor applied to the fair market value of our common stock on the date of the grant
(measurement date), and is being recognized over the derived service period using the straight-line method.
Prior
to January 1, 2006, we applied the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to
Employees,
and related interpretations including FASB Interpretation No. 44,
Accounting for Certain Transactions involving Stock Compensation, an
Interpretation of APB Opinion No. 25
, as allowed by FASB Statement No. 123,
Accounting for Stock-Based
Compensation
. FASB Statement No. 123 and FASB Statement No. 148,
Accounting for Stock-Based Compensation—Transition and
Disclosure, an amendment of FASB Statement No. 123
, established accounting and disclosure requirements using a fair-value-based method of accounting for
stock-based employee compensation plans. Under APB Opinion No. 25, stock-based compensation expense is recognized for stock awards granted with an exercise price below fair market value on the
date of grant.
Stock-based
compensation expense was recorded in the respective statement of operations expense categories for the employees to whom it applies, as set forth in the table below.
Year Ended December 31,
2007
2006
(in 000'S)
Cost of revenue
$
463
$
281
Sales and marketing
615
509
Research, development and engineering
365
325
General and administrative
2,451
1,863
Intellectual Property
51
35
$
3,945
$
3,013
The
increase in stock-based compensation expense was primarily due to an additional layer of stock-based awards being expensed pursuant to SFAS 123(R). We anticipate incurring an
additional $7.3 million in stock-based compensation expense through fiscal 2011 for awards outstanding as of December 31, 2007. The future effect of the adoption of this statement on our
financial position and results of operations will be determined by stock-based awards granted in future periods and the assumptions on which the value of those stock-based awards is based. Our tax
accounting may also be affected by actual exercise behavior and the relative market prices at exercise.
Other income (expense), net
Year Ended December 31,
2007
2006
(in 000'S)
Interest income
$
1,521
$
1,391
Interest expense
(112
)
(93
)
Foreign currency and other
296
289
$
1,705
$
1,587
28
The
increase in other income (expense) was due primarily to higher interest earned on cash and investment balances, which was partially offset by increased interest expense related to
additional capitalized leases.
Provision for income taxes.
Due to our domestic losses for the years ended December 31, 2007 and 2006 there was no
provision for U.S. federal or state income taxes. Because we were profitable in some foreign jurisdictions during 2007 and 2006 we provided for income taxes expected to be paid on our international
operations. At December 31, 2007, we had net operating loss carry-forwards for federal, state and foreign income tax reporting purposes of approximately $114.6 million and research and
experimentation credits of approximately $2.0 million which expire through 2027, if not utilized. Approximately $27.3 million of the net operating losses is related to the tax benefit
from the exercise of stock options and any tax benefit realized in relation to those carry-forwards will be allocated to contributed capital if subsequently recognized. Under the Tax Reform Act of
1986, the amounts of and benefits from net operating loss carry-forwards may be impaired or limited in certain circumstances, including a change of more than 50% in ownership.
Years Ended December 31, 2006 and 2005
Revenue
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Revenue:
Service
$
85,681
$
84,691
$
990
1
%
Product and subscription
18,566
16,362
2,204
13
%
Total
$
104,247
$
101,053
$
3,194
3
%
Revenue (as % of total revenue):
Service
82
%
84
%
Product and subscription
18
%
16
%
Total
100
%
100
%
Service
revenue increased primarily due to increased program work from the consortium of central banks, increased production for certain programs that reached full production in 2006
including programs for state driver license issuers in Florida and Alabama. These increases in service revenue were offset by decreased revenue from the Mexico program due to a hiatus before national
elections, changes in driver license renewal terms in California and Massachusetts, and the completion of our contract with West Virginia.
Product
and subscription revenue increased due primarily to the addition of three large international programs with Yemen, Ghana and Russia, related to either new ID programs or
increased volume of consumable sales. The product and subscription revenue was offset by decreased revenue from certain domestic customers due to lower hardware sales in 2006.
29
Revenue by Geography
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Revenue by geography:
Domestic
$
83,161
$
80,119
$
3,042
4
%
International
21,086
20,934
152
1
%
Total
$
104,247
$
101,053
$
3,194
3
%
Revenue (as % of total revenue):
Domestic
80
%
79
%
International
20
%
21
%
Total
100
%
100
%
The
increase in domestic revenue was primarily due to increased revenue from the state driver license issuers in Florida and Alabama as these programs reached full production levels,
offset by lower production revenues in West Virginia, lower hardware sales in Ohio and decreases in certain other states that occurred as a result of normal fluctuations in issuance volumes that we
may experience from time to time.
