**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

----

**FORM 10-Q**

----

**(Mark One)**

**                          **x                 QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the quarterly period ended JUNE 30, 2004**

**OR**

**                           **o                 TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition periodfrom                             to                             **

**Commission File Number:000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter) 

| **Delaware**                                                     | **94-3342784**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **19801 SW 72nd Ave, Ste 250, Tualatin, Oregon**                 | **97062**                             |
| (Address of  principal executive offices)                        | (Zip Code)                            |
| **(503) 885-9699**                                               |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes  x    No  o

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the ExchangeAct). Yes  x    No  o

Asof July 31, 2004, there were 20,354,367 shares of the registrant’s commonstock, par value $0.001 per share, outstanding.

 

----

 

**Tableof Contents**
| **PART I FINANCIAL  INFORMATION** |
|----------------------------------------|
| Item 1.                                | Financial Statements: |   |
|                                   | Condensed Consolidated Balance Sheets  as of June 30, 2004 and   December 31, 2003. | 3 |
|                                   | Condensed  Consolidated Statements of Operations for the three and six months   ended June 30, 2004 and 2003. | 4 |
|                                   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,   2004 and 2003. | 5 |
|                                   | Notes  to Condensed Consolidated Financial Statements. | 6 |
| Item  2.                               | Management's  Discussion and Analysis of Financial Condition and  Results of Operations. | 13 |
| Item  3.                               | Quantitative  and Qualitative Disclosures About Market Risk. | 38 |
| Item 4.                                | Controls and  Procedures. | 39 |
| **PART II OTHER  INFORMATION**         |
| Item 1.                                | Legal Proceedings. | 40 |
| Item  4.                               | Submission  of Matters to a Vote of Security Holders. | 40 |
| Item 6.                                | Exhibits  and Reports on Form 8-K. | 41 |
| **SIGNATURES**                         | 42 |

 

2

----

**PART I. FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**DIGIMARC CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED)**
| ** **                                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2004**          | ** ** | **2003 (1)**     | ** ** |
| **ASSETS**                                  |       |              |       |                  |       |   |   |
| Current assets:                             |       |              |       |                  |       |   |   |
| Cash and cash equivalents                   |       | $                 | 41,624     |                  |       | $ | 48,426 |   |   |
| Restricted cash                             |       | 1,980             |       |                  | 1,976      |   |   |
| Short-term investments                      |       | 20,926            |       |                  | 28,231     |   |   |
| Trade accounts receivable, net              |       | 12,717            |       |                  | 9,195      |   |   |
| Unbilled trade receivables                  |       | 3,318             |       |                  | 4,321      |   |   |
| Inventory, net                              |       | 5,184             |       |                  | 5,739      |   |   |
| Other current assets                        |       | 2,127             |       |                  | 2,227      |   |   |
| Total current assets                        |       | 87,876            |       |                  | 100,115    |   |   |
| Property and  equipment, net                |       | 57,733            |       |                  | 37,755     |   |   |
| Intangibles, net                            |       | 22,524            |       |                  | 23,713     |   |   |
| Other assets, net                           |       | 810               |       |                  | 843        |   |   |
| Total assets                                |       | $                 | 168,943    |                  |       | $ | 162,426 |   |   |
| **LIABILITIES  AND STOCKHOLDERS' EQUITY**   |       |              |       |                  |       |   |   |
| Current liabilities:                        |       |              |       |                  |       |   |   |
| Accounts payable                            |       | $                 | 11,169     |                  |       | $ | 6,671 |   |   |
| Accrued payroll and related costs           |       | 1,567             |       |                  | 969        |   |   |
| Deferred revenue                            |       | 4,211             |       |                  | 3,160      |   |   |
| Other current liabilities                   |       | 412               |       |                  | 235        |   |   |
| Total current liabilities                   |       | 17,359            |       |                  | 11,035     |   |   |
| Other long-term  liabilities                |       | 1,113             |       |                  | 1,286      |   |   |
| Total liabilities                           |       | 18,472            |       |                  | 12,321     |   |   |
| Stockholders' equity:                       |       |              |       |                  |       |   |   |
| Common stock                                |       | 21                |       |                  | 20         |   |   |
| Additional paid-in capital                  |       | 206,364           |       |                  | 203,634    |   |   |
| Accumulated other comprehensive income      |       | 31                |       |                  | 96         |   |   |
| Warrant                                     |       | —            |       |                  | 881        |   |   |
| Accumulated deficit                         |       | (55,945           | )          |                  | (54,526    | ) |   |
| Total stockholders' equity                  |       | 150,471           |       |                  | 150,105    |   |   |
| Total liabilities  and stockholders' equity |       | $                 | 168,943    |                  |       | $ | 162,426 |   |   |

----

(1)   Derivedfrom the Company's December 31, 2003 audited consolidated financialstatements 

See Notes to Condensed Consolidated Financial Statements. 

3

----

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                        | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                          |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | $                                | 18,562     |                           | $          | 18,834 |   | $ | 35,757 |   | $ | 35,880 |   |
| Product and subscription                          |       | 5,111                            |       | 3,712                          |       | 11,406 |   | 8,370 |   |
| Total revenue                                     |       | 23,673                           |       | 22,546                         |       | 47,163 |   | 44,250 |   |
| Cost of revenue:                                  |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | 12,366                           |       | 9,888                          |       | 21,666 |   | 19,318 |   |
| Product and subscription                          |       | 3,460                            |       | 2,405                          |       | 7,874 |   | 4,921 |   |
| Total cost of revenue                             |       | 15,826                           |       | 12,293                         |       | 29,540 |   | 24,239 |   |
| Gross profit                                      |       | 7,847                            |       | 10,253                         |       | 17,623 |   | 20,011 |   |
| Operating  expenses:                              |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                               |       | 2,771                            |       | 3,268                          |       | 5,318 |   | 6,347 |   |
| Research, development and engineering             |       | 1,243                            |       | 2,109                          |       | 2,538 |   | 4,571 |   |
| General and administrative                        |       | 5,727                            |       | 4,691                          |       | 11,286 |   | 8,945 |   |
| Total operating expenses                          |       | 9,741                            |       | 10,068                         |       | 19,142 |   | 19,863 |   |
| Operating income (loss)                           |       | (1,894                           | )          | 185                            |       | (1,519 | ) | 148 |   |
| Other income  (expense):                          |       |                             |       |                           |       |   |   |   |   |
| Interest income                                   |       | 208                              |       | 148                            |       | 427 |   | 308 |   |
| Interest expense                                  |       | (30                              | )          | (2                             | )          | (51 | ) | (4 | ) |
| Other                                             |       | (6                               | )          | 8                              |       | (4 | ) | (34 | ) |
| Total other income, net                           |       | 172                              |       | 154                            |       | 372 |   | 270 |   |
| Income (loss)  before provision for income taxes  |       | (1,722                           | )          | 339                            |       | (1,147 | ) | 418 |   |
| Provision for  income taxes                       |       | (222                             | )          | (52                            | )          | (272 | ) | (102 | ) |
| Net income (loss)                                 |       | $                                | (1,944     | )                              | $          | 287 |   | $ | (1,419 | ) | $ | 316 |   |
| Net income (loss)  per share—basic           |       | $                                | (0.10      | )                              | $          | 0.02 |   | $ | (0.07 | ) | $ | 0.02 |   |
| Net income (loss)  per share—diluted         |       | $                                | (0.10      | )                              | $          | 0.02 |   | $ | (0.07 | ) | $ | 0.02 |   |
| Weighted average shares outstanding—basic    |       | 20,276                           |       | 17,790                         |       | 20,244 |   | 17,726 |   |
| Weighted average  shares outstanding—diluted |       | 20,276                           |       | 18,540                         |       | 20,244 |   | 18,426 |   |

 

See Notes to Condensed Consolidated Financial Statements. 

4

----

 

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)(UNAUDITED)**
| ** **                                                                                |  

** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|--------------------|--------------------------------|------------|
| ** **                                                                                | ** **         | **June 30,  2004**        | ** ** | **June 30,  2003** | ** ** |
| Cash flows from  operating activities:                                                    |               |                           |       |   |   |
| Net income (loss)                                                                         |               | $                              | (1,419     | ) | $ | 316 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |               |                           |       |   |   |
| Depreciation and amortization                                                             |               | 5,793                          |       | 4,993 |   |
| Stock-based compensation expense                                                          |               | —                         |       | 862 |   |
| Other non-cash charges                                                                    |               | (52                            | )          | 107 |   |
| Changes in operating  assets and liabilities:                                             |               |                           |       |   |   |
| Restricted cash                                                                           |               | (4                             | )          | (579 | ) |
| Trade and unbilled accounts receivable, net                                               |               | (2,519                         | )          | (289 | ) |
| Inventory, net                                                                            |               | 555                            |       | (740 | ) |
| Other current assets                                                                      |               | 100                            |       | 952 |   |
| Other assets, net                                                                         |               | 33                             |       | 20 |   |
| Accounts payable                                                                          |               | 4,498                          |       | (3,043 | ) |
| Accrued payroll and related costs                                                         |               | 598                            |       | 694 |   |
| Deferred revenue                                                                          |               | 1,051                          |       | 767 |   |
| Other liabilities                                                                         |               | 17                             |       | (52 | ) |
| Net cash provided by operating activities                                                 |               | 8,651                          |       | 4,008 |   |
| Cash flows from  investing activities:                                                    |               |                           |       |   |   |
| Purchase of property and equipment                                                        |               | (17,398                        | )          | (4,228 | ) |
| Capitalization of software development costs                                              |               | (7,120                         | )          | (3,579 | ) |
| Sale or maturity of short-term investments                                                |               | 84,006                         |       | 6,057 |   |
| Purchase of short-term investments                                                        |               | (76,701                        | )          | (9,322 | ) |
| Net cash used in investing activities                                                     |               | (17,213                        | )          | (11,072 | ) |
| Cash flows from  financing activities:                                                    |               |                           |       |   |   |
| Net proceeds from issuance of common stock                                                |               | 1,850                          |       | 1,700 |   |
| Principal payments under capital lease obligations                                        |               | (90                            | )          | (5 | ) |
| Net cash provided by financing activities                                                 |               | 1,760                          |       | 1,695 |   |
| Net decrease in cash and cash equivalents                                                 |               | (6,802                         | )          | (5,369 | ) |
| Cash and cash equivalents at beginning of period                                          |               | 48,426                         |       | 30,382 |   |
| Cash and cash equivalents at end of period                                                |               | $                              | 41,624     |   | $ | 25,013 |   |
| Supplemental  disclosure of cash flow information:                                        |               |                           |       |   |   |
| Cash paid for interest                                                                    |               | $                              | 51         |   | $ | 4 |   |
| Cash paid for income taxes                                                                |               | $                              | 160        |   | $ | 82 |   |
| Summary of non-cash  investing and financing activities:                                  |               |                           |       |   |   |
| Equipment  acquired or exchanged under capital lease obligations                          |               | $                              | 77         |   | $ | — |   |

 

 

See Notes to Condensed Consolidated Financial Statements.

5

----

**DIGIMARCCORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

**1.   The Company, Basis of Presentation**

*Description of Business *

Digimarc Corporation (“Digimarc,” the “Company,” “we,”“us,” or “our”) is one of the leading suppliers of secure personalidentification systems, providing more than 60 million personalidentification documents and driver licenses per year. The Company supplies theissuance systems for the majority of driver licenses produced in the UnitedStates (“U.S.”) and provides all or part of the issuance systems for nationalidentifications, voter identifications, and driver licenses in more than twentyinternational programs. 

The Company also is one of the leading providers ofpatented digital watermarking technologies that allow imperceptible digitalcodes to be embedded in all forms of media content, including personalidentification documents, financial instruments, photographs, movies, music andproduct packages. The embedded codes within various types of media content canbe detected and read by software or hardware detectors in personal computersand other digital processing devices. 

In December, 2001, theCompany, through its wholly-owned subsidiary, Digimarc ID Systems, LLC,and certain of that subsidiary's wholly-owned subsidiaries (collectively “DIDS”)acquired the assets and assumed certain liabilities of the U.S. largegovernment programs identification systems and international digitalidentification systems businesses of Polaroid Corporation and certain otheraffiliated entities of Polaroid Corporation. The acquisition was accounted forusing the purchase method of accounting. 

*Interim Financial Statements*

The condensed consolidated financial statementsinclude the accounts of Digimarc and its wholly-owned subsidiaries. Allsignificant intercompany transactions and balances have been eliminated. Thecondensed consolidated financial statements have been prepared from theCompany's records without audit and, in management's opinion, include alladjustments (consisting of only normal recurring adjustments) necessary tofairly reflect the financial condition and the results for the periodspresented. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with U.S. generally acceptedaccounting principles have been condensed or omitted under the Security andExchange Commission's rules and regulations. 

These condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements for the year ended December 31,2003 included in the Company's 2003 Annual Report on Form 10-K filed withthe Securities and Exchange Commission on March 15, 2004. The results ofoperations for the interim periods presented in these condensed consolidatedfinancial statements are not necessarily indicative of the results for the fullyear. 

*Reclassifications*

Certain prior periodamounts in the accompanying condensed consolidated financial statements andnotes thereto have been reclassified to conform to current period presentation.These reclassifications had no effect on the results of operations or financialposition for any period presented. 

