**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(MarkOne)**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended March 31, 2007**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from               to**

**CommissionFile 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.) |

 

**9405SW Gemini Drive, Beaverton, Oregon 97008**

(Address of principalexecutive offices) (Zip Code)

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act:

| Title of Each Class         | ** ** | **Name of Each Exchange on Which Registered** |
|-----------------------------|------------|-----------------------------------------------|
| Common Stock,               |       | The Nasdaq Stock  Market                      |
| $0.001 Par Value  Per Share |       |                                          |

 

Securities registered pursuant to Section 12(g) ofthe Act:

**NONE**

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o                    Acceleratedfiler x                    Non-acceleratedfiler o

Indicate by check markwhether the registrant is a shell company (as defined in rule 12b-2of the Exchange Act). Yes o  No x

Asof April 30, 2007, there were 21,551,507 shares of the registrant’scommon stock, par value $0.001 per share, outstanding.

 

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**Tableof Contents**

| **PART I FINANCIAL  INFORMATION** |                                                                                                                    |   |
|----------------------------------------|-------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.                           | Financial  Statements:                                                                                                  |   | 3 |
|                                   | Consolidated Balance  Sheets as of March 31, 2007 and December 31, 2006 (Unaudited)                      |   | 3 |
|                                   | Consolidated  Statements of Operations for the three-months ended March 31, 2007 and  2006 (Unaudited)             |   | 4 |
|                                   | Consolidated  Statements of Stockholders’ Equity as of March 31, 2007 and  December 31, 2006 (Unaudited) |   | 5 |
|                                   | Consolidated  Statements of Cash Flows for the three-months ended March 31, 2007 and  2006 (Unaudited)             |   | 6 |
|                                   | Notes to Consolidated  Financial Statements (Unaudited)                                                                 |   | 7 |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of  Operations                            |   | 23 |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                                             |   | 40 |
| Item 4.                                | Controls  and Procedures                                                                                                |   | 40 |
| **PART II OTHER INFORMATION**     |                                                                                                                    |   |
| Item 1.                                | Legal  Proceedings                                                                                                      |   | 41 |
| Item 1A.                               | Risk Factors                                                                                                            |   | 42 |
| Item 6.                                | Exhibits                                                                                                                |   | 53 |
| **SIGNATURES**                         |                                                                                                                    | 54     |

 

2

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**PART I.   FINANCIALINFORMATION**

**Item1.**                        FinancialStatements.

**DIGIMARC CORPORATIONCONSOLIDATED BALANCE SHEETS(In thousands, except share and per share data) (UNAUDITED)**

| ** **                                                                                                                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------------------|------------|
| ** **                                                                                                                               | ** ** | **2007**      | ** ** | **2006(1)**           | ** ** |
| **ASSETS**                                                                                                                               |       |          |       |                  |       |   |   |
| Current assets:                                                                                                                          |       |          |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                |       | $             | 21,945     |                  |       | $ | 23,135 |   |   |
| Restricted cash                                                                                                                          |       | —        |       |                  | 378        |   |   |
| Trade accounts receivable, net                                                                                                           |       | 14,089        |       |                  | 14,403     |   |   |
| Inventory, net                                                                                                                           |       | 7,130         |       |                  | 6,600      |   |   |
| Other current assets                                                                                                                     |       | 1,999         |       |                  | 2,273      |   |   |
| Total current assets                                                                                                                     |       | 45,163        |       |                  | 46,789     |   |   |
| Restricted cash                                                                                                                          |       | 9,560         |       |                  | 9,560      |   |   |
| Property and  equipment, net                                                                                                             |       | 65,378        |       |                  | 61,898     |   |   |
| Intangibles, net                                                                                                                         |       | 14,899        |       |                  | 15,374     |   |   |
| Other assets, net                                                                                                                        |       | 1,087         |       |                  | 1,010      |   |   |
| Total assets                                                                                                                             |       | $             | 136,087    |                  |       | $ | 134,631 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                           |       |          |       |                  |       |   |   |
| Current liabilities:                                                                                                                     |       |          |       |                  |       |   |   |
| Accounts payable                                                                                                                         |       | $             | 6,644      |                  |       | $ | 5,708 |   |   |
| Accrued payroll and related costs                                                                                                        |       | 1,698         |       |                  | 3,894      |   |   |
| Deferred revenue                                                                                                                         |       | 5,290         |       |                  | 5,050      |   |   |
| Other current liabilities                                                                                                                |       | 2,068         |       |                  | 2,258      |   |   |
| Total current liabilities                                                                                                                |       | 15,700        |       |                  | 16,910     |   |   |
| Long-term  deferred revenue, net of current portion                                                                                      |       | 7,556         |       |                  | 5,345      |   |   |
| Other long-term  liabilities                                                                                                             |       | 770           |       |                  | 885        |   |   |
| Total liabilities                                                                                                                        |       | 24,026        |       |                  | 23,140     |   |   |
| Commitments and  contingencies (Note 5)                                                                                                  |       |          |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                               |       |          |       |                  |       |   |   |
| Common stock  (21,549,447 and 21,191,918 shares issued and outstanding at March 31,  2007 and December 31, 2006, respectively) |       |  

22    |       |                  | 22         |   |   |
| Additional  paid-in capital                                                                                                              |       | 212,519       |       |                  | 211,072    |   |   |
| Accumulated other  comprehensive income                                                                                                  |       | 137           |       |                  | 137        |   |   |
| Accumulated  deficit                                                                                                                     |       | (100,617      | )          |                  | (99,740    | ) |   |
| Total stockholders’ equity                                                                                                          |       | 112,061       |       |                  | 111,491    |   |   |
| Total liabilities  and stockholders’ equity                                                                                         |       | $             | 136,087    |                  |       | $ | 134,631 |   |   |

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(1)          Derived from the Company’sDecember 31, 2006 audited consolidated financial statements

See Notes to Unaudited Consolidated Financial Statements.

3

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(UNAUDITED)**

| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** |
| ** **                                        | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Revenue:                                          |       |                             |       |   |   |
| Service                                           |       | $                                | 21,299     |   | $ | 22,290 |   |
| Product and subscription                          |       | 5,547                            |       | 4,903 |   |
| Total revenue                                     |       | 26,846                           |       | 27,193 |   |
| Cost of revenue:                                  |       |                             |       |   |   |
| Service                                           |       | 14,715                           |       | 17,099 |   |
| Product and subscription                          |       | 2,100                            |       | 2,549 |   |
| Total cost of revenue                             |       | 16,815                           |       | 19,648 |   |
| Gross profit                                      |       | 10,031                           |       | 7,545 |   |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 4,277                            |       | 4,539 |   |
| Research, development and engineering             |       | 2,042                            |       | 3,236 |   |
| General and administrative                        |       | 4,098                            |       | 5,210 |   |
| Amortization of intangibles                       |       | 500                              |       | 573 |   |
| Intellectual property                             |       | 499                              |       | 431 |   |
| Total operating expenses                          |       | 11,416                           |       | 13,989 |   |
| Operating income (loss)                           |       | (1,385                           | )          | (6,444 | ) |
| Other income (expense):                           |       |                             |       |   |   |
| Interest income                                   |       | 412                              |       | 325 |   |
| Interest expense                                  |       | (19                              | )          | (16 | ) |
| Other                                             |       | (11                              | )          | 48 |   |
| Total other income, net                           |       | 382                              |       | 357 |   |
| Income (loss)  before provision for income taxes  |       | (1,003                           | )          | (6,087 | ) |
| Provision for  income taxes                       |       | (19                              | )          | (85 | ) |
| Net income (loss)                                 |       | $                                | (1,022     | ) | $ | (6,172 | ) |
| Net income (loss)  per share—basic           |       | $                                | (0.05      | ) | $ | (0.30 | ) |
| Net income (loss)  per share—diluted         |       | $                                | (0.05      | ) | $ | (0.30 | ) |
| Weighted average shares outstanding—basic    |       | 20,797                           |       | 20,607 |   |
| Weighted average  shares outstanding—diluted |       | 20,797                           |       | 20,607 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