The
slight increase in international revenue was primarily due to increased revenue from Yemen, Ghana and Russia related to either new ID programs or an increase in consumable sales.
These increases are not expected to continue in a linear manner or recur at regular intervals. The increase in international revenue was offset by reduced revenue from our Mexico program due to a
hiatus before national elections and decreased product sales to Honduras.
Revenue by Source
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Revenue by source:
Media identification and management
$
11,071
$
11,119
$
(48
)
<(1
)%
Identification
93,176
89,934
3,242
4
%
Total
$
104,247
$
101,053
$
3,194
3
%
Revenue (as % of total revenue):
Media identification and management
11
%
11
%
Identification
89
%
89
%
Total
100
%
100
%
The
decrease in media identification and management revenue was due primarily to delayed payments from certain cash basis customers where billings were made in 2006 but not yet collected
by year-end, offset by increased program work from the Central Banks as discussed above.
The
increase in identification revenue was due primarily to programs reaching full production in 2006, increased variable sales to various international customers, offset by the hiatus
in our Mexico program and variable sales to various domestic customers as discussed above.
30
Cost of Revenue
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Cost of Revenue:
Service
$
60,817
$
61,465
$
(648
)
(1
)%
Product and subscription
7,952
6,707
1,245
19
%
Total
$
68,769
$
68,172
$
597
1
%
Cost of Revenue (as % of related revenue components):
Service
71
%
73
%
Product and subscription
43
%
41
%
Cost
of service revenue decreased primarily due to:
•
decreased
depreciation expense, net of $3.4 million, as a result of the estimated decrease of $8.0 million attributable to the change in estimated useful lives
of program assets as of December 31, 2005, as discussed below, offset by an increase of $4.6 million related to programs that were deployed in 2005 and for which we realized a full year
of depreciation in 2006 and an increase in depreciation attributable to upgrades made to certain other programs,
•
decreased
contract and temporary labor of $2.6 million as part of the cost cutting initiative where a number of contractors were converted to employees at lower
average costs,
•
decreased
other operating expenses such as small tools and repairs and maintenance of $0.7 million related to cost cutting initiatives, offset by
•
increased
employee compensation-related expenses of $5.7 million resulting from:
•
converting
contract labor to permanent labor at a lower average cost per person,
•
redeploying
resources to program activities as part our restructuring initiative undertaken throughout the year,
•
allocating
resources to fixing or improving existing programs, rather than to capital projects relating to the development of new programs, which occurred primarily during
the first half of the year,
•
increase
in stock option expense related to the adoption of SFAS 123(R) regarding stock-based compensation as discussed below, and
•
increased
allocated infrastructure and centralized costs of $0.9 million primarily due to system upgrades and enhancements in our information technology operations.
Cost
of product and subscription revenue increased primarily due to:
•
increased
direct consumable costs related to three international customers of $2.5 million, offset by
•
lower
direct hardware costs related to a domestic customer of $1.8 million.
31
The
costs components included in our cost of revenue are comprised of three categories as described below:
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Cost of revenue:
Variable
$
29,145
$
28,083
$
1,062
4
%
Fixed field support and manufacturing
28,972
25,997
2,975
11
%
Program depreciation
10,652
14,092
(3,440
)
(24
)%
Total
$
68,769
$
68,172
$
597
1
%
Cost of revenue (as % of total revenue):
Variable
28
%
28
%
Fixed field support and manufacturing
28
%
26
%
Program depreciation
10
%
14
%
Total
66
%
68
%
While
the variable cost as a percentage of revenue remained the same, the increase in variable costs is primarily due to the increase in sales of consumables and product sales to our
international customers.
The
increase in fixed costs are primarily due to newer contracts requiring additional headcount, as well as travel costs to support them. During the first two quarters of the fiscal
year, we focused on improving certain existing programs and as a result fewer expenditures were capitalized to the balance sheet. As a result of these actions, fixed support costs increased. After
improving the efficiencies in these programs, our fixed costs returned to more normal levels during the second half of the year.
Program
depreciation decreased in relation to the other components of cost of revenue primarily due to the change in the estimated useful lives of program-related fixed assets.