6

----

**2.   Net Income (Loss) Per Share Computation**

Netincome (loss) per share (or earnings per share (“EPS”)) is calculated inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 128, *Earnings per Share*,which provides that basic and diluted net income per share for all periodspresented are to be computed using the weighted average number of common sharesoutstanding during each period, with diluted net income (loss) per shareincluding the effect of potentially dilutive common shares. 
| ** **                                           | ** ** | **Three Months Ended June 30, 2004** | ** ** | **Three Months Ended June 30, 2003** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Loss**                                                      | ** ** | **Shares**                                                    | ** ** | **Per** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per** | ** ** |
| ** **                                           | ** ** | **(000's)**                                                   | ** ** | **(000's)**                                                   | ** ** | **Share** | ** ** | **(000's)** | ** ** | **(000's)** | ** ** | **Share** | ** ** |
| ** **                                           | ** ** | **(Numerator)**                                               | ** ** | **(Denominator)**                                             | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| **Basic EPS**                                        |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available  to common stockholders |       |                                                          | $          | (1,944                                                        | )          |   |   | 20,276 |   |   | $ | (0.10 | ) |   | $ | 287 |   |   |   | 17,790 |   |   |   | $ | 0.02 |   |   |
| **Effect  of Dilutive Securities**                   |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock  equivalents                            |       |                                                          |       |                                                          |       |   | — |   |   |   |   |   |   |   |   |   | 750 |   |   |   |   |   |   |
| **Diluted  EPS**                                     |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available  to common stockholders |       |                                                          | $          | (1,944                                                        | )          |   |   | 20,276 |   |   | $ | (0.10 | ) |   | $ | 287 |   |   |   | 18,540 |   |   |   | $ | 0.02 |   |   |

 
| ** **                                      | ** ** | **Six Months Ended June 30, 2004** | ** ** | **Six Months Ended June 30, 2003** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                      | ** ** | **Loss**                                                    | ** ** | **Shares**                                                  | ** ** | **Per** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per** | ** ** |
| ** **                                      | ** ** | **(000's)**                                                 | ** ** | **(000's)**                                                 | ** ** | **Share** | ** ** | **(000's)** | ** ** | **(000's)** | ** ** | **Share** | ** ** |
| ** **                                      | ** ** | **(Numerator)**                                             | ** ** | **(Denominator)**                                           | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| **Basic EPS**                                   |       |                                                        |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available  to common stockholders |       |                                                        | $          | (1,419                                                      | )          |   |   | 20,244 |   |   | $ | (0.07 | ) |   | $ | 316 |   |   |   | 17,726 |   |   |   | $ | 0.02 |   |   |
| **Effect  of Dilutive Securities**              |       |                                                        |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock  equivalents                       |       |                                                        |       |                                                        |       |   | — |   |   |   |   |   |   |   |   |   | 700 |   |   |   |   |   |   |
| **Diluted  EPS**                                |       |                                                        |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available  to common stockholders |       |                                                        | $          | (1,419                                                      | )          |   |   | 20,244 |   |   | $ | (0.07 | ) |   | $ | 316 |   |   |   | 18,426 |   |   |   | $ | 0.02 |   |   |

 

Common stock equivalentsrelated to stock options and warrants of 5,819,000 and 5,695,000 were excludedfrom diluted net loss per share calculations for the three and six monthperiods ended June 30, 2004, respectively, as their exercise price washigher than the average market price of the underlying common stock for theperiod and therefore their impact would be antidilutive.  In addition, common stock equivalents relatedto stock options of 317,000 and 361,000 for the three and six month periodsended June 30, 2004, respectively, were excluded from diluted net loss pershare as the Company was in a loss position and their inclusion would beantidilutive.  The effect of 4,471,000and 4,591,000 outstanding stock options for the three and six months ended June30, 2003, respectively, are excluded from the calculation of diluted net incomeper share because their exercise price was higher than the average market priceof the underlying common stock for the period and therefore their inclusion wouldbe antidilutive.

**3.   Stock Based Compensation**

The Company has various stock-based compensationplans, including stock incentive plans and an employee stock purchase plan. TheCompany continues to apply the recognition and measurement principles of AccountingPrinciples Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to*

7

----

*Employees,*and related interpretations including Financial AccountingStandards Board (“FASB”) Interpretation No. 44, *Accounting for Certain Transactions involving Stock Compensation, anInterpretation of APB Opinion No. 25*, as allowed by FASBstatement No. 123, *Accounting forStock-Based Compensation*. FASB statement No. 123 and FASBstatement No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure, an amendment of FASBStatement No. 123*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans. Under APB Opinion No. 25, stock-basedcompensation expense is recognized for stock awards granted with an exerciseprice below fair market value on the date of grant.

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share (or earnings per share) if the Company had applied the fairvalue recognition provisions of SFAS No. 123 to stock-based employeecompensation for the three months and six months ended June 30, 2004 and 2003,respectively (in thousands, except per-share amounts): 
| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                        | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss),  as reported                                                                                   |       | $                                | (1,944     | )                              | $          | 287 |   | $ | (1,419 | ) | $ | 316 |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       | —                           |       | 418                            |       | — |   | 862 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards |       | 3,187                            |       | 4,859                          |       | 5,959 |   | 10,261 |   |
| Pro forma net  loss                                                                                               |       | $                                | (5,131     | )                              | $          | (4,154 | ) | $ | (7,378 | ) | $ | (9,083 | ) |
| *Earnings  per share:*                                                                                            |       |                             |       |                           |       |   |   |   |   |
| Basic—as reported                                                                                            |       | $                                | (0.10      | )                              | $          | 0.02 |   | $ | (0.07 | ) | $ | 0.02 |   |
| Diluted—as reported                                                                                          |       | $                                | (0.10      | )                              | $          | 0.02 |   | $ | (0.07 | ) | $ | 0.02 |   |
| Basic—pro forma                                                                                              |       | $                                | (0.25      | )                              | $          | (0.23 | ) | $ | (0.36 | ) | $ | (0.51 | ) |
| Diluted—pro forma                                                                                            |       | $                                | (0.25      | )                              | $          | (0.23 | ) | $ | (0.36 | ) | $ | (0.51 | ) |

 

Stock based compensationexpense is based on the difference between the fair market value of theCompany's common stock and the exercise price of options to purchase that stockon the measurement date, and is being recognized over the vesting period of therelated options, usually four years. No stock-based compensation expense wasrecorded for the three and six month periods ended June 30, 2004, while$418,000 and $862,000 of stock-based compensation expense was recorded for thethree and six month periods ended June 30, 2003. Stock-based compensationexpense is included in the respective statements of operations expensecategories for the employees to which it applies. 

**4.   SegmentInformation**

The Company derives itsrevenue from a single reporting segment, secure media solutions. There was nosingle customer in the three or six month periods ended June 30, 2004 or 2003that accounted for more than 10% of total revenue. 

**5.   Commitments and Contingencies**

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including Digimarc, certain ofits officers and directors, and certain underwriters of Digimarc’s initialpublic offering as defendants. The complaints have since been consolidated intoa single action, and a consolidated amended complaint was filed inApril 2002. The amended complaint alleges, among other things, that theunderwriters of the Company's initial public offering violated securities lawsby failing to disclose certain alleged compensation arrangements (such as 

8

----

undisclosed commissions orstock stabilization practices) in the Company's initial public offeringregistration statement and by engaging in manipulative practices to artificiallyinflate the price of the Company's stock in the after-market subsequent to theCompany's initial public offering. Digimarc and certain of its officers anddirectors are named in the amended complaint pursuant to Section 11 of theSecurities Act of 1933, and Section 10(b) and Rule 10b-5 of theSecurities Exchange Act of 1934 on the basis of an alleged failure to disclosethe underwriters' alleged compensation arrangements and manipulative practices.The complaint seeks unspecified damages. The individual officer and directordefendants entered into tolling agreements and, pursuant to a court order datedOctober 9, 2002, were dismissed from the litigation without prejudice.Furthermore, in July 2002, Digimarc and the other defendants in the consolidatedcases filed motions to dismiss the amended complaint for failure to state aclaim. The motion to dismiss claims under Section 11 was denied as tovirtually all the defendants in the consolidated actions, including Digimarc.The claims against Digimarc under Section 10(b), however, were dismissed.In June 2003, a committee of the Company's board of directorsconditionally approved a proposed partial settlement with the plaintiffs inthis matter. In June 2004, an agreement of settlement was submitted to the courtfor preliminary approval, but Digimarc is unable to determine whether or whenthe settlement will be approved or be finalized.The settlement wouldprovide, among other things, a release of Digimarc and of the individualdefendants for the conduct alleged in the amended complaint to be wrongful.Digimarc would agree to undertake other responsibilities under the partialsettlement, including agreeing to assign away, not assert, or release certainpotential claims Digimarc may have against its underwriters. Any directfinancial impact of the proposed settlement (other than defense costs incurredand expensed prior to May 31, 2003) is expected to be borne by Digimarc'sinsurers. Due to the inherent uncertainties of litigation and because thesettlement process is still at an early stage, the ultimate outcome of thematter cannot be predicted.

In October 2003, Hugh Mackworth, the formerPresident and Chief Executive Officer of the Company and aformer member of the Company’s board of directors,filed a complaint against the Company and its subsidiaries inthe Circuit Court of the State of Oregon for the County of Washingtonasserting, among other things, the right to 56,000 shares of the Company’scommon stock, or the value thereof, based on a claim that the Company failed totimely exercise its right of repurchase with regard to such shares followingthe Company’s termination of Mr. Mackworth in 1997.  Mr. Mackworth also seeks attorneys’fees and costs in connection with his lawsuit. To date, the Company has contested, and intends to continue to contest, theclaims included in Mr. Mackworth’scomplaint.  The matteris scheduled to go to trial in September 2004.  Due to the inherent uncertainties of litigation, the ultimate outcome of the mattercannot be predicted.

DIDS in its normal course of business from time totime experiences delays in identification system implementation, timelyacceptance for identification systems programs, concerns regardingidentification system program performance, and other contractual disputes.Management does not believe that there will be any material effect to theresults of operations for costs related to these contingencies. 

The Company's product license and services agreementsinclude a limited indemnification provision for claims from third partiesrelating to the Company's intellectual property. Such indemnificationprovisions are accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*. Theindemnification is generally limited to the amount paid by the customer. Todate, claims under such indemnification provisions have not been significant. 

Digimarc is subject fromtime to time to other legal proceedings and claims arising in the ordinarycourse of business. Although the ultimate outcome of these matters cannot bedetermined, management believes that the final disposition of these proceedingswill not have a material adverse effect on the consolidated financial position,results of operations, or liquidity of the Company. 

9

----

**6.   Comprehensive Income (Loss)**

TheCompany has adopted SFAS No. 130, *ReportingComprehensive Income*, which establishes standards of reporting anddisplaying comprehensive income (loss) and its components of net income (loss)and other comprehensive income (loss). Other comprehensive income (loss) refersto revenues, expenses, gains and losses that are not included in net income(loss) but rather are recorded directly in stockholders' equity. Comprehensiveincome (loss) is defined as changes in stockholders' equity exclusive oftransactions with owners. To date, only foreign currency translationadjustments are required to be reportedin comprehensive income (loss). The following table provides a summary ofcomprehensive income (loss) for the three and six month periods ended June 30,2004 and 2003, respectively (in thousands): 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                               | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss)                        |       | $                                | (1,944     | )                              | $          | 287 |   | $ | (1,419 | ) | $ | 316 |   |
| Foreign currency  translation adjustment |       | 19                               |       | 67                             |       | (65 | ) | 107 |   |
| Comprehensive income  (loss)             |       | $                                | (1,925     | )                              | $          | 354 |   | $ | (1,484 | ) | $ | 423 |   |

 

**7.   Recent Accounting Pronouncements**

In December 2003, theFASB issued Interpretation No. 46 (revised December 2003) (“FIN 46R”)*, Consolidation of Variable Interest Entities*,which addresses how a business enterprise should evaluate whether it has acontrolling financial interest in an entity through means other than votingrights and accordingly should consolidate the entity. FIN 46R replaces FASBInterpretation No. 46, *Consolidation ofVariable Interest Entities*, which was issued in January 2003.The Company is required to apply FIN 46R to variable interests in variableinterest entities (“VIEs”) created after December 31, 2003. For variableinterests in VIEs created before January 1, 2004, FIN 46R will beapplied beginning on January 1, 2005. For any VIEs that must beconsolidated under FIN 46R that were created before January 1, 2004,the assets, liabilities, and non-controlling interests of the VIEs initiallywould be measured at their carrying amounts with any difference between the netamount added to the balance sheet and any previously recognized interest beingrecognized as the cumulative effect of an accounting change. If determining thecarrying amounts is not practicable, fair value at the date FIN 46R firstapplies may be used to measure the assets, liabilities, and non-controllinginterest of the VIEs. Digimarc does not currently have any variable interestsin VIEs, and, as a result, the adoption of FIN 46R has not had an impacton us. 

**8.   RevenueRecognition**

Revenue from the Company's long-term identificationand driver license issuance systems is generated from the production of cards.The Company recognizes revenue on these contracts based on the actual monthlyproduction of cards, if available, or in limited situations on the estimatedproduction of cards. When actual production information becomes available,typically within one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Revenue earned which has not been invoiced is classified as unbilled tradereceivables in the condensed consolidated balance sheets. Revenue related to anenhancement of or upgrade to an existing system is deferred and recognized overthe remaining life of the contract. 

Revenue for sales of consumables and equipment notrelated to a long-term identification or driver license production contract isrecognized when the products have been shipped, ownership has been transferred,evidence of an arrangement exists, the sales price is fixed and determinable,and collectibility is reasonably assured. 

10

----

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. The Company also has limited long-term, fixed price servicecontracts under which revenue and profit are recognized as work progresses on amethod that approximates using an output measure to determine the percentcomplete. Progress towards completion is measured using costs incurred comparedto the budgeted amounts contained in the contract. Our estimates of revenue andcosts on customer contracts change periodically in the normal course ofbusiness, occasionally due to modifications of our contractual arrangements orcost overruns. Losses on contracts, if any, are provided for in the period inwhich the loss becomes determinable. Billing for services rendered generallyoccurs within one month following when the services are provided. Revenueearned which has not been invoiced is classified as unbilled trade receivablesin the condensed consolidated balance sheets. 

Royalty revenue is recognized when the royalty amountsowed to the Company have been earned, are determinable, and collection isprobable. Subscriptions are paid in advance and revenue is recognized ratablyover the term of the subscription. 

Deferred revenue consists of payments received inadvance for professional services and subscriptions for which revenue has notbeen earned. 

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorizedduplication or alteration of high-value documents, for use in communicatingcopyright, asset management and business-to-business image commerce solutions,and for use in connecting analog media to a digital environment. Softwarerevenue is recognized in accordance with the American Institute of Certified PublicAccountant (“AICPA”) Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition*, as amendedby AICPA SOP No. 98-9, *Modification ofSOP 97-2*, *With Respect to CertainTransactions*. Revenue for licenses of the Company's softwareproducts is recognized upon the Company meeting the following criteria:persuasive evidence of an arrangement exists; delivery has occurred; thevendor's fee is fixed or determinable; and collectibility is probable. 