4

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**

| ** **                                       | ** ** | **Common stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred  stock** | ** ** | ** **       | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Accumulated** | ** ** | **Total  stockholders’** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|-----------------------------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**         | ** ** | **compensation** | ** ** | **Warrant**                                   | ** ** | **(loss)**      | ** ** | **Deficit**                   | ** ** | **equity** | ** ** |
| **BALANCE AT   DECEMBER 31, 2005**          |       | 20,808,994            |       |                    | $          | 21                  |       |             |       | $                                             | 209,337    |            |       |                          | $          | (1,519 | ) |   |   | — |   |   |   | $ | 137 |   |   |   | $ | (88,000 | ) |   |   | $ | 119,976 |   |   |
| Initial adjustment to adopt   SFAS 123R          |       | —                |       |                    | —     |                |       |             | (1,519     | )                                             |       |            | 1,519      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Exercise of stock options                        |       | 44,584                |       |                    | 1          |                |       |             | 201        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 202 |   |   |
| Issuance of employee stock  purchase plan shares |       | 52,957                |       |                    | —     |                |       |             | 248        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 248 |   |   |
| Issuance of restricted  common stock             |       | 312,365               |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and retirement of  common stock    |       | (26,982)              |       |                    | —     |                |       |             | (208       | )                                             |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (208 | ) |   |
| Stock-based  compensation   expense              |       | —                |       |                    | —     |                |       |             | 3,013      |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,013 |   |   |
| Net loss                                         |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | (11,740 | ) |   |   | (11,740 | ) |   |
| **BALANCE AT   DECEMBER 31, 2006**          |       | 21,191,918            |       |                    | 22         |                |       |             | 211,072    |                                          |       |            | —     |                          |       |   | — |   |   |   | 137 |   |   |   | (99,740 | ) |   |   | 111,491 |   |   |
| Initial adjustment to adopt   FIN 48             |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | 145 |   |   |   | 145 |   |   |
| Exercise of stock options                        |       | 64,354                |       |                    | —     |                |       |             | 388        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 388 |   |   |
| Issuance of employee stock  purchase plan shares |       | 25,377                |       |                    | —     |                |       |             | 194        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 194 |   |   |
| Issuance of restricted  common stock             |       | 285,490               |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and retirement of  common stock    |       | (17,692)              |       |                    | —     |                |       |             | (140       | )                                             |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (140 | ) |   |
| Stock-based  compensation   expense              |       | —                |       |                    | —     |                |       |             | 1,005      |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,005 |   |   |
| Net loss                                         |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | (1,022 | ) |   |   | (1,022 | ) |   |
| **BALANCE AT MARCH 31, 2007**               |       | 21,549,447            |       |                    | $          | 22                  |       |             |       | $                                             | 212,519    |            |       |                          | $          | — |   |   |   | $ | — |   |   |   | $ | 137 |   |   |   | $ | (100,617 | ) |   |   | $ | 112,061 |   |   |
|                                                  |            |                       |            |                         |            |                     |            |                  |            |                                               |            |                 |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See Notes to UnauditedConsolidated Financial Statements.

5

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands, except share and per share data)(UNAUDITED)**

| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Cash flows from  operating activities:                                                     |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (1,022     | ) | $ | (6,172 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                              |       | 3,921                            |       | 3,818 |   |
| Stock-based compensation expense                                                           |       | 1,005                            |       | 794 |   |
| Increase (decrease) in allowance for doubtful  accounts                                    |       | 1                                |       | (64 | ) |
| Other non-cash charges                                                                     |       | (29                              | )          | — |   |
| Changes in  operating assets and liabilities:                                              |       |                             |       |   |   |
| Restricted cash                                                                            |       | 378                              |       | 499 |   |
| Trade and unbilled accounts receivable                                                     |       | 313                              |       | 2,595 |   |
| Inventory, net                                                                             |       | (530                             | )          | 1,608 |   |
| Other current assets                                                                       |       | 234                              |       | 605 |   |
| Other assets, net                                                                          |       | (77                              | )          | 33 |   |
| Accounts payable                                                                           |       | 936                              |       | (1,396 | ) |
| Accrued payroll and related costs                                                          |       | (2,196                           | )          | (830 | ) |
| Deferred revenue                                                                           |       | 2,451                            |       | (844 | ) |
| Other liabilities                                                                          |       | 24                               |       | (214 | ) |
| Net cash provided by (used in) operating activities                                        |       | 5,409                            |       | 432 |   |
| Cash flows from  investing activities:                                                     |       |                             |       |   |   |
| Purchase of property and equipment and capitalized  labor costs                            |       | (6,897                           | )          | (769 | ) |
| Sale or maturity of short-term investments                                                 |       | 38,355                           |       | 33,961 |   |
| Purchase of short-term investments                                                         |       | (38,355                          | )          | (34,223 | ) |
| Net cash provided by (used in) investing activities                                        |       | (6,897                           | )          | (1,031 | ) |
| Cash flows from  financing activities:                                                     |       |                             |       |   |   |
| Issuance of common stock                                                                   |       | 582                              |       | 5 |   |
| Purchase of common stock                                                                   |       | (140                             | )          | — |   |
| Principal payments under capital lease obligations                                         |       | (144                             | )          | (146 | ) |
| Net cash provided by (used in) financing activities                                        |       | 298                              |       | (141 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | (1,190                           | )          | (740 | ) |
| Cash and cash equivalents at beginning of period                                           |       | 23,135                           |       | 23,964 |   |
| Cash and cash equivalents at end of period                                                 |       | $                                | 21,945     |   | $ | 23,224 |   |
| Supplemental disclosure  of cash flow information:                                         |       |                             |       |   |   |
| Cash paid for interest                                                                     |       | $                                | 19         |   | $ | 16 |   |
| Cash paid for income taxes                                                                 |       | $                                | 12         |   | $ | — |   |
| Summary of non-cash  investing and financing activities:                                   |       |                             |       |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       | $                                | —     |   | $ | 413 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

6

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share data) (UNAUDITED)**

**1.**                 TheCompany, Basis of Presentation

*Description ofBusiness*

Digimarc Corporation (“Digimarc,”“the Company,” “our” or “we”) is a supplier of secure identity solutions andadvanced technologies for use in media management. The Company’s solutionsenable governments and businesses around the world to deter counterfeiting andpiracy, enhance traffic safety and national security, combat identity theft andfraud, facilitate the effectiveness of voter identification programs, improvethe management of media content, and support new digital media distributionmodels that provide consumers with more choice and access to media content.

*Principles ofConsolidation*

The consolidated financialstatements include the accounts of Digimarc and its wholly-owned subsidiaries.All significant intercompany transactions and balances have been eliminated.

*Interim FinancialStatements*

The accompanying consolidated financial statementshave been prepared from the Company’s records without audit and, in management’sopinion, include all adjustments (consisting of only normal recurringadjustments) necessary to fairly reflect the financial condition and theresults for the periods presented. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States (the “U.S.”) havebeen condensed or omitted under the rules and regulations of theSecurities and Exchange Commission (the “SEC”).

These consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006, which was filed with the SEC on March 8,2007. The results of operations for the interim periods presented in theseconsolidated financial statements are not necessarily indicative of the resultsfor the full year.

*Use of Estimates*

The preparation ofconsolidated financial statements in accordance with accounting principlesgenerally accepted in the U.S. requires Digimarc to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenue andexpenses, and related disclosure of contingent assets and liabilities. Certainof the Company’s accounting policies require higher degrees of judgment thanothers in their application. These include revenue recognition on long-termservice contracts, impairments and estimation of useful lives of long-livedassets, inventory valuation, reserves for uncollectible accounts receivable,inputs for stock-based compensation calculations, and contingencies andlitigation. Digimarc bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

7

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Reclassifications*

Certain amounts in the2006 consolidated financial statements and notes thereon have been reclassifiedto conform to the current period presentation. These reclassifications had nomaterial effect on the results of operations or financial position for any periodpresented.

**2.**                 NetIncome (Loss) Per Share Computation

Net income (loss) pershare (or earnings per share (“EPS”)) is calculated in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 128, *Earnings per Share*, which provides thatbasic and diluted net income (loss) per share for all periods presented are tobe computed using the weighted average number of common shares outstandingduring each period, with diluted net income (loss) per share including theeffect of potentially dilutive common shares.

The following table showsthe reconciliation of weighted average basic shares to weighted average dilutedshares outstanding.

| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **Shares  (in 000’S)**                 | ** ** |
| **Basic  EPS**                       | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Weighted average shares outstanding  |       | 20,797                                           | ** ** | 20,607 |   |
| **Effect of Dilutive Securities**    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Options                              |       | —                                           | ** ** | — |   |
| **Diluted EPS**                      | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Weighted  average shares outstanding |       | 20,797                                           | ** ** | 20,607 |   |

 

Common stock equivalentsrelated to stock options of 4,393 and 5,386 were excluded from diluted net lossper share calculations for the three-month periods ended March 31, 2007and 2006, respectively, as their exercise price was higher than the averagemarket price of the underlying common stock for the period and therefore theirimpact would be anti-dilutive. In addition, common stock equivalents related tostock options and restricted stock of 1,604 and 852 for the three-month periodsended March 31, 2007 and 2006, respectively, were excluded from dilutednet loss per share as the Company was in a loss position and the inclusionwould be anti-dilutive.

**3.**                 Stock-BasedCompensation

Stock-based compensation includes expense charges forall stock-based awards to employees and directors. Such awards include optiongrants, restricted stock awards, and shares expected to be purchased under anemployee stock purchase plan. On January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123(R), *Share-Based Payment (Revised 2004)*, which requires themeasurement and recognition of compensation for all stock-based awards made toemployees and directors including stock options and employee stock purchasesunder a stock purchase plan based on estimated fair values. SFAS 123(R) supersedesprevious accounting under Accounting Principles Board Opinion No. 25, 

8

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Accountingfor Stock Issued to Employees*, for periods beginning infiscal 2006. In March 2005, the SEC issued Staff Accounting Bulletin No. 107relating to application of SFAS 123(R). The Company has applied the provisionsof Staff Accounting Bulletin (“SAB”) 107 in the adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of its 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the three-month periods ended March 31, 2007 and 2006 isbased on the value of the portion of the stock-based award that will vestduring the period, adjusted for expected forfeitures. Stock-based compensationrecognized in the Company’s consolidated financial statements in the three-monthperiods ended March 31, 2007 and 2006 includes compensation cost forstock-based awards granted prior to, but not fully vested as of, December 31,2005 and stock-based awards granted subsequent to December 31, 2005. Thecompensation cost for awards granted prior to January 1, 2006 is based onthe grant date fair value estimated in accordance with the pro forma provisionsof SFAS 123 while awards granted on or after January 1, 2006 follow theprovisions of SFAS 123(R) to determine the grant date fair value andcompensation cost. Compensation cost for all stock-based awards is recognizedusing the straight-line method.