The
following table shows the effect of this policy of reducing depreciation expense in 2006 for assets in place at December 31, 2005, as well as the expected effect in the future
periods specified based on assets in place at that time:
2006
2007
2008
(in 000'S)
Previous estimated depreciation
$
17,380
$
16,067
$
14,911
Updated estimated depreciation
9,376
9,787
10,788
Reduction in depreciation expense
$
8,004
$
6,280
$
4,123
For
the year ended December 31, 2006, the change in estimating the useful lives of program-related fixed assets had the effect of reducing depreciation expense by
$8.0 million and increasing basic and diluted earnings per share by $0.39. Given that the depreciation expense attributed to contract-specific assets is included in cost of revenue, the
decrease in depreciation expense also caused gross margins to increase by the amount of the reduction in depreciation expense.
The
primary factor offsetting the reduction in program depreciation was higher than average costs to deploy certain new programs where we provided a complete system replacement using
advanced technologies. These programs were completed in late 2005 and 2006 and are now in production. These installations were particularly challenging for us, representing a more expanded scope than
that of our historical system deliveries. We were successful in delivering these programs, but at higher costs than have been customary. In another case, we bid a program aggressively as part of a
broader market
32
development
strategy that we believe will yield good long-term performance. The fixed costs for these systems, which include amortization and depreciation of costs capitalized during the
delivery process, as well as field service and operational costs to manage and maintain them, are higher than average and, thus, reduce reported margins. We anticipate that we will be able to improve
profit margins in these accounts over time and earn a better return on investment over the life of the account relationship.
Gross Profit
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Gross Profit:
Service
$
24,864
$
23,226
$
1,638
7
%
Product and subscription
10,614
9,655
959
10
%
Total
$
35,478
$
32,881
$
2,597
8
%
Gross Profit (as % of related revenue components):
Service
29
%
27
%
Product and subscription
57
%
59
%
Total
34
%
32
%
The
changes in gross profit as a percentage of revenue, for both the revenue components and overall gross profit, for the year ended December 31, 2006 and as compared to the year
ended December 31, 2005 was primarily due to commensurate changes in revenues and costs of revenues, as described above.
Operating Expenses
Sales and marketing
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Sales and marketing
$
16,355
$
15,777
$
578
4
%
Sales and marketing (as % of total revenue)
15
%
16
%
The
increase in sales and marketing expense was due primarily to the following:
•
increased
professional fees of $0.5 million related to supporting the sales effort in a number of state bids and proposals,
•
increased
stock option expense of $0.5 million, related to the adoption of SFAS 123(R) regarding stock-based compensation as discussed below, offset by
•
decreased
temporary labor of $0.5 million as part of the cost cutting initiative.
33
Research, development and engineering
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Research, development and engineering
$
10,269
$
13,131
$
(2,862
)
(22
)%
Research, development and engineering (as % of total revenue)
10
%
13
%
The
decrease in research, development and engineering expenses was due primarily to the following:
•
decreased
employee compensation-related expenses of $2.4 million resulting from the completion of key products and subsequent redeployment of resources to program
activities as part our restructuring initiative undertaken throughout the current year, offset by
•
increased
stock option expense of $0.3 million.
General and administrative
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
General and administrative
$
17,484
$
21,524
$
(4,040
)
(19
)%
General and administrative (as % of total revenue)
16
%
21
%
The
decrease in general and administrative expenses was due primarily to the following:
•
decreased
audit, consulting and legal fees of $2.7 million related to our audit and review, Sarbanes-Oxley audit, compliance and remediation efforts in 2005,
•
decreased
other administration costs such as travel related expenses, telephone and insurance of $0.8 million related to cost cutting initiatives,
•
decreased
temporary labor of $0.7 million as part of the cost cutting initiative,
•
decrease
in depreciation expense of $0.5 million as part of the cost cutting initiative and assets being fully depreciated,
•
decreased
reserves for bad debts of $0.2 million, offset by
•
increased
stock option expense of $1.4 million.
Amortization of intangible assets
Year Ended December 31,
Dollar Increase (Decrease)
Percent Increase (Decrease)
2006
2005
(in 000'S)
Amortization of intangibles
$
2,171
$
4,035
$
(1,864
)
(46
)%
Amortization of intangibles (as % of total revenue)
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