AICPA SOP No. 98-9requires that revenue be recognized using the “residual method” incircumstances when vendor specific objective evidence exists only forundelivered elements. Under the residual method, revenue is recognized asfollows: (1) the total fair value of undelivered elements, as indicated byvendor specific objective evidence, is deferred and subsequently recognized inaccordance with the relevant sections of AICPA SOP No. 97-2, and(2) the difference between the total arrangement fee and the amountdeferred for the undelivered elements is recognized as revenue related to thedelivered elements. 

**9.   Inventories**

Inventories consist of the components used tomanufacture identification cards, such as inks, laminates, and adhesives.  Inventories are valued on a first-in,first-out basis at the lower of cost or market value (net realizable value).

The reserve for slowmoving and obsolete items was $861,000 and $70,000 at June 30, 2004 andDecember 31, 2003, respectively. While we do not currently expect to be able tosell or otherwise use the reserved inventory we have on hand based upon ourforecast and backlog, it is possible that a customer or customers will decidein the future to purchase a portion of the reserved inventory. It is notpossible currently to predict if or when this will happen, or how much we maysell. We do not expect that if such sales occur, they will have a materialimpact on gross profit margin.

11

----

**10.   Software Development Costs**

Under SFAS No. 86, *Accounting for the Cost of Computer Software to Be Sold, Leased, orOtherwise Marketed*, software development costs are to be capitalizedbeginning when a product's technological feasibility has been established andending when a product is made available for general release to customers. Todate, the establishment of technological feasibility of the Company's productshas occurred shortly before general release and, therefore, softwaredevelopment costs qualifying for capitalization have been immaterial.Accordingly, the Company has not capitalized any software development costs andhas charged all such costs to research and development expense. 

Internal use softwaredevelopment costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred in thepreliminary project stage are expensed as incurred and costs incurred in theapplication development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. 

**11.   Related Party Transactions**

During the second quarter of 2004, the Company enteredinto a licensing arrangement with a holder of common stock. In connection withthis arrangement, the Company recognized revenue of $300,000 in the three monthperiod ended June 30, 2004.  Inconnection with all arrangements with this holder of common stock, the Companyrecognized revenue of $363,000 during the second quarter of 2004 and $25,000during the second quarter of 2003.  AtJune 30, 2004, net accounts receivable from this customer was $750,000, whichhas subsequently been collected.  At June30, 2003, no receivables were outstanding from this customer.  The Company believes these transactions arearm’s length transactions and reflect the market value of such arrangements.

**12.   Provisionfor Income Taxes**

TheCompany provided $222,000 for income tax expense during the second quarter of2004.  The provision relates to incometaxes the Company expects to pay in foreign countries related to our profitableinternational operations.  No provisionhas been made for U.S. taxes due to offsetting loss carry-forwards.

12

----

**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

*The following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contains forward-lookingstatements relating to future events or the future financial performance ofDigimarc, which involve risks and uncertainties. Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of certain factors, including those set forth under “Risks Related toOur Business” and “Risks Related to Our Market,” and those risks described inour Annual Report on Form 10-K filed with the Securities and ExchangeCommission on March 15, 2004. This discussion and analysis should be readin conjunction with our interim unaudited condensed consolidated financialstatements and related notes included in this quarterly report onForm 10-Q.*

**Overview**

We believe we are one of the leading suppliers ofsecure personal identification systems, providing more than 60 millionpersonal identification documents and driver licenses per year. We supply theissuance systems for the majority of driver licenses produced in the UnitedStates (“U.S.”) and provide all or part of the issuance systems for nationalidentifications, voter identifications, and driver licenses in more than twentyinternational programs. We estimate that our next-closest competitor withregard to driver license issuance systems held contracts with approximately 15driver license issuing authorities in the United States as of December 31,2003. We are developing and marketing enhanced security for personalidentification documents enabled by our proprietary digital watermarkingtechnology.

We also believe we are one of the leading providers ofpatented digital watermarking technologies that allow imperceptible digitalcodes to be embedded in all forms of media content, including personalidentification documents, financial instruments, photographs, movies, music,and product packages. The embedded codes within various types of media contentcan be detected and read by software or hardware detectors in personalcomputers and other digital processing devices. We provide solutions based onthis technology directly and through our licensees. We believe we have thebroadest intellectual property patent portfolio and commercial deployment ofwatermarking-based applications amongst entities of which we are aware.

The majority of ourrevenue comes from multi-year contracts with government agencies, includingU.S. state departments of motor vehicles and central banks. We intend toincrease our revenue through increasing adoption of our products and services,marketing new digital watermarking applications, marketing our products in newsecure identification markets and components and subsystems markets, andlicensing our intellectual property. We expect to target, among other sourcesof revenue, government agencies, commercial printers, packaging companies,publishers, advertisers, proprietors of large image collections, and otherproducers of printed materials. Our aim is to license our technologies to thosecontent producers so that they may embed our digital watermarks in theirprinted media, such as identification documents, magazine advertisements andarticles, direct mail coupons, catalogs, stationery and envelopes, productpackaging, labels and tags, trading cards, credit cards, and business cards.Our current and anticipated products are intended to enable content producersto control reproduction and alteration of their content, as well as to enabletheir printed materials to provide a link to relevant network services. Revenuefrom our new applications may include one-time license fees, time-based orvolume-based fees, subscription fees, royalties and revenue-sharingarrangements. We anticipate that the calculation of revenue and royalties forthese new applications will be based at least in part on the size of theinstalled base of personal computers, cameras, scanners, digital image captureand output devices, and software carrying our patented reader technology, aswell as the nature of the use, and amount of licensed content carrying ourdigital watermarks.

13

----

**Critical Accounting Policies and Estimates**

The preparation of our condensed consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to bad debts, inventories,intangible assets, income taxes, restructuring, long-term service contracts,warranties, investments, and contingencies and litigation. We base ourestimates on historical experience and on various other assumptions we believeto be reasonable under the circumstances. Actual results may differ from theseestimates under different assumptions or conditions.

Certain of our accounting policies require higherdegrees of judgment than others in their application. These include revenuerecognition on long-term service contracts, impairments and estimation ofuseful lives of long-lived assets, inventory valuation, and reserves foruncollectible accounts receivable. We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our condensed consolidated financial statements:

**Revenuerecognition on long-term service contracts:****  **We recognize revenue and profit aswork progresses on long-term, fixed price service contracts (other than ourlong-term identification and driver license production contracts) using thepercentage-of-completion method, which relies on estimates of total expectedcontract revenue and costs. We follow the percentage-of-completion method sincereasonably dependable estimates of the revenue and costs applicable to variousstages of a contract can be made. Revenue is recognized based on the percentageof completion of the contract using budgeted amounts established with thecustomer at the inception of the contract. Progress towards completion ismeasured using allowable costs incurred as compared to the budgeted amountscontained in the contract. Recognized revenue and profit are subject torevisions as the contract progresses to completion. Revisions in profitestimates are charged to income in the period in which the facts that give riseto the revision become known. Any estimation process, including that used inpreparing contract accounting models, involves inherent risk. We reducethe inherent risk relating to revenue and cost estimates inpercentage-of-completion models through our contract approval and budgetmonitoring processes. Our estimates of revenue and costs on customer contractschange periodically in the normal course of business, occasionally due tomodifications of our contractual arrangements or cost overruns.

We recognize revenue on long-term identification anddriver license production contracts using a price-per-card method. We useactual monthly volume amounts, if available, or we estimate the card productionvolume on a monthly basis for certain of these contracts in order to recognizerevenue earned during the period. In the case of estimates, when the actualproduction information becomes available, which is typically within four weeks,we bill the customer accordingly and any differences from the estimates arerecognized in the month the billing occurs. These amounts represent our bestestimates of cards produced and are based on historical trends, known eventsduring the period, and discussions with contract representatives. Theprice-per-card is known; therefore, these estimates represent the best availableinformation regarding revenue earned during that specific period. Revisions toour estimates have been less than 0.5% of total revenue in every periodreported since the beginning of 2002 (since the acquisition of certain assetsand the assumption of certain liabilities from Polaroid Corporation and itsaffiliates). If our estimates of monthly volumes were too high by 10%, therewould be no significant impact on the reported revenue recognized. If thedifferences are material, we adjust our estimates to actual volumes to reflectthe difference, thus leaving little or no estimated volumes reflected in ourreported results. The estimated amounts are recorded as unbilled receivables onthe balance sheet until the actual production information is available and thebilling occurs. Any estimation process involves inherent risk. We reduce theinherent risk relating to production estimation through our approval andmonitoring processes related to accounting estimates.

14

----

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically review long-livedassets for impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable. We account forlong-lived assets in accordance with the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets.*This statementrequires that long-lived assets and certain identifiable intangibles bereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future net undiscounted cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Fair value is determined based ondiscounted cash flows or appraised values, depending on the nature of theasset. If our estimates of projected future cash flows were too high by 10%,there would be no material impact on the reported value of long-lived assetson our condensed consolidated balance sheets. Also, we periodically review theuseful lives of long-lived assets whenever events or changes in circumstancesindicate that the useful life may have changed. If the estimated useful livesof such assets do change, we adjust the depreciation or amortization on a goforward basis based on the circumstances identified.

**Inventoryvaluation:****  **Inventoryconsists of consumable supplies that are used in the production of driverlicenses and products held for resale to customers. We value inventory at thelower of cost or market value (which lower amount is the net realizable value).We reduce the value of our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.

**Reserves for uncollectibleaccounts receivable:****  **Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. We determine theallowance based on historical write-off experience and current information. Wereview our allowance for doubtful accounts monthly. If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required. If ourestimate of uncollectible accounts were too low by 10%, there would be nomaterial impact on the reported value of accounts receivable on our condensedconsolidated balance sheets.

**Results of Operations**

During the three and six month periods ended June 30,2004, we invested in capital equipment and software development for several newprograms, including programs based in Florida, Mexico, and Alabama which causedour working capital to decrease for the periods. These new programs areexpected to contribute to revenue growth in the second half of the year and inearly 2005. We also experienced unusually low gross profits when compared tohistorical performance as a result of increased inventory reserves,unexpectedly high yield losses on start up production of a new product, andhigher than anticipated costs associated with servicing existing contracts.

15

----

Thefollowing table presents our condensed consolidated statements of operationsdata for the periods indicated as a percentage of total revenue.
| ** **                                       | ** ** | **Three Months  Ended** | ** ** | **Six Months  Ended** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                                       | ** ** | **June 30,**            | ** ** | **June 30,**          | ** ** |
| ** **                                       | ** ** | **2004**                     | ** ** | **2003**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                         |       |                         |       |                       |       |   |   |   |   |
| Service                                          |       | 78                           | %          | 84                         | %          | 76 | % | 81 | % |
| Product and subscription                         |       | 22                           |       | 16                         |       | 24 |   | 19 |   |
| Total revenue                                    |       | 100                          |       | 100                        |       | 100 |   | 100 |   |
| Cost of revenue:                                 |       |                         |       |                       |       |   |   |   |   |
| Service                                          |       | 52                           |       | 44                         |       | 46 |   | 44 |   |
| Product and subscription                         |       | 15                           |       | 11                         |       | 17 |   | 11 |   |
| Total cost of revenue                            |       | 67                           |       | 55                         |       | 63 |   | 55 |   |
| Gross profit                                     |       | 33                           |       | 45                         |       | 37 |   | 45 |   |
| Operating expenses:                              |       |                         |       |                       |       |   |   |   |   |
| Sales and marketing                              |       | 12                           |       | 15                         |       | 11 |   | 14 |   |
| Research, development and engineering            |       | 5                            |       | 9                          |       | 5 |   | 10 |   |
| General and administrative                       |       | 24                           |       | 21                         |       | 24 |   | 21 |   |
| Total operating expenses                         |       | 41                           |       | 45                         |       | 40 |   | 45 |   |
| Operating income (loss)                          |       | (8                           | )          | 0                          |       | (3 | ) | 0 |   |
| Other income (expense):                          |       |                         |       |                       |       |   |   |   |   |
| Interest income                                  |       | 1                            |       | 1                          |       | 1 |   | 1 |   |
| Interest expense                                 |       | 0                            |       | 0                          |       | 0 |   | 0 |   |
| Other                                            |       | 0                            |       | 0                          |       | 0 |   | 0 |   |
| Total other income, net                          |       | 1                            |       | 1                          |       | 1 |   | 1 |   |
| Income (loss)  before provision for income taxes |       | (7                           | )          | 1                          |       | (2 | ) | 1 |   |
| Provision for  income taxes                      |       | (1                           | )          | 0                          |       | (1 | ) | 0 |   |
| Net income (loss)                                |       | (8                           | )%         | 1                          | %          | (3 | )% | 1 | % |

 

*Revenue*

Total revenue was $23.7 million and $47.2 millionfor the three and six month periods ended June 30, 2004, respectively, comparedto total revenue of $22.5 million and $44.3 million for the three and sixmonth periods ended June 30, 2003, respectively. The changes in totalrevenue between the comparable three and six month periods of 2004 and 2003resulted primarily from a change in our product and subscription revenue forthe period. In particular, we delivered a large international film-based systemto one customer that resulted in approximately $942,000 and $4.4 millionof revenue for the three and six month periods ended June 30, 2004,respectively.

Based on projected driver license production volumesfor the periods under contract with our respective customers, including driverlicense issuing authority customers, we anticipate our current contracts as ofJune 30, 2004 to generate more than $260 million in revenue during thelife of such contracts, currently expected to be up to eight years. This backlogamount has increased since June 30, 2004 due to the award of additionalcontracts. We consider as backlog production volumes reasonably expected to beachieved under currently existing contractual terms, government orders that arefirm but not yet funded, and government contracts awarded but not yet signed. 

In non-U.S. markets, where we provide driver license,national identification, and voter identification systems, services, andcomponents in partnership with local card producers, security printers, systemintegrators, and others, we may serve as prime contractor or sub-contractor,depending on the 

16

----

circumstances. As asub-contractor, we are responsible for delivering hardware, software, orconsumables to the prime contractor and, as a prime contractor, we areresponsible for integrating the components of the system to the customer’sspecifications. Revenue from international customers was $5.1 million and$11.1 million for the three and six month periods ended June 30,2004, respectively, compared to $3.8 million and $8.3 million for the three andsix month periods ended June 30, 2003, respectively. International sales duringthe six month period ended June 30, 2004 represented approximately 23% of ourtotal revenue. International sales for us have typically taken the form of anoutright sale of equipment and/or consumables to non-U.S. government agenciesor their prime contractors. These sales often can be large, carry relativelylow margins and may cause noticeable spikes in quarterly revenue and grossprofit trends. We enter into such contracts from time to time to maintainmarket presence and customer and partner relationships, as such programs oftentransition to more profitable digital technologies over time. Due to the natureof the international customers, the timing of these sales is somewhat lesspredictable than in the context of service revenues provided to us by domesticcustomers and, consequently, international sales can occur unevenly during thecourse of a year. We believe that international growth opportunities exist forus and we expect to continue to invest in personnel and resources to supportour potential revenue growth outside of the United States.