Upon adoption ofSFAS 123(R), the Company continued to use the Black-Scholes option pricingmodel as its method of valuation for stock-based awards. The Company’sdetermination of the fair value of stock-based awards on the date of grantusing an option pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited, to the expected life of theaward, our expected stock price volatility over the term of the award andactual and projected exercise behaviors. Although the fair value of stock-basedawards is determined in accordance with SFAS 123(R) and SAB 107, theBlack-Scholes option pricing model requires the input of highly subjectiveassumptions, and other reasonable assumptions could provide differing results.

***Determining Fair Value Under SFAS 123(R)***

*Stock Options*

*Valuationand Amortization Method.**  **The Company estimates the fair value ofstock-based awards granted using the Black-Scholes option valuation model. TheCompany amortizes the fair value of all awards on a straight-line basis overthe requisite service periods, which are generally the vesting periods.*The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model.

*ExpectedLife.*   The expected lifeof awards granted represents the period of time that they are expected to beoutstanding. The Company determines the expected life based on historicalexperience with similar awards, giving consideration to the contractual terms,vesting schedules and pre-vesting and post-vesting forfeitures. Stockoptions granted during the three months ended March 31, 2007 and 2006generally vest over four years and have contractual terms of ten years.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*ExpectedVolatility.*   The Companyestimates the volatility of its common stock at the date of grant based on thehistorical volatility of its common stock. The volatility factor the Companyuses in the Black-Scholes option valuation model is based on its historicalstock prices over the most recent period commensurate with the estimatedexpected life of the award. This historical period excludes portions of timewhen unusual transactions occurred, such as a significant acquisition.

*Risk-FreeInterest Rate.**  *TheCompany bases the risk-free interest rate used in the Black-Scholes optionvaluation model on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent remaining term approximately equal to theexpected life of the award.

*ExpectedDividend Yield.**  *TheCompany has never paid any cash dividends on its common stock and does notanticipate paying any cash dividends in the foreseeable future. Consequently,the Company uses an expected dividend yield of zero in the Black-Scholes optionvaluation model.

*ExpectedForfeitures.**  *TheCompany uses relevant historical data to estimate pre-vesting optionforfeitures. The Company records stock-based compensation only for those awardsthat are expected to vest.

A summary of the weighted averageassumptions and results for options granted during the periods presented is asfollows:

| ** **               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| ** **               | ** ** | **  2007  **                 | ** ** | **  2006  ** | ** ** |
| Expected life (in years) |       |                                             | 5.8        |   |   |   | 6.0 |   |   |
| Expected volatility      |       |                                             | 44         | % |   |   | 53 | % |   |
| Risk-free interest rate  |       |                                             | 4.7        | % |   |   | 4.7 | % |   |
| Expected dividend yield  |       |                                             | 0          | % |   |   | 0 | % |   |
| Expected forfeiture rate |       |                                             | 16         | % |   |   | 14 | % |   |
| Fair value               |       |                                             | $          | 4.27 |   |   |   | $ | 3.89 |   |   |
|                          |            |                                                  |            |  |  |  |  |  |  |  |  |

 

*Employee StockPurchase Plans*

The Company also recognizes stock-based compensation in connection withits 1999 Employee Stock Purchase Plan. The plan allowed employees to purchaseshares of Digimarc common stock through payroll deductions of up to 15% oftheir base compensation during each six-month plan period, up to a maximumdeduction of $10.6 for each plan period, not to exceed $21 per year. Plan periodswere generally from December 1 to May 31 and from June 1 to November 30.The price an employee paid for the shares was 85% of the lower of (i) thefair market value of Digimarc common stock at the beginning of the plan periodor (ii) the fair market value at the end of the plan period. No shareswere purchased under the plan during the three months ended March 31,2006  The plan was suspended effective June 1,2006.

An amended plan was reinstated effective November 2,2006 which slightly modified the earlier plan. The changes included changingthe plan periods from six to three months and the maximum deduction to $5.3 foreach plan period. The plan periods are generally from December 1 to February 28,March 1 to May 31, June 1 to August 31 and from September 1to November 30. Employees purchased 25,377 shares under the plan duringthe three months ended March 31, 2007.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Restricted Stockand Performance Vesting Shares*

During 2007 and 2006 the Compensation Committee of theBoard of Directors awarded restricted stock shares under the Company’s 1999Stock Incentive Plan, as amended, to certain officers, employees and directors.The shares subject to the restricted stock awards vest over a certain period,usually one to four years, following the date of the grant. In addition theCompensation Committee awarded performance vesting shares under the 1999 StockIncentive Plan, as amended, to certain officers and employees. The performancevesting shares vest in full (or terminate) based on the achievement of specifiedperformance goals. Specific terms of the restricted stock awards andperformance vesting share awards are governed by Restricted Stock Agreementsand Performance Vesting Share Agreements between the Company and the awardrecipients.

The fair value of restricted stock awards granted isbased on the fair market value of the Company’s common stock on the date of thegrant (measurement date), and is recognized over the vesting period of therelated restricted stock using the straight-line method.

The fair value of performance vesting shareawards granted is based on a Monte Carlo valuation model that results in afactor applied to the fair market value of the Company’s common stock on thedate of the grant (measurement date), and is recognized over the derivedservice period using the straight-line method.

***Stock-based Compensation Under FAS 123(R)***

The following table summarizes stock-basedcompensation expense related to stock-based awards under SFAS 123(R) forthe three months ended March 31, 2007 and 2006, which was incurred asfollows:

| ** **                             | ** ** | **Three Months Ended**March 31, | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **   2007   **   | ** ** | **   2006   ** | ** ** |
| Stock-based compensation:              |       |                                           |       |   |   |   |   |   |   |
| Cost of revenue                        |       |                                           | $          | 106 |   |   |   | $ | 54 |   |   |
| Sales and marketing                    |       |                                           | 207        |   |   |   | 122 |   |   |
| Research, development and  engineering |       |                                           | 72         |   |   |   | 114 |   |   |
| General and  administrative            |       |                                           | 608        |   |   |   | 496 |   |   |
| Intellectual property                  |       |                                           | 12         |   |   |   | 8 |   |   |
| Total stock-based compensation         |       |                                           | $          | 1,005 |   |   |   | $ | 794 |   |   |

 

At March 31, 2007, the Company had1.7 million non-vested stock options that had a weighted average grantdate price of $6.91. As of March 31, 2007, the Company had$9.9 million of total unrecognized compensation cost related to non-vestedstock-based awards granted under all equity compensation plans, includingoptions, restricted stock, and employee stock purchase plan. Total unrecognizedcompensation cost will be adjusted for any future changes in estimatedforfeitures. The Company expects to recognize this cost over a weighted averageperiod of 1.59 years.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

***Stock Option Activity***

As of March 31, 2007, under all of the Company’s stock-basedcompensation plans, options to purchase an aggregate of 7.3 million shareswere outstanding, and options to purchase an additional 7.2 million shareswere authorized for future grants under the plans. The Company issues newshares upon option exercises.

Options granted, exercised, canceled andexpired under the Company’s stock option plans are summarized as follows:

| **Three-months ended March 31, 2007:** | ** ** | ** ** | ** ** | **Options** | ** ** | **Weighted**Average Exercise Price | ** ** | **Weighted**Average Remaining  Contractual Life | ** **      |
|------------------------------------------------------------|------------|------------|------------|-------------|------------|------------------------------------|------------|-------------------------------------------------|-----------------|
| Outstanding at December 31, 2006                      |       | 7,045,751  |       |        | $          | 13.67                              |       |                                            |            |   |
| Options granted                                            |       | 367,950    |       |        | 8.85       |                               |       |                                            |            |
| Options exercised                                          |       | (64,354    | )          |        | 6.04       |                               |       |                                            |            |
| Options canceled                                           |       | (70,459    | )          |        | 10.29      |                               |       |                                            |            |
| Options expired                                            |       | —     |       |        | —     |                               |       |                                            |            |
| Outstanding at March 31, 2007                         |       | 7,278,888  |       |        | $          | 13.53                              |       |                                            | 6.31 years |   |
| Exercisable at March 31, 2007                         |       | 5,606,621  |       |        | $          | 15.50                              |       |                                            | 5.52 years      |   |

 