*Service.**  *Service revenue consists primarilyof card production on a price-per-card basis and software development services.These arrangements are typically structured as price-per-card productagreements, time and materials consulting agreements, or fixed price consultingagreements. Service revenue is an umbrella category consisting of both servicerevenue and contract-based service revenue. The distinction between these twosubcategories is that service revenue is generated from long-termidentification and driver license production contracts, while contract-basedservice revenue is generated from other long-term, time-and-materials servicecontracts.

Service revenue was $18.6 million and$35.8 million for the three and six month periods ended June 30, 2004,respectively, compared to $18.8 million and $35.9 million for the three and sixmonth periods ended June 30, 2003, respectively. The $272,000 or 1% decreasefor the three month period and $123,000 decrease or 0% change in revenue forthe six month period ended June 30, 2004, respectively, as compared to thecorresponding three and six month periods of 2003 were primarily the result ofdecreased revenue from services work done for customers based in the U.S. during2003, partially offset by increased issuance revenue from program transitions(the addition of programs based in Mexico and Latvia offset by the loss ofprograms based in Oklahoma and Maryland). Issuance revenue increased due toboth an increase in overall production volumes and an increase in the averageprice-per-card payment from the various driver license issuing authorities. Thehigher price-per-card payments come as a result of several factors, includingsecurity upgrades for existing programs and new programs starting that are generallyhigher in price due to the features requested and level of security included.

*Productand subscription.**  *Productand subscription revenue consists primarily of the sale of equipment andconsumables related to identification card production systems, software licensesales, and subscriptions related to various software products.

Product and subscriptionrevenue was $5.1 million and $11.4 million for the three and sixmonth periods ended June 30, 2004, respectively, compared to $3.7 millionand $8.4 million for the three and six month periods ended June 30, 2003,respectively. The $1.4 million or 38% increase for the three month periodand $3.0 million or 36% increase for the six month period ended June 30, 2004,respectively, as compared to the corresponding three and six month periods of2003 were primarily related to the delivery of a large, internationalfilm-based system to a customer, the sale of equipment to a domestic customer,and the license of intellectual property rights to an international customer.

17

----

*Cost of Revenue*

*Service.**  *Cost of service revenue primarilyincludes compensation for software developers, quality assurance personnel,product managers, field operations personnel, and business developmentpersonnel, outside contractors, costs of consumables used in delivering a service,depreciation charges for machinery, equipment, capitalized software, anddeployment costs used specifically for service delivery, and travel costsdirectly attributable to service and development contracts.

Cost of service revenue was $12.4 million and$21.7 million for the three and six month periods ended June 30,2004, respectively, compared to and $9.9 million and $19.3 million for thethree and six month periods ended June 30, 2003, respectively. The$2.5 million or 25% increase for the three month period and $2.3 millionor 12% increase for the six month period ended June 30, 2004, respectively, ascompared to the corresponding three and six month periods of 2003 wereprimarily the result of inventory charges taken during the second quarter of2004 and unexpectedly high yield losses during the start-up production of a newproduct. These factors resulted in approximately $1.4 million in charges duringthe three month period ended June 30, 2004. We also experienced generally highercosts to deliver support and maintenance for existing programs. Fieldoperations employees totaled 157 and 153 at June 30, 2004 and 2003,respectively.

*Productand subscription.**  *Costof product and subscription revenue primarily includes compensation foroperations personnel, costs of consumables sold to third parties, costs ofmachinery sold to third parties, Internet service provider connectivity chargesand image search data fees to support the services offered to our subscriptioncustomers.

Cost of product andsubscription revenue was $3.5 million and $7.9 million for the threeand six month periods ended June 30, 2004, respectively, compared to $2.4million and $4.9 million for the three and six month periods ended June 30,2003, respectively. The $1.1 million or 44% increase for the three monthperiod and $3.0 million or 60% increase for the six month period ended June 30,2004, respectively, as compared to the corresponding three and six monthperiods of 2003 were the result of increased material costs in connection withthe delivery of the large international film based system to one customerduring the three and six month periods ended June 30, 2004 noted above. Thislarge delivery had particularly low margins. We also sold quantities of olderor expiring film at low or no margin during the second quarter which drove upcosts and reduced margins for the three and six month periods ended June 30,2004.

*Gross Profit*

Overall grossprofit as a percentage of revenue for the three and six month periods endedJune 30, 2004 was 33% and 37%, respectively, compared to the 45% for both thethree and six month periods ended June 30, 2003.  The decrease in gross profit as a percentageof revenue was primarily related to the following factors: 

·  inventory charges related to excess, obsolete,and slow-moving inventory;

·  an unfavorable revenue mix, including lowmargin revenues from follow-on film sales into a foreign voter identificationproject and some domestic equipment sales; 

·  cost overruns in implementing the New Jerseydriver license issuance system that was completed during the quarter; and 

·  higher than anticipated freight costs andother expenses associated with the unusually high level of new programs that weare delivering.

In particular, thehigh level of new programs, while indicative of our continuing marketingsuccesses and anticipated to be a precursor to significant growth in revenues,exerted operational pressures on our identification systems business during thequarter as the organization incurred higher expenses as part of 

18

----

the upfront implementation costs associated with making these newprograms operational.  We believe thatthese operational pressures on our identification systems business will likelycontinue for the next few quarters, resulting in continued margin pressures aswe continue to incur significant expenses without corresponding revenueincreases, until the new programs are fully implemented and producing revenuesin timing and amount that offset such increased expenses in connection withthem.

*Operating Expenses*

*Salesand marketing.**  *Salesand marketing expenses consist primarily of compensation, benefits and relatedcosts of sales and marketing employees, product managers and sales engineers,as well as recruiting, travel, market research, and costs associated withmarketing programs, such as trade shows, public relations and new productlaunches. Sales and marketing expenses were $2.8 million and$5.3 million for the three and six month periods ended June 30, 2004,respectively, compared to $3.3 million and $6.3 million for the three and sixmonth periods ended June 30, 2003, respectively. The overall decrease generallyresulted from managing costs effectively within the group, in particular bytightening controls on spending.

The $497,000 or 15%decrease for the three month period ended June 30, 2004 as compared to thecorresponding three month period of 2003 resulted primarily from:

·       decreasedsalaries and other employee-related costs of approximately $299,000 due toseverance costs incurred in the second quarter of 2003 that were not repeatedin 2004;

·       decreasedadministrative costs related to sales and marketing employees of $98,000; and

·       decreasedconsultant fees of $73,000.

The $1.0 million or16% decrease for the six month period ended June 30, 2004 as compared to thecorresponding six month period of 2003 resulted primarily from:

·       decreasedsalaries and other employee-related costs of $526,000;

·       decreasedoperating expenses associated with sales and marketing due to employeesproviding more services directly related to our revenue generating contracts of$355,000; and

·       decreasedadministrative costs related to sales and marketing personnel of $186,000.

Sales and marketing employees totaled 58 and 48 as ofJune 30, 2004 and 2003, respectively. Although overall sales and marketingexpenses have decreased, we have recently added resources to the marketing areaof our watermarking business and have added experienced sales resources to helpexpand opportunities in identified markets in our identification systemsbusiness. We also anticipate that we will continue to invest at or slightlyabove the current run rate in sales and marketing for the foreseeable future.

*Research,development and engineering.**  *Research, development and engineering expensesconsist primarily of compensation, benefits and related costs of softwaredevelopers and quality assurance personnel and payments to outside contractors.Research, development and engineering expenses were $1.2 million and$2.5 million for the three and six month periods ended June 30, 2004,respectively, compared to $2.1 million and $4.6 million for the three and sixmonth periods ended June 30, 2003, respectively. The overall decrease generallycame from tighter controls on spending.

The $866,000 or 41%decrease for the three month period ended June 30, 2004 as compared to thecorresponding three month period of 2003 resulted primarily from:

·       decreasedoperating expenses associated with research, development, and engineering dueto  employees providing more services forour revenue generating contracts of $1.7 million;

19

----

·       decreasedsalaries and other employee-related costs of approximately $526,000; partiallyoffset by

·       increasedconsulting expenses of $1.5 million.

The $2.0 million or44% decrease for the six month period ended June 30, 2004 as compared to thecorresponding six month period of 2003 resulted primarily from:

·       decreasedoperating expenses associated with research, development, and engineering dueto employees providing more services for our revenue generating contracts of$2.9 million;

·       decreasedsalaries and other employee-related costs of $1.2 million; partially offset by

·       increasedconsulting expenses of $2.3 million.

Research, development and engineering personneltotaled 115 and 109 as of June 30, 2004 and 2003, respectively. We anticipatethat we will continue to invest at the current run rate in product research,development and engineering for the foreseeable future.

*Generaland administrative.**  *Generaland administrative expenses consist primarily of compensation, benefits andrelated costs of executive, finance and administrative personnel, facilitiescosts, legal and other professional fees, and depreciation and amortization expensenot directly associated with programs. General and administrative expenses were$5.7 million and $11.3 million for the three and six month periodsended June 30, 2004, respectively, compared to $4.7 million and $8.9million for the three and six month periods ended June 30, 2003, respectively.

The$1.0 million or 22% increase for the three month period ended June 30,2004 as compared to the corresponding three month period of 2003 resultedprimarily from:

·       increasedsalaries and other employee related costs of $545,000;

·       increasedconsulting and professional fees of $594,000;

·       increasedadministrative costs of $533,000, which includes amortization and depreciation;partially offset by

·       decreasedoperating expenses associated with general and administrative due to employeesproviding more services for our revenue generating contracts and to otherfunctional groups within the company of $645,000.

The $2.3 million or26% increase for the six month period ended June 30, 2004 as compared tothe corresponding six month period of 2003 resulted primarily from:

·       increasedsalaries and other employee related costs of $1.2 million;

·       increasedconsulting and professional fees of $1.4 million;

·       increasedadministrative costs of $1.0 million, which includes amortization anddepreciation; partially offset by

·       decreasedoperating expenses associated with general and administrative due to employeesproviding more services for our revenue generating contracts and to otherfunctional groups within the company of $1.3 million.

20

----

 

General and administrative employees totaled 62 and 52as of June 30, 2004 and 2003, respectively. We have acceleratedinvestments to strengthen our finance and information technologiesorganizations. We have also incurred, and will continue to incur, expenditureswith respect to the continued implementation of the requirements of theSarbanes-Oxley Act of 2002, in particular, with respect to Section 404requiring management to report on, and the independent auditors to attest to,internal controls. We also plan to improve the operational infrastructure atour identification systems business. As a result of these factors, weanticipate that we will continue to increase our investment in general andadministrative costs for the second half of the year.

*Stock based compensation.**  *Stock-based compensation expenseincludes costs relating to stock-based employee compensation arrangements.Stock-based compensation expense is based on the difference between the fairmarket value of our common stock and the exercise price of options to purchasethat stock on the date of grant, and is being recognized over the vestingperiods of the related options, usually four years. Stock-based compensationexpense of $418,000  and $862,000 was recorded for the three and six monthperiods ended June 30, 2003, respectively, with no expense recorded duringthe comparable periods in 2004. Stock-based compensation is included in therespective statements of operations expense categories for the employees towhich it applies. These expenses were recorded to the following categories:
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                             | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Sales and  marketing                   |       | $                                | —     |                           | $          | 93,000 |   | $ | — |   | $ | 199,000 |   |
| Research,  development and engineering |       | —                           |       | 106,000                        |       | — |   | 222,000 |   |
| General and  administrative            |       | —                           |       | 219,000                        |       | — |   | 441,000 |   |
|                                   |       | $                                | —     |                           | $          | 418,000 |   | $ | — |   | $ | 862,000 |   |

 

*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $172,000 and $372,000 for the three and six month periods endedJune 30, 2004, respectively, as compared to $154,000 and $270,000 for thethree and six month periods ended June 30, 2003, respectively. The $18,000or 12% increase for the three month period and $102,000 or 38% increase for thesix month period ended June 30, 2004, respectively, as compared to thecorresponding three and six month periods of 2003 resulted primarily fromhigher average interest-earning balances and interest rates during 2004.

*Provision for Income Taxes.**  *Weprovided $222,000 and $272,000 for income taxes for the three and six monthperiods ended June 30, 2004, respectively, compared to $52,000 and$102,000 for the three and six month periods ended June 30, 2003,respectively. The increase in the provision for income taxes resulted fromincreased profitability in foreign jurisdictions and true-ups from thefinalization of tax filings in certain foreign jurisdictions. We have availablenet operating loss carryforwards and, as such, have included no provision forU.S. federal and state income tax reporting purposes. The provision for incometaxes relates to taxes we expect to pay in non-U.S. countries due to ourprofitable foreign operations.

**Liquidity and Capital Resources**

As of June 30, 2004, we had cash and cashequivalents, restricted cash, and short-term investments of $64.5 million,representing a decrease of approximately $14.1 million from$78.6 million at December 31, 2003. The decrease primarily resultedfrom investments in significant new program implementations, in particular inFlorida, Mexico, and Alabama. As of June 30, 2004, $2.0 million ofcash and cash equivalents is restricted as a result of the requirements ofperformance bonds that we are obligated to maintain in connection with some ofour long-term contracts in our personal identification systems business.Working capital at June 30, 2004 was $70.5 million, compared toworking capital of $89.1 million at December 31, 2003. The decreasein working capital resulted primarily from investments made in the new Florida,

21

----

 

Mexico, and Alabamaprograms that we anticipate will contribute to revenue growth in the secondhalf of the year and early 2005.

The $8.7 million of cash provided by operationsfor the six months ended June 30, 2004 resulted from a net loss of $1.4million, offset by non cash items related to depreciation and amortization of$5.8 million, along with an increase in accounts payable of$4.5 million and an increase in deferred revenue of $1.1 million. Cashprovided by operations was negatively impacted by an increase in trade andunbilled accounts receivable, net of $2.5 million. The $4.0 millionof cash provided by operations for the six months ended June 30, 2003 waspositively impacted by $316,000 of net income for the period, depreciation andamortization of $5.0 million, a decrease of other current assets of $1.0million, stock-based compensation expense of $862,000, an increase in deferredrevenue of $767,000, and an increase in accrued payroll and related costs of$694,000. Cash provided by operations for the six months ended June 30,2003 was negatively impacted by a decrease in accounts payable of $3.0 million,an increase in inventory of $740,000, and an increase in restricted cash of$579,000.

The $17.2 million of cash used in investingactivities for the six month period ended June 30, 2004 primarily relatedto $17.4 million for the purchase of property and equipment, and$7.1 million related to the capitalization of software development costs, partiallyoffset by $7.3 million in net sale or maturity of short-term investments.We also acquired approximately $77,000  of fixed assets during 2004through capital lease arrangements. The $11.1 million of cash used in investingactivities for the six months ended June 30, 2003 was related primarily tothe purchase of property and equipment of $4.2 million, $3.6 million ofcapitalized software development costs, and $3.3 million net purchases ofshort-term investments.

The $1.8 million of cash provided by financingactivities for the six month period ended June 30, 2004 resulted primarilyfrom the issuance of common stock. On January 7, 2004, five holders ofwarrants to purchase shares of common stock exercised their warrants for anaggregate of 74,506 shares of common stock, which resulted in approximately$1.0 million of gross proceeds to us. The remaining proceeds resulted fromthe issuance of stock related to our stock incentive plans. The $1.7 million ofcash provided by financing activities for the six months ended June 30,2003 primarily related to the issuance of stock for $1.7 million related to ourstock incentive plans.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $10.4 million as of June 30,2004, and are payable in monthly installments through August 2011. Ourobligations under non-cancelable capital leases, which totaled$1.5 million as of June 30, 2004, are payable in monthly installmentsthrough 2007.

Our planned operating expenses and capitalexpenditures may constitute a material use of our cash resources. In addition,we may utilize cash resources to fund acquisitions or investments incomplementary businesses, technologies or product lines.

We believe that our current cash, cash equivalents,and short-term investment balances will satisfy our projected working capitaland capital expenditure requirements for at least the next 12 months,although we expect that investments in new programs during the fiscal yearending December 31, 2004 will exceed cash from operations through the endof the year. Thereafter, we anticipate continuing to use cash, cashequivalents, and short-term investment balances to satisfy our projectedworking capital and capital expenditure requirements.

In order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities although we do not believe atthis time that our long-term working capital and capital expenditures will beof such a nature that we would be required to take steps presently to remedyany such potential deficiency. If it were necessary to obtain additionalfinancings or credit facilities, we may not be able to do so, or if these fundsare available, they may not be available on satisfactory terms.

22

----

 

**Off-Balance Sheet Arrangements**

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenue or expenses, results of operations, liquidity, capitalexpenditures or capital resources that are material to investors.

**Recent Accounting Pronouncements**

In December 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 46(revised December 2003) (“FIN 46R”), *Consolidationof Variable Interest Entities*, which addresses how a businessenterprise should evaluate whether it has a controlling financial interest inan entity through means other than voting rights and accordingly should consolidatethe entity. FIN 46R replaces FASB Interpretation No. 46, *Consolidation of Variable Interest Entities*,which was issued in January 2003. We are required to apply FIN 46R tovariable interests in variable interest entities (“VIEs”) created after December 31,2003. For variable interests in VIEs created before January 1, 2004, FIN46R will be applied beginning on January 1, 2005. For any VIEs that mustbe consolidated under FIN 46R that were created before January 1, 2004,the assets, liabilities, and non-controlling interests of the VIEs initiallywould be measured at their carrying amounts with any difference between the netamount added to the balance sheet and any previously recognized interest beingrecognized as the cumulative effect of an accounting change. If determining thecarrying amounts is not practicable, fair value at the date FIN 46R firstapplies may be used to measure the assets, liabilities, and non-controllinginterest of the VIEs. We do not currently have any variable interests in VIEs,and, as a result, the adoption of FIN 46R has not had an impact on us.

**Risks Related to Our Business**

*The market for digital watermark applications is newand developing, resulting in less predictable and fluctuating revenue fromquarter to quarter*

Digital watermarking is anew and developing technology. Our success depends on the acceptance of thistechnology and the adoption of applications in areas such as digital mediacommerce, counterfeiting and piracy deterrence, self-authentication of documents,and security and intelligence applications. The market for products andservices using digital watermarks is evolving and is characterized by anincreasing number of market entrants who have introduced or developed productsand services using digital watermarking or alternative technologies. As istypical in a new and evolving industry, demand and market acceptance ofrecently introduced products and services are subject to a high level ofuncertainty. Our products and services relating to digital watermarking arecurrently used by only a limited number of customers. We are actively working,independently and with others, to expand the market for using digitalwatermarking technology, such as in the monitoring and tracking of usage ofprogramming content broadcast by television networks and stations and in thesecurity features of driver licenses. While we believe a trend may have begunin the use of digital watermarking security features and adoption by U.S.states representing more than 30% of all U.S. driver license issuance volumesindicates alignment with customer needs, we have yet to garner broad adoptionof reader applications, and while we believe that adoption could increase ourrevenue, it is difficult to predict the future growth rate, if any, andultimate size of this market opportunity or other new applicationopportunities. We cannot assure you that new applications and customers for ourtechnologies, products and services will develop or that our existing marketwill grow.

23

----

 

*The majority of our revenue is subject to governmentprocurement processes that are subject to unpredictable delays or unexpectedchanges which might limit our actual revenue in any given quarter*

We derive substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new revenueare tied to procurement schedules, which could shift as the needs of the relatedgovernment procurement agencies change. Many U.S. state customers are facingcontinued budget pressures, and some international customers are facing debtcrises, introducing added uncertainty. Any shift in the government procurementprocess, which is outside our control and may not be predictable, could resultin delays in bookings forecasted for any particular financial period, couldimpact the predictability of our quarterly results, and might limit our actualrevenue in any given quarter, resulting in reduced and less predictable revenueand lower profitability.

*Because some of our revenue models relating toanticipated products and services are under development and the correspondinganticipated products and services may fail to attract or retain customers, ourrevenue models and pricing structures may not gain market acceptance and we maynot be able to generate new or sustain existing revenue*

Our business involvesembedding digital watermarks in traditional and digital media, includingidentification documents, secure documents, audio, video and imagery, andlicensing our intellectual property. Through 2001, our revenue stream was basedprimarily on a combination of development, consulting, subscription and licensefees from copyright protection and counterfeit deterrence applications.Beginning in 2002 and for the foreseeable future, we have seen, and weanticipate, that the majority of our revenue will be from government andprivate sector customers for security-related applications relating to securepersonal identification, copyright protection, and counterfeit deterrence togovernment and private sector customers. We have not fully developed revenuemodels for our future applications and licensing endeavors. In addition,because some of our products and services are not yet fully established in themarketplace and because such products and services will not directly displaceexisting solutions, we cannot be certain that the pricing structure andmarketing for them will be effective. We cannot assure you that our anticipatedproducts and services and licensable intellectual property will be able tocompete effectively against other alternative technologies or that we will beable to compete effectively against current or future digital watermarkingsuppliers in terms of price, performance, applications or other features oftheir technologies. In addition, as we develop models for generating revenue,they may not gain market acceptance or may not be sustainable over time, and asa result, we may not be able to generate new or sustain existing revenue.

*The loss of any large contract may result in loss ofrevenue and potential acceleration of amortization expense or impairment ofintangible assets*

Contracts betweengovernment agencies and our wholly-owned subsidiary, Digimarc ID Systems, LLC,and/or its affiliates (collectively known as DIDS) have varying duration,averaging four to five years in length, after which the government agency canre-open the contract for competitive bidding. If we were to lose a contract, inaddition to the loss of revenue and margin on a prospective basis, we couldalso incur accelerated amortization expense or impairment of intangible assetsrelated to the customer.

*We have a history of losses, and we cannot assure youthat we will maintain profitability, particularly if we were to lose largecontracts*

We incurred significantnet losses from inception through the fiscal year ended December 31, 2002.Our accumulated deficit as of June 30, 2004 was $55.9 million. Inorder to regain profitability, we will need to generate higher revenue than wehave in prior years while controlling expenditures related to the higherrevenue. Even though we achieved profitability during 2003 and in the firstquarter of 2004, we were not 

24

----

 

profitablein the second quarter of 2004 and we expect to not be profitable in the thirdquarter of 2004. Moreover, if we lose large contracts, our revenue would growmore slowly than we anticipate, and if our operating expenses at the same timeexceed our expectations, we may not be able to regain profitability.

*Our future growth will depend to some extent on oursuccessful implementation of our intellectual property in solutions provided bythird-party partners*

Some of the products, services, and licensing of intellectualproperty that we intend to provide in the future will rely on the successfulimplementation of our technology, including our reader technology, bythird-party software developers and original equipment manufacturers. Weanticipate maintaining and entering into agreements with third-party vendors tocreate, promote and service products that incorporate, embed, integrate orbundle our technologies. If we fail to obtain partners that will incorporate,embed, integrate or bundle our technologies, or these partners are unsuccessfulin their efforts, we would not be able to bring our technologies to market and,consequently, we would not generate revenue as anticipated. In addition, if ourtechnologies do not perform according to market expectations, our future saleswould suffer as customers sought other providers and, consequently, revenuewould decrease.

We are not materiallydependent on any third party to produce systems or assemblies for us. However,our business relies, in part, on deployment of our watermark reader technologyby third parties. For example, one form of our watermark reader is commonlydeployed in image editing applications (offered by vendors including Adobe andJASC) to permit users of these products to read watermarks embedded in imagery,and thereby discern the identities of image owners. Another form of ourwatermark reader is used in our anti-counterfeiting product offerings. If thethird parties who include such technology in their products declined to do so,then we would lose a portion of our currently anticipated revenue, althoughsuch amounts are not currently foreseen to be significant, but may be in thefuture.

*We are subject to risks encountered by companiesdeveloping and relying upon new technologies, products and services forsubstantial amounts of their growth or revenue*

Our business andprospects must be considered in light of the risks and uncertainties to whichcompanies with new and rapidly evolving technologies, products and services,such as digital watermarking, are exposed. These risks include the following:

·       Wemay be unable to develop sources of new revenue or sustainable growth inrevenue because our current and anticipated technologies, products and servicesmay be inadequate or may be unable to attract or retain customers;

·       Theintense competition and rapid technological change in our industry couldadversely affect the market’s acceptance of our existing and new products andservices; and

·       Wemay be unable to develop and maintain new technologies upon which our existingand new products and services are dependent in order for our products andservices to be sustainable and competitive and in order for us to expand ourrevenue and business.

Some of our keytechnologies are still in the development stage. Consequently, productsincorporating these key technologies are undergoing technological change andare in the early stage of introduction in the marketplace. Delays in theadoption of these products or adverse competitive developments may result indelays in the development of new revenue sources or the growth in our revenue.In addition, we may be required to incur unanticipated capital expenditures inthe event product changes or improvements are required. Additionally, newindustry standards might redefine the products that we are able to sell,especially if these products are only in the prototype stage of development. Ifproduct changes or improvements are required, success in marketing theseproducts and achieving profitability from these 

25

----

 

productscould be delayed or halted. We also may be required to fund such changes orimprovements out of operating income, which could reduce or eliminate ourprofitability.

*A significant portion of our business depends on largepublic sector contracts, which can be terminated at the convenience of thegovernment authority, are subject to a variety of requirements and influencesand may only result in one-time revenue without potential for renewal, and as aresult may cause our quarterly results to fluctuate and anticipated revenue topotentially decrease significantly*

A significant portion ofour business depends on a limited number of large public sector contracts.Government contracts are generally subject to termination for convenience orlack of appropriation at the determination of the subject agency. Further, somegovernment contracts may be one-time events, such as in the case of somepersonal identification systems in non-U.S. markets involving voterregistration programs. In such cases, we may generate substantial revenuewithout renewal. Moreover, government contracts result from purchasingdecisions made by public sector agencies that may be subject to politicalinfluence, unusual procurement procedures, strict legal requirements, budgetchanges and cutbacks during economic downturns, variations in appropriationscycles, and protests of contract awards. For example, since March 2003 wehave been involved in a protest of a contract awarded to a competitor byGeorgia’s Department of Motor Vehicle Safety and it remains unclear when suchprotest will be finally adjudicated. Additionally, some governmentalauthorities require performance or fidelity bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bondsrequire that we maintain large restricted cash reserves as a guarantee,reducing our ability to use these funds for our other business purposes. Thesize, nature and purpose of, and the risks and uncertainties associated with,public sector contracts can cause our quarterly results to fluctuate andanticipated revenue to potentially decrease significantly.

*Products that we are developing for new secureidentification markets and components and subsystems markets may not beaccepted as quickly as we have projected or at all, which may negatively impactour revenues, margins, earnings and stock price*

We have concentrated a significant amount of time andresources in product development activities for new secure identificationmarkets, designing and building a number of enhancements for our driver licensesystems. For example, over several quarters we spent significant financialresources and personnel time developing our new Source Verification System (orSVS), through our exclusive partnership with ChoicePoint, to provide a real-timemeans for verifying the demographic information provided by an applicant duringthe enrollment process prior to issuing a new license. We also have spent alarge amount of time and resources developing a Credential VerificationSolution (or CVS), which is intended to authenticate an existing driver licenseas well as other source documents used during the enrollment process in orderto obtain a new or reissued driver license. Because one of the largest sourcesof identity theft and fraud is the use of false source documents to establishidentity during the application process for driver licenses, we believe thatSVS and CVS, along with our facial recognition solutions, will help to close amajor loophole in most current secure identification document issuanceprocesses. While we believe we are the only supplier addressing thesesignificant needs in a meaningful way, the development of these new productshave required us to focus significant financial and personnel resources on thedevelopment of products in a new market area where, to date, such products  have not yet gained widespread acceptance,and there is no assurance that our efforts will be accepted by issuingauthorities as rapidly as we have projected or at all. If we do not experiencea timely, positive reaction from issuing authorities to our new offerings, ourrevenues, margins and earnings may be negatively impacted and, consequently,the future market price of our common stock might experience significantvolatility.