The following tablesummarizes information about stock options outstanding at March 31, 2007:

| ** **                                      | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices**     | ** ** | ** **                   | ** ** | **Number**Outstanding        | ** ** | **Remaining**Contractual Life  (Years) | ** ** | **Weighted**Average Price | ** ** | **Number**Exercisable | ** ** | **Weighted**Average Price | ** ** |
| $  0.50 - $  5.96 |       |                         | 834,284    |                         |       |   | 7.51 |   |   |   | $ | 5.05 |   |   | 422,347 |   |   | $ | 4.26 |   |   |
| $  6.00 - $  6.15 |       |                         | 487,846    |                         |       |   | 8.25 |   |   |   | $ | 6.07 |   |   | 196,376 |   |   | $ | 6.05 |   |   |
| $  6.16 - $  6.99 |       |                         | 575,772    |                         |       |   | 8.83 |   |   |   | $ | 6.47 |   |   | 150,273 |   |   | $ | 6.48 |   |   |
| $  7.02 - $  9.85 |       |                         | 979,292    |                         |       |   | 8.50 |   |   |   | $ | 8.57 |   |   | 446,231 |   |   | $ | 8.68 |   |   |
| $10.29 - $12.23                       |       |                         | 634,737    |                         |       |   | 6.77 |   |   |   | $ | 11.51 |   |   | 624,437 |   |   | $ | 11.53 |   |   |
| $12.40 - $13.25                       |       |                         | 582,720    |                         |       |   | 5.85 |   |   |   | $ | 12.82 |   |   | 582,720 |   |   | $ | 12.82 |   |   |
| $13.38 - $14.13                       |       |                         | 792,000    |                         |       |   | 3.92 |   |   |   | $ | 14.07 |   |   | 792,000 |   |   | $ | 14.07 |   |   |
| $14.40 - $15.24                       |       |                         | 569,410    |                         |       |   | 5.72 |   |   |   | $ | 15.11 |   |   | 569,410 |   |   | $ | 15.11 |   |   |
| $15.25 - $17.00                       |       |                         | 690,677    |                         |       |   | 5.67 |   |   |   | $ | 16.24 |   |   | 690,677 |   |   | $ | 16.24 |   |   |
| $17.88 - $26.25                       |       |                         | 757,900    |                         |       |   | 4.16 |   |   |   | $ | 21.03 |   |   | 757,900 |   |   | $ | 21.03 |   |   |
| $27.50 - $53.94                       |       |                         | 374,250    |                         |       |   | 2.93 |   |   |   | $ | 46.74 |   |   | 374,250 |   |   | $ | 46.74 |   |   |
| $  0.50 - $53.94            |       |                         | 7,278,888  |                         |       |   | 6.31 |   |   |   | $ | 13.53 |   |   | 5,606,621 |   |   | $ | 15.50 |   |   |
|                                                 |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006, 5,559,602 options wereexercisable at a weighted average price of $15.62.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

AtMarch 31, 2007, the aggregate intrinsic value of outstanding andexercisable stock options was $9,796 and $4,449, respectively. The aggregateintrinsic value is based on our closing price of $10.11 on March 30, 2007,which would have been received by the optionees had all of the options withexercise prices less than $10.11 been exercised on that date.

*Restricted Stockand Performance Vesting Shares Activity*

Thefollowing table reconciles the unvested balance of restricted and performanceshares:

| ** **                                             | ** **       | **Number of  Shares** | ** ** |
|--------------------------------------------------------|------------------|----------------------------|------------|
| **Three-months ended March 31,  2007:** | **  ** | **  **           |       |   |   |   |   |
| Unvested balance,  December 31, 2006              |             |                       | 444,032    |   |   |
| Granted                                                |             |                       | 285,490    |   |   |
| Vested                                                 |             |                       | (40,460    | ) |   |
| Canceled                                               |             |                       | (3,000     | ) |   |
| Unvested balance,  March 31, 2007                 |             |                       | 686,062    |   |   |
|                                                        |                  |                            |            |  |  |  |  |

 

**4.**                 SegmentInformation

*GeographicInformation*

The Company derives its revenue from a singlereporting segment: secure identification and media management solutions.Revenue is generated in this segment through licensing and subscription of itsvarious products and the delivery of contracted and consulting services relatedto these products. The Company markets its products in the United States and innon-U.S. countries through its sales personnel and its subsidiaries. TheCompany’s management evaluates resource allocation decisions and theperformance of the Company based upon revenue by the geographic regions of thesegment and does not receive discrete financial information about assetallocation and expense allocation on a disaggregated basis.

Revenueby geographic areas is as follows:

| ** **    | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------|------------|--------------------------------------------------|------------|
| ** **    | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| United States |       | $                                                | 20,520     |   | $ | 20,105 |   |
| International |       | 6,326                                            |       | 7,088 |   |
| Total         |       | $                                                | 26,846     |   | $ | 27,193 |   |

 

*Major Customers*

One customer accounted forslightly over 10% of the Company’s revenues in both of the three-month periodsended March 31, 2007 and 2006.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

**5.**                 Commitments andContingencies

Beginning in September 2004, three purportedclass action lawsuits were filed in the U.S. District Court for the District ofOregon against the Company and certain of its current and former directors andofficers on behalf of purchasers of the Company’s securities during the periodApril 17, 2002 to July 28, 2004. These lawsuits were laterconsolidated into one action for all purposes. The amended complaint, whichsought unspecified damages, asserted claims under the federal securities lawsrelating to the Company’s restatement of its financial statements for 2003 andthe first two quarters of 2004 and alleged that the Company issued false andmisleading financial statements and issued misleading public statements aboutthe Company’s operations and prospects. On August 4, 2006, the courtgranted our motion to dismiss the lawsuit with prejudice and entered judgmentin our favor. Plaintiffs have filed a notice of appeal in the Ninth CircuitCourt of Appeals. The appeal has been stayed pending the U.S. Supreme Court’sdetermination in another case of issues relating to the Private SecuritiesLitigation Reform Act. Due to the inherent uncertainties of litigation, theCompany cannot accurately predict the ultimate outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes onMarch 14, 2005. This suit claims that certain of these officers anddirectors breached their fiduciary duties to the Company’s shareholders and tothe Company. The complaint is derivative in nature and does not seek relieffrom the Company. The Board of Directors appointed an independent committee toinvestigate the claims asserted in this derivative lawsuit. On July 19,2005, the court granted the Company’s motion to stay these consolidated actionsin favor of a shareholder derivative action to be filed by plaintiffs in theCircuit Court of the State of Oregon for the County of Washington. OnAugust 25, 2005, the California plaintiffs filed two new derivativelawsuits in the United States District Court for the District of Oregon. OnOctober 17, 2005, defendants filed a motion to dismiss these complaintsfor lack of subject matter jurisdiction and failure to state a claim. In May of2006, the Board committee, after completing its investigation, concluded thatpursuit of the allegations would not be in the best interests of Digimarc orits shareholders. On August 24, 2006, the court granted defendants’ motionand dismissed the lawsuit with prejudice. Plaintiffs filed a notice of appealon September 22, 2006. Plaintiffs’ appellate brief is due onApril 27, 2007. We expect to file our appellate brief in late May of2007. Due to the inherent uncertainties of litigation, the Company cannotaccurately predict the ultimate outcome of the matter.

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 the Company’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 asundisclosed commissions or stock stabilization practices) in the Company’sinitial public offering registration statement and by engaging in manipulativepractices to artificially inflate the price of the 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

Company’s stock in theafter-market subsequent to the Company’s initial public offering. The Companyand certain of its officers and directors are named in the amended complaintpursuant to Section 11 of the Securities Act of 1933, andSection 10(b) and Rule 10b-5 of the Securities ExchangeAct of 1934 on the basis of an alleged failure to disclose the underwriters’alleged compensation arrangements and manipulative practices. The complaintseeks unspecified damages. The individual officer and director defendantsentered into tolling agreements and, pursuant to a court order datedOctober 9, 2002, were dismissed from the litigation without prejudice.Furthermore, in July 2002, the Company 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, including theCompany. The claims against the Company 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. The settlement would have provided, among otherthings, a release of the Company and of the individual defendants for thealleged wrongful conduct in the amended complaint in exchange for a guaranteefrom the Company’s insurers regarding recovery from the underwriter defendantsand other consideration from the Company regarding its underwriters, includingagreeing to assign away, not assert, or release certain potential claims theCompany may have against its underwriters. The plaintiffs have continued tolitigate against the underwriter defendants. The district court directed thatthe litigation proceed within a number of “focus cases” rather than in all ofthe 310 cases that have been consolidated. The Company’s case is not one ofthese focus cases. On October 13, 2004, the district court certified thefocus cases as class actions. The underwriter defendants appealed that ruling,and on December 5, 2006, the Court of Appeals for the Second Circuitreversed the district court’s class certification decision. On April 6,2007, the Second Circuit denied plaintiffs’ petition for rehearing. In light ofthe Second Circuit opinion, we have informed the district court that thissettlement cannot be approved because the defined settlement class, like thelitigation class, cannot be certified. We cannot predict whether we will beable to renegotiate a settlement that complies with the Second Circuit’smandate. Due to the inherent uncertainties of litigation, we cannot accuratelypredict the ultimate outcome of the matter.

Our contracts fordriver license and other identification issuance systems and their relatedproducts typically include provisions imposing (i) development, deliveryand installation schedules and milestones, (ii) customer acceptance andtesting requirements and (iii) other performance requirements,  Such provisions are common in large scalegovernment contracts at the state and federal levels. To the extent theseprovisions involve performance over extended periods of time, there may beincreased risk of noncompliance. The Company from time to timeexperiences delays in identification system implementation, timely acceptancefor identification systems programs, concerns regarding identification systemprogram performance, and other contractual disputes. Customers have asserted from time totime, and may in the future assert, claims for compensatory or liquidateddamages or breach of contract, or other claims alleging that the Company hasfailed to meet timing or other delivery requirements and milestones pursuant tothe terms of such contracts. Management believes that these assertionsare often part of the resolution process involving commercial disagreementsover the terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. However,the Company’s failure to meet contractual milestones or other performancerequirements as promised, or to successfully resolve customer 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

disputes, could result in the Company incurring liability for damages,as well as increased costs, lower margins, or compensatory obligations inaddition to other losses, such as harm to the Company’s reputation. Suchcircumstances could have a material adverse effect on the Company’s businessand financial results. The Company anticipates that future contracts will continueto have such provisions unless and until industry practices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on a milestonebasis. We have experienced low margins or losses on such contracts in therecent past. Such contracts involve greater financial risks because we bear therisk if actual project costs exceed the amounts we are paid under thecontracts. A material percentage of our revenues are derived from fixed pricecontracts and our reliance on fixed price contracts may grow.