In addition, we are developingnew sales channels in domestic and foreign markets for certain components andsubsystems of our domestic driver license solutions. During the second quarterof 2004, 

26

----

 

wesubstantially increased our initiatives in these areas and anticipate continuingto do so in future periods. We believe these new sales channels will contributesignificantly to our future results, as our products get placed into programsand start generating recurring revenue streams. However, given that this is anemerging area of our business, involving significant time and effort by us inconnection with the development of new products and distribution relationships,there are ongoing risks that these market areas will not develop in the manneror along the timeline that we are projecting or at all, resulting in ourincurrence of significant costs and expenses without corresponding increases inrevenues and profits.

*Our future quarterly operating results may not meetour, our analysts’ or our investors’ expectations or predictions and mayfluctuate significantly, which could decrease our stock price*

Our quarterly operating results have fluctuatedsignificantly in the past and may do so in the future. Our operating resultsare difficult to forecast because of our limited operating history and thenature of our business. Accordingly, you should not rely on quarter-to-quartercomparisons of our historical results as an indication of future performance orany trend in our performance. If our quarterly operating results do not meet theexpectations of analysts or investors, the market price of our common stockwill likely decline.

Our quarterlyresults may fluctuate in the future as a result of several factors, many ofwhich are outside our control, including:

·       Thetiming, introduction and successful commercialization of our new products andservices; The loss of or reduction in revenue from any large customer;

·       Themarket’s acceptance of our products and services;

·       Ourability to establish and maintain strategic relationships;

·       Thepotential costs of litigation and intellectual property protection;

·       Theoperating costs and capital expenditures related to the expansion of ourbusiness operations and infrastructure, domestically and internationally,including the hiring of key personnel and new employees;

·       Theintroduction of similar or substitute technologies by our competitors;

·       Theunpredictability and irregularity of our revenue from government contracts dueto political, budgetary appropriations, purchasing and delivery constraints;

·       Thetiming of future licensing revenue;

·       Thecosts associated with marketing arrangements that we enter into during earlymarket development;

·       Themanufacturing yield losses that we may incur as we develop new products;

·       Theexcess and obsolete inventory adjustments and charges that we determine may beappropriate at the termination of government contracts or during the course ofthose contracts; and,

·       Thefailure of or delay in efforts to establish industry standards involvingwatermarking.

In addition, because themarket demand for certain of our products and services is new and rapidlyevolving, it is difficult for us to predict certain aspects of our futurefinancial results. Our research and development, sales and marketing effortsand business expenditures are based in part on our predictions regardingdevelopments involving counterfeiting and piracy, as well as other security andintelligence needs, and on our estimates as to the use of digital watermarkingas a solution to those problems. To the 

27

----

 

extentthat these predictions and estimates prove inaccurate, our actual revenue andoperating results will fluctuate from our anticipated results, which coulddecrease our stock price.

*We may not be able to adequately protect ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could reduce the perceived valuation of the company andresult in a lower stock price*

Our success depends in part on licensing ourproprietary technologies. To protect our growing patent and relatedintellectual property investments, we rely on a combination of patent,copyright, trademark and trade secret rights, confidentiality procedures andlicensing arrangements to establish and protect our proprietary rights.However, unlicensed copying and use of our intellectual property or illegalinfringements of our intellectual property rights represent losses of revenueto our company.

We face risks associated with our patent position,including the potential and sometimes actual need from time to time to engagein significant legal proceedings to enforce our patents, the possibility thatthe validity or enforceability of our patents may be denied, the possibilitythat third parties will be able to compete against us without infringing ourpatents and the possibility that our products may infringe patent rights ofthird parties. Budgetary concerns may cause us not to file, or continue,litigation against known infringers of our patent rights, or may cause us notto file for, or pursue, patent protection for all of our inventive technologiesin jurisdictions where they may have value. Failure to reliably enforce ourpatent rights against infringers may make licensing more difficult. If we failto protect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to our interests,or if we become involved in litigation relating to our intellectual propertyrights and proprietary technologies or relating to the intellectual propertyrights of others, our business could be seriously harmed because the valueascribed to our intellectual property could diminish and result in a lowerstock price.

As part of our confidentiality procedures, wegenerally enter into non-disclosure agreements with our employees, directors,consultants and corporate partners, and attempt to control access to anddistribution of our technologies, solutions, documentation and otherproprietary information. Despite these procedures, third parties could copy orotherwise obtain and make unauthorized use of our technologies, solutions orother proprietary information or independently develop similar technologies,solutions or information. The steps that we have taken to preventmisappropriation of our solutions, technologies or other proprietaryinformation may not prevent their misappropriation, particularly outside theUnited States where laws or law enforcement practices may not protect ourproprietary rights as fully as in the United States.

Effective protection of intellectual property rightsmay be unavailable or limited, both in the United States and in othercountries. Patent protection throughout the world is generally established on acountry-by-country basis. We have applied for patent protection both in theUnited States and in various other countries. However, we cannot assure youthat pending patents will be issued or that issued patents will be valid orenforceable. Failure to obtain such patents or failure to enforce those patentsthat are obtained may result in a loss of revenue to us. We cannot assure youthat the protection of our proprietary rights will be adequate or that ourcompetitors will not independently develop similar technologies, duplicate ourservices or design around any of our patents or other intellectual propertyrights we hold.

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. If aninfringement arose in a context governed by such a contract, we may have torefund to our customer amounts already paid to us or we may be sued by theparty allegedly infringed upon and our exposure could be large and we may incursignificant litigation, settlement, or judgment expenses. Similarly, as we seekto broaden the number of companies licensed under our patent portfolio, somemay seek contractual assurances that we will pursue—by litigation ifnecessary—their competitors 

28

----

 

who use Digimarc’spatented technology but are not licensed to do so. Compliance with any suchcontract provisions may require that we pursue litigation where our costsexceed our likely damages award.

We are the exclusive licensee under some third-partypatents, and may need the assistance of these parties if we choose to enforceany of these patent rights. The cooperation of these third parties cannot beassured. Although we do not currently rely on these technologies for our coreproducts, we may in the future.

We have registered “DIGIMARC”, “MARCSPIDER”, “MEDIABRIDGE”,“PICTUREMARC” and the “D” logo, among other marks, as trademarks in the UnitedStates and some other countries, and are pursuing registration of the “DIGIMARC”trademark in additional countries. However, our tradenames or trademarks may beregistered by third parties in other countries, impairing our ability to enterand compete in these markets. In the United States, the trademark “Digimark”and the domain names “Digimark.com” and “Mediabridge.com” have been registeredby unrelated companies. While we have put in place formal arrangements forco-existence with one of these unrelated companies, and while we haveco-existed successfully to date with the other, if we were forced to change ourname or were prevented from using our other brand names, we would lose asignificant amount of our brand equity.

As more companies engagein business activities relating to personal identification technologies and digitalwatermarking, and develop corresponding intellectual property rights, it isincreasingly likely that claims may arise which assert that some of ourproducts or services infringe upon other parties’ intellectual property rights.These claims could subject us to costly litigation, divert management resourcesand result in the invalidation of our intellectual property rights. Theseclaims may require us to pay significant damages, cease production ofinfringing products, terminate our use of infringing technologies or developnon-infringing technologies. In these circumstances, continued use of ourtechnologies may require that we acquire licenses to the intellectual propertythat is the subject of the alleged infringement, and we might not be able toobtain these licenses on commercially reasonable terms or at all. Our use ofprotected technologies may result in liability that threatens our continuingoperation. In addition, we offer indemnification against intellectual propertyinfringement for some contracts to which we are a party. As deployment of ourtechnology increases, and more companies enter our markets, the likelihood of athird party lawsuit resulting from such indemnification increases. If a claimwere made under such an indemnity provision, we could incur significantexpense.

*The security systems that we use in our proprietarytechnologies and in our business may be circumvented by third parties, whichcould damage our reputation and disrupt our business*

Many of our products and services involve theembedding of digital code in media content that is imperceptible in normal usebut that can be read by digital devices. The success of these products andservices depends on the security of our media commerce, anti-counterfeiting andpiracy systems, self-authentication solutions, and supporting infrastructure.Security breaches of these systems and solutions could damage our reputationand expose us to a risk of loss or litigation and possible liability. Thesecurity measures that we use may not prevent security breaches, and failure toprevent these security breaches may disrupt our business. A party who is ableto circumvent our security measures could misappropriate proprietaryinformation or cause interruptions or otherwise damage our products, servicesand reputation and the property of our customers. If unintended parties obtainsensitive data and information, or create bugs or viruses in an attempt tosabotage the functionality of our products and services, we may receivenegative publicity, incur liability to our customers or lose the confidence ofour customers, any of which may cause the termination or modification of ourcontracts.

We may be required toexpend significant capital and other resources to protect ourselves against thethreat of security breaches or to alleviate problems caused by these breaches.However, protection or 

29

----

 

remedialmeasures may not be available at a reasonable price or at all, or may not beentirely effective if commenced.

*Our products could have unknown defects or errors,which may give rise to claims against us or divert application of our resourcesfrom other purposes*

Products and systems as complex as those we offer ordevelop frequently contain undetected defects or errors. Despite testing,defects or errors may occur in existing or new products, which could result inloss of revenue or market share, failure to achieve market acceptance,diversion of development resources, injury to our reputation, increasedinsurance costs and increased service and warranty costs. Furthermore, we oftenprovide implementation, customization, consulting and other technical servicesin connection with the implementation and ongoing maintenance of our products.The performance of these products typically involves working with sophisticatedsoftware, computing and communications systems. Our inability to meet customerexpectations or project milestones in a timely manner could also result in aloss of, or delay in, revenue, loss of market share, failure to achieve marketacceptance, injury to our reputation and increased costs.

Because many customers rely on our products forcritical security applications, defects or errors in our products or servicesmight discourage customers from purchasing future products and services. Thesedefects or errors could also result in product liability or warranty claims.Although we attempt to reduce the risk of losses resulting from these claimsthrough warranty disclaimers and liability limitation clauses in our salesagreements, these contractual provisions are sometimes not included and may notbe enforceable in every instance. Furthermore, although we maintain errors andomissions insurance, this insurance coverage may not adequately cover theseclaims. If a court refused to enforce the liability-limiting provisions of ourcontracts for any reason, or if liabilities arose that were not contractuallylimited or adequately covered by insurance, the expense associated withdefending such actions or paying the resultant claims could be significant anddecrease our profits.

As watermarking technology is more broadly deployed byour licensees, our potential exposure to litigation may increase through theirsuccess. For example, if we license large companies, in industries such as theconsumer electronics, information technology, or motion picture businesses, andthe deployed technology is found to be flawed or subject to abuse (as is apossibility with any technology), we may be the target of class action or otherlitigation—either alone or in conjunction with our licensee(s).

*If our new operating structure is not effective, or ifwe are required to restructure our business to address new growth rates, we mayencounter higher expenses and reduced margins*

As of June 30, 2004,we had 392 employees and 186 contract workers. To effectively manage ouroperations, management must continue to improve our operational and financialsystems and train, improve and manage our employee base. As part of our goal tocontinue to improve operating efficiencies, we organized our operations into aportfolio of peer-level operating units under a corporate umbrella, consistingof two units, the first of which is Watermarking Solutions and the second ofwhich is ID Systems, both of which are overseen by a small corporate staff.While our management anticipates that this operating structure will facilitateeffective management of the continuing growth and expansion of our business, wecannot assure you that the operating structure will be effective or achieve thedesired results. Additionally, less than optimal rates of growth of our productlines and areas of business may require us to restructure our business fromtime to time, which, in turn, could significantly strain our managerial andfinancial resources. If we cannot manage our growth effectively, we may not beable to coordinate the activities of our technical, legal, accounting and marketingstaffs and, as a result, we may experience higher expenses and reduced margins.

30

----

*Becausewe are investing time and resources into new business systems and compliancewith recently enacted regulatory changes in order to further strengthen ourfinancial management, we anticipate corresponding increases in our operatingexpenses which may reduce our profitability in the near future*

Changes in the laws andregulations that have recently been enacted or that will soon become effectiveand that affect public companies, including the provisions of theSarbanes-Oxley Act of 2002, are likely to increase our expenses as we evaluatetheir implications and devote resources in response to them. For example, wealready have deployed significant resources to document our financial processesas part of our implementation of the requirements under Section 404 of theSarbanes-Oxley Act of 2002 and we expect to incur additional time and expensesas we proceed to meet the requirements under Section 404 for ourmanagement to report on, and our independent auditors to attest to, ourinternal controls. Moreover, compliance with these rules could also cause us tofurther modify our existing review processes and/or further divert ourmanagement’s time and attention away from otherwise running the revenuegenerating part of our business, both of which could result in our companyexperiencing additional costs and expenses without corresponding increases inrevenue.

We are currentlyconducting evaluations required to ensure compliance with the managementcertification and auditor attestation requirements under Section 404 ofthe Sarbanes-Oxley Act of 2002. However, we have no precedent upon which tomeasure the adequacy of our compliance. Consequently, we cannot assure you asto the timing of completion of our evaluation and related actions or the impactof any of them on our operations. While we currently anticipate that we willtimely complete all such actions, if we do not, we are unsure of theconsequences of such a failure, although possible consequences may includesanctions or investigation by regulatory authorities, such as the Securitiesand Exchange Commission or The Nasdaq National Market, and the inability totimely file our next annual report on Form 10-K.

Wehave been implementing, and we anticipate continuing to implement, newfunctionality and tools in the areas of manufacturing resource planning and management of inventories throughout the supplychains associated with our identification systemsbusiness. We also have been implementing, and expect to continue to implement,new procedures and controls within our day-to-day finance operations at ouridentification systems business. Consequently, as we take steps to furtherimprove and strengthen our financial management, we anticipate corresponding increasesin our operating expenses which may reduce our profitability in the nearfuture.