A significant portionof our business depends on a limited number of large, public-sector contracts,which are generally subject to termination for convenience, as determined bythe subject agency, or for lack of budgetary appropriation provided for thesubject agency. Some government contracts also may be one-time events, such asin the case of some personal identification systems in non-U.S. marketsinvolving voter registration programs. In such cases, we may generatesubstantial revenue that may not be subject to future renewal. Further, we mayface competitive bids for a number of our major accounts in 2007. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards.

Certain of the Company’s product license and servicesagreements include an 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*. To date,there have been no claims made under such indemnification provisions.

The Company is subject from time to time to otherlegal proceedings and claims arising in the ordinary course of business. Although the ultimateoutcome of these matters cannot be determined, management believes that, as ofMarch 31, 2007, the final disposition of these proceedings will not have amaterial adverse effect on the consolidated financial position, results ofoperations, or liquidity of the Company. No accrual has been recorded becausethe amounts are not probable or reasonably estimatable in accordance withSFAS No. 5, *Accounting forContingencies*.

A portion of the Company’srevenue each year is generated from licensing of technology. In the competitiveenvironment in which the Company operates, product generation, development andmarketing processes relating to technology are uncertain and complex, requiringaccurate prediction of demand as well as successful management of variousdevelopment risks inherent in technology development. In light of thesedependencies, it is possible that failure to successfully manage future changesin technology with respect to the Company’s technology could have a long-termimpact on the Company’s growth and results of operations.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Performance Bonds*

Some governmentalauthorities require performance bonds that we are obligated to maintain duringthe life of the contract. Often, the terms of these bonds require that weobtain letters of credit to secure our obligations under the bonds. The lettersof credit may in turn require us to maintain large restricted cash reserves assecurity, reducing our ability to use these funds for our other businesspurposes. Even with the availability of such cash reserve guarantees, we maynot be able to obtain such performance bond underwriting at a favorable rate orat all. Our failure to be able to provide such performance bonds may preclude us from bidding on new government contracts ormaintaining our existing contracts for their full terms. In addition, theseperformance bonds may provide for security interests covering ourreceivables or other assets, which could cause additional financing to be moredifficult or more expensive to obtain. The size, nature and purpose of, and therisks and uncertainties associated with, public sector contracts canpotentially cause our quarterly results to fluctuate and anticipated revenue todecrease significantly.

**6.**                 Recent AccountingPronouncements

In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements,*whichdefines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue. This statement does not require any new fair value measurements, butprovides guidance on how to measure fair value by providing a fair valuehierarchy used to classify the source of the information. SFAS No. 157 iseffective for first fiscal year beginning after November 15, 2007. TheCompany is currently assessing the potential impact that adoption of thisstandard will have on our financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Option for theFinancial Assets and Financial Liabilities,*which permits entitiesto choose to measure certain financial assets and liabilities at fair value.SFAS No. 159 is effective for first fiscal year beginning afterNovember 15, 2007. The Company has not determined whether it will adoptthe fair value option method permitted by SFAS No. 159.

**7.**                 RevenueRecognition

The Company’s revenue is comprised of service revenuefrom its government-issued credentials systems and related maintenance,installation and system integration services as well as product andsubscription revenue which includes hardware and software sales, royalties andrevenues from the licensing of digital watermarking products and relatedauthentication services. The Company’s revenue recognition policy follows SECSAB No. 104 *“Revenue Recognition”,*Statementof Position (“SOP”) No. 97-2, *“Software RevenueRecognition,”*as amended by SOP No. 98-9, *“Modification of SOP No. 97-2, Software Recognition, WithRespect to Certain Transactions,”*SOP 81-1*“Accountingfor the Performance of Construction Type and Certain Production-TypeContracts,”*and Emerging Issues Task Force (“EITF”) IssueNo. 00-21, *Revenue Arrangements with Multiple Deliverables.*

Certain customer arrangements encompass multiple deliverables, such as software, hardware sales, consumables sales,maintenance fees, and software development fees. The Company accounts for thesearrangements in accordance with EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If thedeliverables meet the criteria in EITF Issue No. 00-21, thedeliverables are divided into separate units 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

of accounting and revenueis allocated to the deliverables based on their relative fair values. Thecriteria specified in EITF Issue No. 00-21 are as follows(i) the delivered item has value to the customer on a stand-alone basis,(ii) there is objective and reliable evidence of the fair value of theundelivered item, and (iii) if the arrangement includes a general right ofreturn relative to the delivered item, delivery or performance of theundelivered item is considered probable and substantially in the control of thevendor. For our purposes, fair value is generally defined as the price at whicha customer could purchase each of the elements independently from other vendorsor as the price that the Company has sold the element separately to anothercustomer. Management applies judgment to ensure appropriate application of EITFIssue No. 00-21, including value allocation among multiple deliverables, determination of whether undelivered elements areessential to the functionality of delivered elements and timing of revenuerecognition, among others.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence (“VSOE”) exists only for undelivered elements. Under theresidual method, revenue is recognized as follows: (1) the total fairvalue of undelivered elements, as indicated by vendor specific objectiveevidence, is deferred and subsequently recognized in accordance with therelevant sections of AICPA SOP No. 97-2, and (2) the differencebetween the total arrangement fee and the amount deferred for the undeliveredelements is recognized as revenue related to the delivered elements.

Applicable revenuerecognition criteria is considered separately for each separate unit ofaccounting as follows:

·       Revenuefrom the Company’s government-issued credential systems is generally billed andrecognized on a per card produced basis. The Company recognizes revenue onthese contracts based on the actual monthly production, if available, and inlimited situations on estimated volume information. When actual productioninformation becomes available, typically within one month, the Company billsthe customer accordingly and any differences from the estimates are recognizedin the month the billing occurs. Differences to date have not been significant.

·       Revenuerelated to an enhancement of, or upgrade to, an existing system is deferred andrecognized over the remaining life of the contract unless VSOE can be establishedfor the delivered items, title passes to those items and all obligations arecompleted in which case we recognize revenue at acceptance.

·       Revenuefor sales of consumables and equipment not related to a driver licenseproduction contract is recognized when the products have been shipped,ownership has been transferred, evidence of an arrangement exists, the salesprice is fixed and determinable, and collectibility is reasonably assured. Whensignificant obligations remain after products are delivered, such as for systemintegration or customer acceptance, revenue and related costs are deferreduntil such obligations are fulfilled.

·       Revenuefrom professional services arrangements is generally determined based on timeand material or a cost plus a profit margin measure. Revenue for professionalservices is recognized as the services are performed. Progress towardscompletion is measured using costs incurred compared to the budgeted amountscontained in the contract. Losses on contracts, if any, are 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

provided for in the periodin which the loss becomes determinable. Billing for services rendered generallyoccurs within one month following when the services are provided.

·       Maintenancerevenue is recognized when the maintenance amounts owed to the Company havebeen earned, are determinable, and collection is probable. Maintenancecontracts are, at times, paid in advance and revenue is recognized ratably on astraight-line basis over the term of the service period.

·       Royaltyrevenue is recognized when the royalty amounts owed to the Company have beenearned, are determinable, and collection is probable. Subscriptions are paid inadvance and revenue is recognized ratably over the term of the subscription.These revenues include the licensing of digital watermarking products andservices for use in authenticating documents, detecting fraudulent documentsand deterring unauthorized duplication or alteration of high-value documents,for use in communicating copyright, asset management and business-to-businessimage commerce solutions, and for use in connecting analog media to a digitalenvironment.

·       Softwarerevenue is recognized in accordance with AICPA SOP No. 97-2, asamended by AICPA SOP No. 98-9, *Modificationof SOP 97-2*, *With Respectto Certain Transactions*. Revenue for licenses of the Company’ssoftware products is recognized upon the Company meeting the followingcriteria: persuasive evidence of an arrangement exists; delivery has occurred;the vendor’s fee is fixed or determinable; and collectibility is probable.Software revenue is recognized over the term of the license or upon deliveryand acceptance if the Company grants a perpetual license with no furtherobligations.

·       TheCompany records revenue from certain customers upon cash receipt as a result ofcollectibility not being reasonably assured.

·       Revenueearned which has not been invoiced is classified as unbilled trade receivables,which is included in the balance of trade accounts receivable, net in theconsolidated balance sheets. Billing for services rendered generally occurswithin one month following when the services are provided.

·       Deferred revenue consistsof payments received in advance for professional services, subscriptions andhardware for which revenue has not been earned.

**8.**                 Trade Accounts Receivable

Tradeaccounts receivable are recorded at the invoiced amount and do not bearinterest. Revenue earned which has not been invoiced is classified as unbilledtrade receivables in the consolidated balance sheets.

| ** **                       | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Billed trade  receivables        |       |                     | $          | 7,650                       |       |   |   | $ | 8,990 |   |   |
| Unbilled trade  receivables      |       |                     | 6,626      |                        |       |   | 5,599 |   |   |
| Trade accounts  receivable       |       |                     | 14,276     |                        |       |   | 14,589 |   |   |
| Allowance for  doubtful accounts |       |                     | (187       | )                           |       |   | (186 | ) |   |
| Trade accounts  receivable, net  |       |                     | $          | 14,089                      |       |   |   | $ | 14,403 |   |   |

 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

The allowance for doubtfulaccounts is the Company’s best estimate of the amount of probable credit lossesin the Company’s existing accounts receivable. The Company determines theallowance based on historical write-off experience and current information. TheCompany reviews its allowance for doubtful accounts monthly. Account balancesare charged off against the allowance after all means of collection have beenexhausted and the potential for recovery is considered remote. The Company doesnot have an off-balance sheet credit exposure related to its customers.

*Major Customers*

No single customeraccounted for more than 10% of the Company’s trade and unbilled accountsreceivable, net at March 31, 2007 and at December 31, 2006.

**9.**                 Inventory

Inventoryconsists primarily of the consumable materials used to manufactureidentification cards, such as inks, card stock, laminates, and adhesives(considered raw material), equipment held for sale (considered finished goods)and deferred contract costs (considered either finished goods or in-process).Inventories are valued on a first-in, first-out basis at the lower of cost ormarket value (net realizable value).

| ** **                                  | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Equipment and  deferred contract costs      |       |                     | $          | 1,172                       |       |   |   | $ | 1,046 |   |   |
| Consumable  materials                       |       |                     | 6,052      |                        |       |   | 5,654 |   |   |
| Inventory                                   |       |                     | 7,224      |                        |       |   | 6,700 |   |   |
| Reserve for slow  moving and obsolete items |       |                     | (94        | )                           |       |   | (100 | ) |   |
| Inventory, net                              |       |                     | $          | 7,130                       |       |   |   | $ | 6,600 |   |   |

 

While the Company does notcurrently expect to be able to sell or otherwise use the reserved inventory onhand based upon our forecast and backlog, it is possible that a customer orcustomers will decide in the future to purchase a portion of the reservedinventory.

**10.**          IncomeTaxes

*Provisionfor Income Taxes.*   The provision for income taxesreflects expected tax expense in certain foreign jurisdictions. We haverecorded a full valuation allowance against our domestic net deferred taxassets at March 31, 2007 due to the uncertainty of realization of theCompany’s domestic net operating losses. The Company did record a foreigndeferred tax asset of $124 at March 31, 2007 that it believes is morelikely then not to be realized. We will continue to evaluate the realizabilityof our domestic and other foreign net deferred tax assets and may recordadditional benefits in future earnings if we determine the realization of theseassets is more likely than not.

We adopted the provisions of FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes—an Interpretation of FASB Statement 109* (“FIN 48”), onJanuary 1, 2007. Our consolidated financial statements as of and for thefirst quarter of 2007 reflect the impact of FIN 48, but the consolidated 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

financial statements forthe first quarter of 2006 have not been restated to reflect, and do not include,the impact of FIN 48.

As a result of the implementation of FIN 48, werecognized a $145 reduction in our net liability for uncertain tax positionspreviously recorded, which was accounted for as an adjustment to theJanuary 1, 2007 retained earnings balance. As part of the FIN 48implementation, we adopted a policy to record accrued interest and penaltiesassociated with uncertain tax positions in income tax expense in theaccompanying consolidated statements of operations. On initial adoption of FIN48, we recognized an additional $52 of accrued interest and penaltiesassociated with uncertain tax positions in prior years, which reduced theoverall adjustment to the January 1, 2007 retained earnings.

Asummary reconciliation of our uncertain tax positions is listed below:

| Beginning balance  at January 1, 2007                           |   | $    | 289    |   |
|----------------------------------------------------------------------|--------|------|--------|--------|
| Additions for tax  positions of prior years (interest and penalties) |   | 52   |   |
| Reductions for net  tax positions of prior years                     |   | (196 | )      |
| Revised balance at  January 1, 2007                             |   | $    | 145    |   |

 

**11.**          Software DevelopmentCosts

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, software developmentcosts qualifying for capitalization have been immaterial. Accordingly, theCompany has not capitalized any software development costs and has charged allsuch 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 inthe preliminary project stage are expensed as incurred and costs incurred inthe application 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. Costs incurred in thepost-implementation stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to cardmanufacturing and control systems software.

**12.**          Related PartyTransactions

During the three monthsended March 31, 2007 and 2006, the Company recognized revenue of $138 and$125, respectively, from a holder of common stock pursuant to a licenseagreement. Net accounts receivable from this customer was $172 atMarch 31, 2007 and $329 at December 31, 2006. Deferred revenue fromthis customer was $238 at March 31, 2007 and $288 at December 31,2006.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

**13.**          Quarterly SelectedFinancial Information

Thefollowing table shows the quarterly reported numbers. 

| **Quarter ended:**                   | ** ** | ** ** | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-------------------------------------------|------------|------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| ***2007***                                |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 26,846            |       |             |       |                  |       |                 |       |   |   |   |   |   |
| Total cost of  revenue                    |       |       | 16,815     |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Gross profit                              |       |       | 10,031     |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Sales and  marketing                      |       |       | 4,277      |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Research,  development and engineering    |       |       | 2,042      |              |       |             |       |                  |       |                 |       |   |   |   |   |
| General and  administrative               |       |       | 4,098      |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Amortization of  intangibles              |       |       | 500        |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Intellectual  property                    |       |       | 499        |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Restructuring  charges, net               |       |       | —     |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Operating income  (loss)                  |       |       | (1,385     | )                 |       |             |       |                  |       |                 |       |   |   |   |   |
| Net income (loss)                         |       |       | (1,022     | )                 |       |             |       |                  |       |                 |       |   |   |   |   |
| Net income (loss)  per share—basic   |       |       | (0.05      | )                 |       |             |       |                  |       |                 |       |   |   |   |   |
| Net income (loss)  per share—diluted |       |       | (0.05      | )                 |       |             |       |                  |       |                 |       |   |   |   |   |
| ***2006***                                |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 27,193            |       |             | $          | 24,907                |       |                 | $          | 26,733 |   |   |   | $ | 25,414 |   |   |
| Total cost of  revenue                    |       |       | 19,648     |              |       | 16,677           |       |                  | 16,719     |                 |       |   | 15,725 |   |   |
| Gross profit                              |       |       | 7,545      |              |       | 8,230            |       |                  | 10,014     |                 |       |   | 9,689 |   |   |
| Sales and  marketing                      |       |       | 4,539      |              |       | 4,685            |       |                  | 3,440      |                 |       |   | 3,691 |   |   |
| Research,  development and engineering    |       |       | 3,236      |              |       | 2,994            |       |                  | 2,158      |                 |       |   | 1,881 |   |   |
| General and  administrative               |       |       | 5,210      |              |       | 4,172            |       |                  | 3,684      |                 |       |   | 4,418 |   |   |
| Amortization of  intangibles              |       |       | 573        |              |       | 550              |       |                  | 537        |                 |       |   | 511 |   |   |
| Intellectual  property                    |       |       | 431        |              |       | 481              |       |                  | 460        |                 |       |   | 402 |   |   |
| Restructuring  charges, net               |       |       | —     |              |       | 547              |       |                  | —     |                 |       |   | — |   |   |
| Operating income  (loss)                  |       |       | (6,444     | )                 |       | (5,199           | )          |                  | (265       | )                    |       |   | (1,214 | ) |   |
| Net income (loss)                         |       |       | (6,172     | )                 |       | (4,869           | )          |                  | 213        |                 |       |   | (912 | ) |   |
| Net income (loss)  per share—basic   |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   | (0.04 | ) |   |
| Net income (loss) per  share—diluted |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   | (0.04 | ) |   |
|                                           |            |            |            |                   |            |                  |            |                       |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

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**Item2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

*The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements relating to future events or thefuture financial performance of Digimarc, which involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements. Please see the discussionregarding forward-looking statements included in this quarterly report on Form 10-Qunder the caption “Safe Harbor Statement under the Private SecuritiesLitigation Reform Act of 1995.”*

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readersare also urged to carefully review and consider the various disclosures made byus which attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made in Item 1A (RiskFactors) of this Form 10-Q and in the audited consolidated financialstatements and related notes included in our Annual Report on Form 10-K forthe year ended December 31, 2006 filed on March 8, 2007, and otherreports and filings made with the Securities and Exchange Commission (“SEC”).*

**Overview**

Digimarc (“Digimarc,” “the Company,” “our” or “we”) isa supplier of secure identification documents (“IDs”) and digital watermarkingtechnology for use in media management. Our secure ID solutions enablegovernments and businesses around the world to enhance traffic safety andnational security, combat identity theft and fraud and facilitate theeffectiveness of voter identification programs. We are also a pioneer andleading owner of intellectual property in a signal processing technologyinnovation known as “digital watermarking,” which allows imperceptible digital information to be embedded in allforms of digitally designed, produced or distributed media content, includingpersonal identification documents, financial instruments, photographs, movies,music, television, and product packages. The embedded data within various typesof media content can be detected and read by software or hardware detectors inpersonal computers and other digital devices.

The substantial majorityof our revenue is generated pursuant to long-term contracts (normally five ormore years) with government agencies—primarily state government agenciesresponsible for driver license issuance, a consortium of central banks, andnational governments of foreign countries. These customers rely on our systemsdesign, integration and materials science expertise, and proprietarytechnologies such as digital watermarking, to implement issuance systems andprocesses that improve the security of identity documents and banknotes. Theremainder of our revenue is generated through commercial applications of ourdigital watermarking and related technologies, primarily from patent and technologylicense fees paid by business partners.

*Secure ID Solutions*

We issue more than 60 million IDs annually and are theleading supplier of government-issued citizen IDs in North America, producingmore than two-thirds of all driver licenses issued in the United States (the “U.S.”)   We have also provided secure ID solutions toapproximately 25 foreign governments.