*Recentand ongoing* leadership and staffing changes in ouridentification systems business, finance and administrationand information technology staffs of our business may result in disruptions andinefficiencies in our businessduringtransition periods, may require process changes in our business, and will likely cause additional costs to ourbusiness in the short term before benefits from such changesmay be realized

During the course of the second quarter of 2004,we made significant changes in our leadership, andinformation technology capabilities as a result of a detailedreview of many of our financial and businessprocesses. Many of these changes were initiated following the hiring of our new Chief FinancialOfficer in June 2004 and other senior managers inthe finance and administration and information technologystaffs of our business, and in conjunction with thecontinuing implementation of our new accounting and material requirements planning systems and work on Sarbanes-Oxley compliance. In addition, Paul Gifford, our President and ChiefOperating Officer, assumed direct control andresponsibility for ouridentification systems business in order to make day-to-dayimprovements to the efficiency, effectiveness, and predictabilityof its operations.We anticipate that these changes in leadership and staffing may result in somedisruptions in the operations of our business and,consequently, may result in someshort-term inefficiencies aspersonnel complete their transitions and new leaders implement their new plansand procedures. We also expect that these changes may require furthermodifications of our finance and 

31

----

business processes and will likely cause additional costs to ourbusiness in the short term before any benefits from suchchanges, if any, may be realized by our business. 

*In the course of implementing, testing andreviewing the results of our new accounting system and material requirementsplanning system, we have made modifications to our review processes, which havecaused us to increase reserves and take charges in some cases and, while we donot anticipate significant modifications in connection with our reviewprocesses in the future, such modifications if they occur may lead toincreasing reserves or the taking of additional charges in some cases*

Changes in leadership in ourfinance and administration staff and refinements in information made availableto us as a result of the implementation of our new accounting system and material requirements planning system has led us to makemodifications to our review processes, which have caused us to increasereserves and take charges in some cases, and to make, among other things,further improvements to the management of our identificationsystems business. For example,during the second quarter of 2004, our new accounting systemand material requirements planning system provided us with additional detail inconnection with the usability and disposition of slow-moving or excessinventories, allowing us to make more nuanced estimates of valuations forexcess and obsolete inventory related to our product life-cycle processes and spare parts on hand, and manufacturing yield losses. Themanufacturing yield losses were associated with the introduction and up-front production requirements of our new Exian DualPolycarbonate card architecture, which yields weexpect to improve as the manufacturing process stabilizes and productionvolumes increase. As a result of betterinformation, we revised our inventory reserves primarilyrelated to changes in estimates of the value of our inventories andunanticipated manufacturing yield losses in the initial manufacturing of somenew card materials. Moreover, we strengthened our inventory management and controls systems and procedures,including those governing the usability and disposition of slow-moving orexcess inventories. While we do not anticipate significantmodifications in connection with our inventory management and controls systemsand procedures or other review processes in the future, such modifications ifthey occur may lead to increasing reserves or the taking of additional chargesin some cases until such time as our new accountingsystem and the materialrequirements planning system are fully implemented, tested, and reviewed. 

*Due primarily to the increase in newprograms in the second quarter of 2004, our*identification systems business expects to experience margin pressures for the next fewquarters until such new programs begin generating revenuesto offset such expenses

The identification systems businessexperienced lower than anticipated gross margin in the second quarter of 2004,primarily due to a combination of four factors: (1) inventory charges relatedto excess, obsolete, and slow-moving inventory; (2) an unfavorable revenue mix,including low margin revenues from follow-on film sales into a foreign voter identificationproject and some domesticequipment sales; (3) cost overruns in implementing the New Jersey driverlicense issuance system that was completed during the quarter; and (4) higherthan anticipated freight costs and other expenses associated with the unusuallyhigh level of new programs that we are delivering. Inparticular, the high level of new programs, whileindicative of our continuing marketing successes and anticipatedto be a precursor to significant growth in revenues,exerted operational pressures on our identification systemsbusiness during the quarter as the organization incurred higher expenses aspart of the upfront implementation costs associated with making these newprograms operational. We believe that these operational pressures on ouridentification systems business will likely continue for the next few quarters,resulting in continued margin pressures as we continue to incur significantexpenses without corresponding revenue increases, until the new programs are fully implemented and producing revenues intiming and amount that offset suchincreased expenses in connection with them. 

32

----

*We are* engagedin litigation from time to timewhich is unpredictable and can lead to additional expense, lower margins andlower profits

From time to time we are engaged inlitigation with third parties. In particular, wecurrently are engaged in twopieces of litigation related to the securities of our company, one case involving an alleged improper grant of a driverlicense contract to a competitor, and various otherroutine actions. Litigation typicallyis an expensive process and, due to its inherentuncertainties and because the settlement and trialpreparation processes are lengthy and potentiallyinconclusive, the ultimate costand outcome of such matters cannot be predicted. As a result, while we believe that litigation often is necessary to preserve the interests of ourcompany, it also can lead to additional expense,lower margins and lower profits to our business withoutgenerating offsetting and lasting benefits.

*If there is asustained downturn in purchases or adoption of new technologies we may notachieve our future revenue objectives*

Our growth plans assume,in part, that our watermarking technologies will gain broader market acceptanceand be purchased by a growing number of customers. If there is a sustaineddownturn in purchases or adoption of digital watermarking-based solutions ornew technologies, we may be unable to realize anticipated future revenue.

*We may acquireother businesses or technologies and, if we do, we may be unable to integratethem with our own business, or we may have reduced earnings from doing so andwe may never achieve any of the benefits that we might anticipate from suchacquisitions*

One part of our strategyis to pursue acquisitions of other businesses and technologies. The pursuit ofsuch acquisitions involves certain risks. We may not be able to identify,negotiate or finance any future acquisition successfully. We may incuradditional or one-time charges related to the pursuit of acquisitions orrestructurings or other matters in connection with acquisitions. Other than theacquisition of the U.S. large government programs identification systems andinternational digital identification systems operations from PolaroidCorporation and its affiliates, we have limited experience in integrating anacquired business into our existing business. The process of integration mayproduce operating difficulties and expenditures and may require significantattention of our management that otherwise would be available for the ongoingdevelopment of our business. In the end, we may be unsuccessful in integratingan acquired business or technology with our existing business. Moreover, if wemake acquisitions, we may issue shares of our stock that would dilute theequity holdings of our existing stockholders, incur debt, assume contingentliabilities or create additional expenses related to amortizing intangible andother acquired assets. Any of these may result in reduced earnings and causeour stock price to decline. Our due diligence of acquired companies may fail toreveal material risks or liabilities. Additionally, in order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities, and we may not be successfulin doing so on satisfactory terms. Any financing that we might need for futureacquisitions may also place restrictions on our business. Furthermore, we maynever achieve any of the benefits that we might anticipate from a futureacquisition.

*We depend on keyemployees for our future success due to the high level of technical expertisethat our industry requires and the loss of any of them could delay projects orundermine customer relationships*

Our success depends to asignificant extent on the performance and continued service of our seniormanagement. Almost all of our senior management do not have employmentagreements. Although our employees generally have executed agreementscontaining non-competition clauses, there is no assurance that a court wouldenforce all of the terms of these clauses or the clauses generally. If theseclauses were not fully enforced, our employees would be freely able to join ourcompetitors. The loss of the services of 

33

----

any ofour senior management or any of our other key employees could delay projects orundermine customer relationships.

*If we are not ableto retain, hire or integrate qualified personnel, we may not be able to deliverthe products and services that our customers require*

Our ability tosuccessfully develop, market, sell and license our products, services, andintellectual property depends to a significant degree upon the continuedcontributions of our key personnel in engineering, sales, marketing,operations, legal and licensing, many of whom would be difficult to replace. Webelieve our future success will also depend in large part upon our ability toretain our current key employees and our ability to attract, integrate andretain such personnel in the future. It may not be practical for us to matchthe compensation certain of our employees could garner at other employment. Ourbusiness is based in part on patented technology, which is unique and notgenerally known. New employees require substantial training, involvingsignificant resources and management attention. Competition for experiencedpersonnel in our business can be intense. If we do not succeed in attractingnew, qualified personnel or in integrating, retaining and motivating ourcurrent personnel, our growth and ability to deliver products and services thatour customers require may be hampered.

*If the promotion ofthe Digimarc brand is unsuccessful, we will not attract new users and otherstrategic partners and we may be unable to increase our future revenue*

We believe thatestablishing and maintaining our brand is important to our success and that theimportance of brand recognition will increase due to the growing number oftechnologies that compete with our watermarking technologies and the increasingnumber of competitors offering technologies similar to ours. If ourbrand-building strategy is unsuccessful, the effort spent and expenses incurredmay never be recovered, we will not attract new users and other strategicpartners and we may be unable to increase our future revenue.

*Anti-takeoverprovisions in our charter documents could prevent or delay transactions thatcould be profitable for our stockholders*

The anti-takeover provisions of Delaware law and ourcertificate of incorporation and bylaws may make a change of control of us moredifficult, even if a change of control would be beneficial to our stockholders.These provisions may allow our board of directors to prevent changes inmanagement and control of us. Under Delaware law, our board may adoptadditional anti-takeover measures in the future.

We have thefollowing anti-takeover provisions in our charter documents:

·       Ourboard of directors is divided into three classes of directors, with a separateclass of directors being elected at each successive annual meeting for a termof three years;

·       Specialmeetings of the stockholders may be called only by our president or oursecretary, or at the discretion of our board of directors;

·       Vacancieson our board of directors may be filled by a majority of directors in office,without the approval of the stockholders; and

·       Ourboard of directors may issue preferred stock and determine the price,designations, rights and preferences as well as qualifications, limitations,and restrictions of those shares without any vote or further action by thestockholders.

These provisions couldhave the effect of discouraging a third party from making a tender offer orotherwise attempting to gain control of us, even though the transactions couldbe profitable for our 

34

----

stockholders.In addition, these provisions could limit the price that investors might bewilling to pay in the future for shares of our common stock.

*As internationalcustomers have accounted for approximately 23% of our total revenue during thesix month period ended June 30, 2004, the loss of these customers or thefailure to find new customers may result in a decline in our internationalrevenue, which could lower our profitability and slow our growth*

We expect revenuefrom sales of products and services to governments and other customers outsidethe United States to represent a growing percentage of our total revenue in thefuture. International sales and services are subject to a number of risks,including the following:

·       changesin foreign government regulations and security requirements;

·       exportlicense requirements, tariffs and taxes;

·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

If our customers are affected by currency devaluationsor general economic downturns or persistent economic difficulties, theirability to purchase our products and subscriptions and services could bereduced significantly. Payment cycles for international customers typically arelonger than those for customers in the United States. Foreign customers maydecide to terminate or delay the implementation of our products and services.Any action like this by foreign customers, in particular foreign governmentauthorities, could potentially delay or reduce our anticipated revenue underour contracts with such customers, and we may have limited recourse againstthem to recover any potential losses.

We generally invoice ourforeign sales in U.S. dollars, and, consequently, if the relative value of theU.S. dollar in comparison to the currency of our foreign customers shouldincrease, the resulting effective price increase of our products and servicesto those foreign customers could result in decreased sales. We may elect in thefuture to take payment for foreign sales in foreign currencies and, if we do,we may be exposed to losses as a result of foreign currency fluctuations. Wecurrently do not engage in foreign currency hedging transactions. We may in thefuture choose to limit our exposure by the purchase of forward foreign exchangecontracts or through similar hedging strategies. No currency hedging strategycan fully protect against exchange-related losses. For the six month periodended June 30, 2004, international customers accounted for approximately23% of our total revenue and international customers are expected to be amaterial driver of our growth. However, if any of the risks described aboveoccur, our future revenue growth and profitability could be limited.

**Risks Related to Our Market**

*If we are unable torespond to regulatory or industry standards effectively, or if we are unable todevelop and integrate new technologies effectively, our growth and thedevelopment of our digital watermarking products and services could be delayed*

Our future success will depend in part on our abilityto enhance and improve the responsiveness, functionality and features of ourproducts and services in accordance with regulatory or industry standards. Ourability to remain competitive will depend in part on our ability to influenceand respond to emerging 

35

----

industry and statutorystandards, including any standards that may be adopted for the protection ofaudio, video, and image content, and for other uses of metadata with suchcontent, in a timely and cost-effective manner. If we are unable to influencethese or other standards or respond to such standards effectively, our growthand the development of our digital watermarking products and services could bedelayed. For example, we have participated in an initiative known as the “VWMgroup” for several years that has proposed a solution to help motion picturestudios to protect their copyrights and enable new business models. Theproposed copy prevention and play control solution would protect videoprogramming on videocassettes, DVDs, or cable or satellite transmissions fromunauthorized copying to recordable DVDs, DVHS and multimedia personalcomputers. The VWM group proposal to the DVD Copy Control Association, orDVDCCA, which considered the proposal as a multi-industry technical standard,could not reach the necessary consensus for adoption. Although the DVDCCA hasnot discontinued its study, it does not currently have a clear process toselect a standard because the relevant decision-makers (includingrepresentatives of the motion picture, information technology, and consumerelectronic industries) have been unable to reach consensus. Given that theprocess is stalled, the VWM group or the DVDCCA could change or discontinue,thus frustrating our ability to market and license the proposed solutionthrough this means.

Our market ischaracterized by new and evolving technologies. The success of our businesswill depend on our ability to develop and integrate new technologieseffectively and address the increasingly sophisticated technological needs ofour customers in a timely and cost-effective manner. Our ability to remaincompetitive will depend in part on our ability to:

·       Enhanceand improve the responsiveness, functionality and other features of theproducts and services we offer or plan to offer;

·       Continueto develop our technical expertise; and

·       Developand introduce new services, applications and technologies to meet changingcustomer needs and preferences and to integrate new technologies.

We cannot assure you thatwe will be successful in responding to these technological and industrychallenges in a timely and cost-effective manner. If we are unable to developor integrate new technologies effectively or respond to these changing needs,our margins could decrease and our release of new products and services couldbe slowed.

*If leadingcompanies in our industry or standard-setting bodies or institutions downplay,minimize, or reject the use of watermarking, the deployment of digitalwatermarking may be slowed and our revenue growth may be diminished*

Many of our businessendeavors, such as our licensing of intellectual property in support of audioand video applications, can be impeded or frustrated by larger, moreinfluential companies or by standard-setting bodies or institutionsdownplaying, minimizing or rejecting the value or use of watermarkingtechnology or any of our other technologies. Such a negative position by thesecompanies, bodies or institutions, if taken, may result in obstacles for usthat we would be incapable of overcoming and may make achieving our businessobjectives difficult or impossible, potentially diminishing our anticipatedrevenue growth as a result.