In North America, most of our revenue is generatedthrough the issuance of state driver licenses and other IDs and is paid in theform of a fixed price per credential issued. In North America, we are generallya prime contractor, providing full issuance systems to federal, state, and provincialdepartments of motor vehicles or other government issuing authorities. Thesesystems typically include hardware (including specialized cameras, printers,personal computers and servers), software, consumable supplies (such asribbons, blank or preprinted card materials and laminated and relatedconsumables) and ongoing support services. These systems may also involve softwareand/or hardware development, integration services, and implementation services.When we provide a full issuance system to a customer, we generally retain titleto 

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all equipment, softwareand consumables associated with the system and are responsible for maintainingthe system over the contractual period.

In markets outside of North America, we generallyprovide driver license, national identification, and voter identificationsystems, services, and components in partnership with local card producers,security printers, system integrators, and others. In these markets, we mayserve as prime contractor or sub-contractor, depending on the circumstances. Asa sub-contractor, we generally are responsible for delivering hardware,software, or consumables, and some degree of integration services to the primecontractor; whereas as a prime contractor, we are responsible for integratingall components of the system to the customer’s specifications.

Outside of North America, our revenues are typicallygenerated from sales of equipment and/or consumables to government agencies ortheir prime contractors. These sales may occur at irregular intervals, carryrelatively low margins and cause variations in quarterly revenue and grossprofit trends. We enter into low margin contracts and transactions from time totime to maintain market presence and build relationships with customers andbusiness partners, and often transition to more profitable digital technologiesover time. Due to the nature of such international programs and customers, thetiming of these sales is less predictable than our service revenues provided bydomestic customers and, consequently, international sales can occur unevenlyduring the course of a year.

*Seasonality.**  *We have observed seasonality in our U.S. driverlicense issuance revenues, with larger revenues in the second and third quarterof the year, and generally lower revenues in the first and fourth quarters. Thefourth quarter is usually the seasonally lowest quarter each year. We use thestraight line method of depreciation and amortization for program-relatedassets. The combination of the seasonality of our revenues and straight linedepreciation and amortization can cause significant variations in quarterlygross margin trends, generally increasing margins in the second and thirdquarters when our issuance revenues are higher and decreasing margins in thefirst and fourth quarters when our issuance revenues are typically lower.

*Variabilityof Capitalized and Deferred Costs.**  *Ourdriver license and ID issuance programs generally require that we incursignificant costs in developing, building and deploying new systems that may besold outright upon completion or used in generating recurring revenue in thefuture. Certain labor and other costs relating to these new systems may bedeferred and expensed upon completion, or capitalized and amortized over thelife of the relevant contract, rather than expensed in the quarter in whichthey are incurred. We may experience variability in our operating income,depending on the extent to which we are able to capitalize or defer these costs.If we are able to win new business, our capitalized or deferred costs andoperating income may increase as a result of an increased allocation of laborresources to capitalized or deferred items. On the other hand, if we experiencedelays or reductions in new business, our capitalized or deferred costs maydecrease, which may result in an increase in operating expenses for therelevant quarter and a decrease in operating income.

*Depreciation.**  *Starting January 1, 2006, we changed our policyfor depreciating fixed assets that were specifically used to provide servicesunder long-term contracts to the shorter of the original contract term plus2.75 years or estimated useful life. Through December 31, 2005, wedepreciated these assets over the shorter of the original contract term orestimated useful life. This change in estimate was supported by an analysis wecompleted during the first quarter of 2006 which showed that historically 95%of contracts were extended beyond the original contract term, that the averagecontract had at least two contract extensions during its life and that theseextensions added on average 2.75 years to the length of the contracts’ originalterms.

Since contract-specificprogram assets are tracked on a contract basis, the finding that contracts areroutinely extended beyond the original term and that these extensions are notgenerally accompanied by significant incremental capital investment indicatesthat the useful life of contract-related assets is 

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generallylonger than the original term of the contract. Given these findings, weconcluded that it was appropriate to change the estimated useful lives of theseassets for purposes of depreciation. In addition, the change in useful livesachieves a better matching of the utility of these assets with the resultingrevenues. For the year ended December 31, 2006, we performed an updatedanalysis on contract specific assets which resulted in no change to ourprevious conclusions. We will continue to analyze the useful lives of contractspecific assets in future periods. The financial impact of this change isdiscussed below under the “Cost of Revenue” heading.

*Backlog*

Based on projected government-issued credentialproduction volumes and other commitments we have for the periods under contractwith our respective customers, we anticipate our current contracts as of March 31,2007 will generate approximately $230 million in revenue during the contractualterms of such contracts, currently up to seven years. We expect more than $65million of this amount to be recognized as revenue during the remainder of2007. This amount includes production volumes reasonably expected to beachieved under currently effective contracts and government orders that arefirm but not yet funded.

Some factors thatlead to increased backlog are:

·        Competitivebid wins,

·        Renewalswith current customers,

·        Add-onsales to current customers, and

·        Contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Some factors thatlead to decreased backlog are:

·        Recognitionof revenue associated with backlog currently in place,

·        Lowbid activity,

·        Contractswith shorter contractual periods replacing contracts with longer contractualperiods, and

·        Therevenue model utilized for a particular customer (e.g., a “price-per-card”model with a large associated backlog vs. a “hardware and consumables” modelwith a small associated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period.

Over the next few years, we anticipate several Statesto request bids on their driver license issuance system programs. This periodof expected high bid activity could lead to additional backlog if we aresuccessful with our bids. Another factor that could affect backlog in thisperiod is the revenue model utilized for a particular customer. From time totime we have sales to our customers that are not made on a price-per-card basis,but instead include hardware and consumable sales. Although these types ofrevenue models are positive growth indicators for our business, they can leadto lower reported backlog.

There is no assurance thatour backlog will result in actual revenue in any particular period, because theorders, awards and contracts included in our backlog may be subject tomodification, cancellation or suspension. We may not realize revenue on certaincontracts, orders or awards included in our backlog or the timing of suchrealization may change.

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*Restructuring*

During the last half of2005 and continuing during 2006, the Company restructured its operations toimprove productivity and reduce fixed costs. During the second quarter of 2006we accelerated those activities significantly, resulting in a reduction of ourworkforce by nearly 20%. Overall, our workforce was reduced by over 30% sincemid 2005. Our actions included the redeployment and reallocation of resourcesto better align with our operating strategies.

**AdditionalInformation**

A more detailed discussionof our business is contained in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2006.

**Critical AccountingPolicies and Estimates**

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the UnitedStates of America requires us to make estimates and judgments that affect thereported 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, contingencies and litigation, and inputs related tostock-based compensation calculations. We base our estimates on historicalexperience and on various other assumptions we believe to be reasonable underthe circumstances. Actual results may differ from these estimates underdifferent 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, reserves foruncollectible accounts receivable, contingencies and litigation, and inputs relatedto stock-based compensation calculations. We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our consolidated financial statements:

**Revenuerecognition on long-term service contracts:****  **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and any differencesfrom the estimates are recognized in the month the billing occurs. Theseamounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting results, our practice isto compare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Any estimated amounts are included inunbilled receivables on the balance sheet until the actual productioninformation is available and the billing occurs. Any estimation processinvolves inherent risk. We reduce the inherent risk relating to productionestimation through our approval and monitoring processes related to accountingestimates. We also evaluate contracts for multiple elements and account forthese items under the appropriate accounting literature.

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. Losses on contracts, if any, are provided for in the period in whichthe loss becomes determinable. Billing for services rendered generally occurswithin one month following 

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when the services areprovided. Revenue earned which has not been invoiced is classified as unbilledtrade receivables in the consolidated balance sheets.

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically assess long-lived assetsfor impairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable, in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets.* This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values,depending on the nature of the asset. Also, we periodically review the usefullives of long-lived assets whenever events or changes in circumstances indicatethat the useful life may have changed. If the estimated useful lives of suchassets do change, we adjust the depreciation or amortization period to a shorteror longer period, based on the circumstances identified.

**Inventoryvaluation:****  **Inventoryconsists primarily of consumable supplies that are used in the production ofdriver licenses and products held for resale to customers. We value inventoryat the lower of cost or market value (which lower amount is the net realizablevalue). We reduce the value of our inventory for estimated obsolescence orunmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand andmarket conditions. If actual market conditions are less favorable than thoseprojected by management, additional inventory write-downs may berequired.

**Reservesfor uncollectible accounts receivable:****  **We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust whenappropriate, our allowance for doubtful accounts on at least a quarterly basis.If the financial condition of our customers were to deteriorate, resulting inan impairment of their ability to make payments, additional allowances may berequired.

**Contingencies and Litigation:**   We periodically evaluate all pending orthreatened contingencies or commitments, if any, that are reasonably likely tohave a material adverse effect on our operations or financial position. Weassess the probability of an adverse outcome and determine if it is remote,reasonably possible or probable as defined in accordance with the provisions ofSFAS No. 5, *Accounting for Contingencies*. Ifinformation available prior to the issuance of our financial statementsindicates that it is probable that an asset has been impaired or a liabilityhas been incurred at the date of our financial statements, and the amount ofthe loss, or the range of probable loss can be reasonably estimated, then suchloss is accrued and charged to operations. If no accrual is made for a losscontingency because one or both of the conditions pursuant to SFAS No. 5are not met, but the probability of an adverse outcome is at least reasonablypossible, we will disclose the nature of the contingency and provide anestimate of the possible loss or range of loss, or state that such an estimatecannot be made.