*The market forsecure media solutions is highly competitive, and as a result, alternativetechnologies or larger companies may undermine, limit or eliminate the marketor our digital watermarking technologies, which would decrease our revenue andprofits*

The market forsecure media solutions is intensely competitive and rapidly evolving. We expectcompetition to continue from both existing competitors and new market entrants.We face competition 

36

----

fromother companies using digital watermarking technologies and from alternativetechnologies. As we expand the applications for our digital watermarking technologies,we will experience more competition from products and services that aresubstitutes for our digital watermarking applications. Because our businessmodels are new and emerging, we may face competition from unexpected sources.Alternative technologies that may directly or indirectly compete withparticular applications of our watermarking technologies include:

·       Encryption—securingdata during distribution using a secret code so it cannot be accessed except byauthorized users;

·       Containers—insertinga media object in an encrypted wrapper, which prevents the media object frombeing duplicated and is used for content distribution and transactionmanagement;

·       DataGlyphs®—aslightly visible modification of the characteristics of an image or document thatis machine-readable;

·       ScrambledIndicia®—an optical refraction-based data-hiding technique that is insertedinto an image and can be read with a lens;

·       Traditionalanti-counterfeiting technologies—a number of solutions used currently by manygovernments (and that compete for budgetary outlays) designed to detercounterfeiting, including optically sensitive ink, magnetic threads and othermaterials used in the printing of currencies;

·       Radiofrequency tags—embedding a chip that emits a signal when in close proximitywith a receiver, which is being used in photo identification, labels and tags;

·       Internettechnologies—numerous existing and potential Internet access and search methodswill be potentially competitive with the Digimarc MediaBridge system and thesearching capabilities of Digimarc ImageBridge;

·       Digitalfingerprints and signatures—a metric, or metrics, computed solely from a sourceimage or audio or video track, that can be used to uniquely identify an imageor track, or authenticate the image or track;

·       Smartcards—badges and cards including a semiconductor memory and/or processor usedfor authentication and related purposes; and

·       Barcodes—a data-carrying code, typically visible in nature (but invisible ifprinted in ultraviolet- or infrared-responsive inks).

In addition, as we more broadly apply our technologiesto the Internet through new commercial solutions applications, we may begin tocompete with a wide range of other types of companies beyond those companiesusing digital watermarking technologies and alternative technologies. Moreover,many of the companies that currently compete with us, as well as othercompanies with whom we may compete in the future, are larger and national orinternational in scope and may have greater technical, financial, marketing,and political resources than we do. These resources could enable thesecompanies to initiate severe price cuts or take other measures in an effort togain market share or otherwise impede our progress. We cannot assure you thatdigital watermarking technologies, and our products and services using thesetechnologies, will gain widespread market acceptance.

New developments areexpected to continue, and we cannot assure you that discoveries by others,including current and potential competitors, will not render our services andproducts noncompetitive. Moreover, because of rapid technological changes, wemay be required to expend greater amounts of time and money than currentlyanticipated to develop new products and services, which in turn may necessitateus to require greater revenue streams on such products and services to coverdevelopmental costs. We 

37

----

cannotassure you that we will be able to compete successfully against current orfuture participants in our market or against alternative technologies, nor canwe assure you that the competitive pressures we face will not decrease ourrevenue and profits in the future.

*Terrorist attacksand threats or actual war may negatively impact all aspects of our operations,revenue, costs and stock price*

Threats of terroristattacks in the United States, as well as future events occurring in response toor in connection with them, including, without limitation, future terroristattacks or threats against United States targets, rumors or threats of war,actual conflicts involving the United States or its allies, or military ortrade disruptions, may impact our operations by leading to deferred orcancelled projects, which may reduce our revenue and profits. While any ofthese terrorist-related events could result in an increased need for newsecurity features that may, as a result, favorably impact our revenue from ourDIDS operations and our sales of product and subscription and service inconnection with our digital watermarking technology, any of these events couldalso, or alternatively, result in increased volatility in the United States andworldwide financial markets and economies, or drive up our research,development and engineering costs associated with attempting to achieveheightened effectiveness in new products. Also, any of these terrorist-relatedevents could result in economic recession in the United States or abroad. Ifsuch negative consequences were to occur, they could reduce our revenue andprofits without the effect of reducing costs in the short-term and might resultin the volatility of the future market price of our common stock.

**Securities Safe Harbor Under the Private SecuritiesLitigation Reform Act of 1995**

Because this quarterlyreport on Form 10-Q contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995, any of the riskfactors set forth above or elsewhere in this quarterly report on Form 10-Qcould cause our actual results to differ materially from those resultsprojected or suggested in such forward-looking statements. Statements that arenot historical facts are hereby identified as “forward-looking statements” forthe purpose of the safe harbor provided by Section 21E of the SecuritiesExchange Act of 1934 and Section 27A of the Securities Act of 1933. Suchforward-looking statements include but are not limited to statements relatingto trends and expectations in revenue growth, including with regard to programsin Florida, Mexico, and Alabama statements regarding anticipated expenses,costs and investment activities in the foreseeable future, statements regardingfuture effects on our business in connection with the continuing implementationof our new accounting and material requirements planning systems andmodifications to our inventory management and controls systems and proceduresor other review processes, statements regarding our expected short-term andlong-term liquidity positions, and other statements containing words such as “anticipate,”“estimate,” “expect,” “management believes,” “we believe,” “we intend” andsimilar words or phrases, which are intended to identify forward-lookingstatements. All forward-looking statements are necessarily only estimates offuture results and there can be no assurance that actual results will notdiffer materially from expectations, and, therefore, investors are cautionednot to place undue reliance on such statements. Investors should understandthat it is not possible to predict or identify all risk factors and that therisks discussed above should not be considered a complete statement of allpotential risks and uncertainties. We undertake no obligation to update anyforward-looking statements as a result of future events or developments.

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk.**

The Company’s market riskdisclosures set forth in Item 7A of its Annual Report on Form 10-K for theyear ended December 31, 2003 have not changed materially.

38

----

**Item 4. Controls and Procedures.**

*Evaluationof disclosure controls and procedures.**  *As of the end of the period coveredby this report, we carried out an evaluation, under the supervision and withthe participation of our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective in timely alerting them to material information required to beincluded in this report.

*Changes in internal control over financial reporting.**  *During our mostrecent fiscal quarter ended June 30, 2004, we took various correctiveactions, under the direction of our audit committee and our board of directors,to further strengthen our internal controls and procedures to ensure thatinformation required to be disclosed in the reports that we file or submitunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported accurately, within the time periods specified in the rules andforms of the Securities and Exchange Commission. Specifically, we made changesin our leadership, including retaining a new Chief Financial Officer and othersenior managers in the finance and administration and information technologystaffs of our business. Following the end of our fiscal quarter, we alsoestablished a lead independent director position on our board of directors toassist, among other things, in bringing issues to the attention of the board ofdirectors. Additionally,refinements in information made available to us as a result of theimplementation of our new accounting and material requirements planning systemshas led us to make further modifications to our review processes and to make,more recently, further improvements to the management of our identification systemsbusiness, in particular by putting Paul Gifford,our President and Chief Operating Officer, in a position of direct control andresponsibility for our identification systems business in order to makeday-to-day improvements to the efficiency, effectiveness, and predictability ofits operations, including as they relate to internal control over financialreporting. We have been implementing, and we anticipate continuing toimplement, new functionality and tools in the areas of manufacturing resourceplanning and management of inventories throughout the supply chains associatedwith our identification systems business. We also have been implementing, andexpect to continue to implement, new procedures and controls within ourday-to-day financial operations at the identification systems business. Finally,we have further strengthened our inventory management and controls systems andprocedures, including those governing the usability and disposition ofslow-moving or excess inventories, by performing monthly physical inventorycounts and analyzing historical and expected usage levels. As a result of theseand other actions, we believe that we have reliable systems in place that willsupport timely and accurate reporting. Other than as described above, there hasbeen no change in our internal control over financial reporting that occurredduring our most recent fiscal quarter ended June 30, 2004 that hasmaterially affected or is reasonably likely to materially affect our internalcontrol over financial reporting.

39

----

**PART II. OTHER INFORMATION.**

**Item 1. Legal Proceedings.**

Beginning in May 2001,a number of substantially identical class action complaints alleging violationsof the federal securities laws were filed in the United States District Courtfor the Southern District of New York naming approximately 300 companies,including Digimarc, certain of its officers and directors, and certainunderwriters of Digimarc’s initial public offering as defendants. Thecomplaints have since been consolidated into a single action, and aconsolidated amended complaint was filed in April 2002. The amendedcomplaint alleges, among other things, that the underwriters of the Company’sinitial public offering violated securities laws by failing to disclose certainalleged compensation arrangements (such as undisclosed commissions or stockstabilization practices) in the Company’s initial public offering registrationstatement and by engaging in manipulative practices to artificially inflate theprice of the Company’s stock in the after-market subsequent to the Company’sinitial public offering. Digimarc and certain of its officers and directors arenamed in the amended complaint pursuant to Section 11 of the SecuritiesAct of 1933, and Section 10(b) and Rule 10b-5 of the SecuritiesExchange Act of 1934 on the basis of an alleged failure to disclose theunderwriters’ alleged compensation arrangements and manipulative practices. Thecomplaint seeks unspecified damages. The individual officer and directordefendants entered into tolling agreements and, pursuant to a court order datedOctober 9, 2002, were dismissed from the litigation without prejudice.Furthermore, in July 2002, Digimarc and the other defendants in theconsolidated cases filed motions to dismiss the amended complaint for failureto state a claim. The motion to dismiss claims under Section 11 was deniedas to virtually all the defendants in the consolidated actions, includingDigimarc. The claims against Digimarc under Section 10(b), however, weredismissed. In June 2003, a committee of the Company’s board of directorsconditionally approved a proposed partial settlement with the plaintiffs inthis matter. In June 2004, an agreement of settlement was submitted to thecourt for preliminary approval, but Digimarc is unable to determine whether orwhen the settlement will be approved or be finalized. The settlement wouldprovide, among other things, a release of Digimarc and of the individualdefendants for the conduct alleged in the amended complaint to be wrongful.Digimarc would agree to undertake other responsibilities under the partialsettlement, including agreeing to assign away, not assert, or release certainpotential claims Digimarc may have against its underwriters. Any directfinancial impact of the proposed settlement (other than defense costs incurredand expensed prior to May 31, 2003) is expected to be borne by Digimarc’sinsurers. Due to the inherent uncertainties of litigation and because thesettlement process is still at an early stage, the ultimate outcome of thematter cannot be predicted. 

**Item 4. Submission of Matters to a Vote of SecurityHolders.**

We held our annual meeting of stockholders on May 6,2004. Two proposals were voted on by our stockholders and the results for eachproposal were as follows:

**Proposal1:****  **Electionof Two Class II Directors

Theelection of two Class II directors was approved as follows: 
| ** **                  | ** ** | **In Favor** | ** ** | **Against** | ** ** | **Abstentions** | ** ** | **Non-votes** | ** ** |
|-----------------------------|------------|-------------------|------------|-------------|------------|-----------------|------------|---------------|------------|
| Philip J.  Monego, Sr. |       | 14,958,310        |       | 244,244     |       |            | 0          |          |       | 5,027,817 |   |
| Peter W. Smith              |       | 15,125,511        |       | 77,043      |       |            | 0          |          |       | 5,027,817 |   |

 

**Proposal2:****  **Ratificationof the Appointment of KPMG LLP as the Company’s Independent Auditors

KPMG LLP was ratified asour independent auditors for the fiscal year ending December 31, 2004 with15,041,654 votes in favor, 154,395 votes against, 6,505 abstentions, and5,027,817 non-votes.

40

----

**Item 6. Exhibits and Reports on Form 8-K.**

(a)          Exhibits.

See attached exhibit index.

(b)         Reports on Form 8-K.

On April 20, 2004, Digimarc filed with theSecurities and Exchange Commission a current report on Form 8-K,dated April 16, 2004 and including reports under items 5 and 7 thereto, inconnection with its press release related to a number of recent developmentsregarding the Company.

On April 29, 2004, Digimarc filed with theSecurities and Exchange Commission a current report on Form 8-K,dated April 29, 2004 and including reports under items 5, 7, and 12thereto, in connection with its announcement of financial results for the firstquarter ended March 31, 2004 and guidance for its second quarter and fullyear 2004.

On June 23, 2004, Digimarc filed with theSecurities and Exchange Commission a current report on Form 8-K,dated June 21, 2004, and including reports under items 5 and 7 thereto, inconnection with the launch of its Digimarc Mobile initiative and the signing ofa multi-year agreement with MediaGrid to serve Japanese consumers.

41

----

 

**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized. 
|                      | DIGIMARC CORPORATION |
|----------------------|----------------------|
| Date: August 9, 2004 | By:                  | /s/ Michael McConnell |
|                 |                 | Michael McConnell*Chief Financial Officer and Treasurer  (Duly Authorized Officer  and Principal Financial Officer)* |

 

42

----

 

**EXHIBIT INDEX**
| **Exhibit  Number** | ** ** | ** **                                                                                                                                                                                                                                                                                                    | **Document** | ** ** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|------------|
|   3.1     |       | Second Amended and  Restated Certificate of Incorporation of the Registrant (incorporated by  reference to Exhibit 3.1 of Exhibits to the Registrant's Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on November 14, 2000)                             |
|   3.2     |       | Certificate of Amendment  of Second Amended and Restated Certificate of Incorporation of the Registrant  (incorporated by reference to Exhibit 3.2 of Exhibits to the Registrant's  Quarterly Report on Form 10-Q, as filed with the Securities and Exchange  Commission on November 14, 2000) |
|   3.3     |       | Amended and Restated  Bylaws of the Registrant, as amended (incorporated by reference to  Exhibit 3.3 of Exhibits to the Registrant's Annual Report on  Form 10-K, as filed with the Securities and Exchange Commission on  March 15, 2004)                                                    |
| 31.1                |       | Rule 13a-14(a)/15d-14(a)  Certification of Chief Executive Officer                                                                                                                                                                                                                                       |
| 31.2                |       | Rule 13a-14(a)/15d-14(a)  Certification of Chief Financial Officer                                                                                                                                                                                                                                       |
| 32.1                |       | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                                   |
| 32.2                |       | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                   |

 

43

----