**Stock-Based Compensation:**   We account for stock-based compensationin accordance with SFAS 123(R), *Share-Based Payment(Revised 2004)*, which requires the measurement and recognition ofcompensation for all stock-based awards made to employees and directorsincluding stock options and employee stock purchases under a stock purchaseplan based on estimated fair values. Under SFAS 123(R), we use theBlack-Scholes option pricing model as our method of valuation for stock 

27

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options and employee stock purchases. Our determination of the fairvalue of these stock-based awards on the date of grant using an option pricingmodel is affected by our stock price as well as assumptions regarding a numberof highly complex and subjective variables. These variables include, but arenot limited to, the expected life of the award, our expected stock price,volatility over the term of the award and actual and projected exercisebehaviors. Although the fair value of these stock-based awards is determined inaccordance with SFAS 123(R), the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results. The fair value of restricted stockawards granted is based on the fair market value of the Company’s common stockon the date of the grant (measurement date), and is being recognized over thevesting period of the related restricted stock using the straight-line method. The fairvalue of performance vesting share awards granted is based on a Monte Carlovaluation model that resulted in a factor applied to the fair market value ofthe Company’s common stock on the date of the grant (measurement date), and isbeing recognized over the derived service period using the straight-linemethod.

**Results ofOperations**

Thefollowing table presents our consolidated statements of operations data for theperiods indicated as a percentage of total revenue.  Unless otherwise indicated, all references tothe three-month period relate to the three-month period ended March 31,2007 and all changes discussed with respect to such period reflect changes ascompared to the three-month period ended March 31, 2006.

| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                       | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Revenue:                                         |       |                                             |       |   |   |   |   |   |   |
| Service                                          |       |                                             | 79         | % |   |   | 82 | % |   |
| Product and subscription                         |       |                                             | 21         |   |   |   | 18 |   |   |
| Total revenue                                    |       |                                             | 100        |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                             |       |   |   |   |   |   |   |
| Service                                          |       |                                             | 55         |   |   |   | 63 |   |   |
| Product and subscription                         |       |                                             | 8          |   |   |   | 9 |   |   |
| Total cost of revenue                            |       |                                             | 63         |   |   |   | 72 |   |   |
| Gross profit                                     |       |                                             | 37         |   |   |   | 28 |   |   |
| Operating expenses:                              |       |                                             |       |   |   |   |   |   |   |
| Sales and marketing                              |       |                                             | 16         |   |   |   | 17 |   |   |
| Research, development and engineering            |       |                                             | 7          |   |   |   | 12 |   |   |
| General and administrative                       |       |                                             | 15         |   |   |   | 19 |   |   |
| Amortization of intangibles                      |       |                                             | 2          |   |   |   | 2 |   |   |
| Intellectual property                            |       |                                             | 2          |   |   |   | 2 |   |   |
| Total operating expenses                         |       |                                             | 42         |   |   |   | 52 |   |   |
| Operating income (loss)                          |       |                                             | (5         | ) |   |   | (24 | ) |   |
| Other income (expense):                          |       |                                             |       |   |   |   |   |   |   |
| Interest income                                  |       |                                             | 1          |   |   |   | 1 |   |   |
| Interest expense                                 |       |                                             | 0          |   |   |   | 0 |   |   |
| Other                                            |       |                                             | 0          |   |   |   | 0 |   |   |
| Total other income, net                          |       |                                             | 1          |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                                             | (4         | ) |   |   | (23 | ) |   |
| Provision for  income taxes                      |       |                                             | 0          |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                                             | (4         | )% |   |   | (23 | )% |   |

 

28

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*Revenue*

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                        | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Revenue:                          |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Service                           |       |                             | $          | 21,299                   |       |           |       | $ | 22,290 |   |   |   | $ | (991 | ) |   |   | (4 | )% |   |
| Product and subscription          |       |                             | 5,547      |                     |       |           | 4,903      |   |   |   | 644 |   |   |   | 13 | % |   |
| Total                             |       |                             | $          | 26,846                   |       |           |       | $ | 27,193 |   |   |   | $ | (347 | ) |   |   | (1 | )% |   |
| Revenue (as % of  total revenue): |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Service                           |       |                             | 79         | %                        |       |           | 82         | % |   |   |   |   |   |   |   |   |   |
| Product and subscription          |       |                             | 21         | %                        |       |           | 18         | % |   |   |   |   |   |   |   |   |   |
| Total                             |       |                             | 100        | %                        |       |           | 100        | % |   |   |   |   |   |   |   |   |   |

 

*Service.*   Service revenue consists primarilyof:

·        cardproduction on a price-per-card basis,

·        softwaredevelopment services, and

·        hardwareand software maintenance.

The majority of service revenue arrangements aretypically structured as price-per-card product agreements, time and materialsconsulting agreements, or fixed price consulting agreements.

Service revenue decreased for the three-monthperiod  primarily as a result of lowerproduction volumes from Haiti’s voter identification project that was anon-recurring sale and the impact of certain States that changed their driverlicense renewal periods, and a short-term revenue increase from Latvia in 2006,offset by increased program work from the consortium of central banks.

*Productand subscription.  *Product revenue consistsprimarily of the sale of equipment and consumables related to identificationcard production systems and software licenses that are variable in nature andoccur from time to time. Subscription revenue consists primarily of royaltyrevenue from our intellectual property licenses and the sale of our web-basedsubscriptions related to various software products, both of which are morerecurring in nature.

Product and subscriptionrevenue increased for the three-month period primarily as a result of additionalpayments from a cash basis customer and increased product sales to ourinternational customers, offset by a net decrease in non-recurring sales to twointernational customers.

*Revenue by Geography*

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                        | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Revenue by geography:             |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Domestic                          |       | $                                | 20,520     |                     |       | $              | 20,105     |   |   |   | $ | 415 |   |   |   | 2 | % |   |
| International                     |       | 6,326                            |       |                     | 7,088      |           |       |   | (762 | ) |   |   | (11 | )% |   |
| Total                             |       | $                                | 26,846     |                     |       | $              | 27,193     |   |   |   | $ | (347 | ) |   |   | (1 | )% |   |
| Revenue (as % of total  revenue): |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Domestic                          |       | 76                               | %          |                     | 74         | %              |       |   |   |   |   |   |   |   |   |
| International                     |       | 24                               | %          |                     | 26         | %              |       |   |   |   |   |   |   |   |   |
| Total                             |       | 100                              | %          |                     | 100        | %              |       |   |   |   |   |   |   |   |   |

 

29

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Domestic revenue increased for the three-month periodprimarily as a result of increased payments from a cash basis customer andincreased program work from the consortium of central banks, offset by lowerproduction revenues from various states, including California and Iowa.

International revenuedecreased for the three-month period primarily as a result of lower productionvolumes from Haiti’s voter identification project that was a non-recurring saleand a short-term revenue increase from Latvia in 2006, offset by additionalproduct sales to Ghana.

*Cost of Revenue*

| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                             | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Cost of revenue:                             |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Service                                                |       | $                                | 14,715     |                     |       | $              | 17,099     |   |   |   | $ | (2,384 | ) |   |   | (14 | )% |   |
| Product and subscription                               |       | 2,100                            |       |                     | 2,549      |           |       |   | (449 | ) |   |   | (18 | )% |   |
| Total                                                  |       | $                                | 16,815     |                     |       | $              | 19,648     |   |   |   | $ | (2,833 | ) |   |   | (14 | )% |   |
| Cost of revenue  (as % of related revenue components): |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Service                                                |       | 69                               | %          |                     | 77         | %              |       |   |   |   |   |   |   |   |   |
| Product and  subscription                              |       | 38                               | %          |                     | 52         | %              |       |   |   |   |   |   |   |   |   |

* *

*Service.*   Cost of service revenue primarilyincludes:

·        costsof consumables used in delivering a service,

·        compensationfor software developers, quality assurance personnel, product managers, fieldoperations personnel, business development personnel and outside contractors,

·        depreciationcharges for machinery, equipment and capitalized software,

·        deploymentcosts used specifically for service delivery,

·        provisionsfor obsolete and excess inventories,

·        travelcosts directly attributable to service and development contracts,

·        stock-basedcompensation expense, and

·        chargesfor infrastructure and centralized costs.

Cost of servicerevenue decreased for the three-month period primarily as a result of:

·        decreasedemployee compensation-related expenses of $0.6 million as part of therestructuring initiative,

·        decreasedcontract and temporary labor of $0.5 million as part of the cost cuttinginitiative under which a number of contractors were converted to employees atlower average costs,

·        decreasedcosts of approximately $1.0 million related to resource allocations; in 2006resources were allocated to projects that were of an operating expense natureand in 2007 resources were allocated to capital projects, offset by

·        increaseddepreciation expense of $0.2 million related to programs completed in the laterhalf of 2006 or implemented during the quarter, and

30

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·        increasedallocated infrastructure and centralized costs of $0.2 million primarily due tothe redeployment of resources to program activities as part of ourrestructuring initiative during the prior year.

*Productand subscription.*   Cost of product and subscription revenue primarilyincludes costs of equipment and consumables related to our ID productionsystems, as well as Internet service provider connectivity charges and imagesearch data fees to support the services offered to our subscription customers.

Cost of product and subscription revenue decreased forthe three-month period primarily as a result of lower direct material costs of$0.5 million relating to consumable sales to our international customers.

The costs included in ourcost of revenue fall under three categories as described below:

*Cost of Revenue Components*

| ** **                               | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                               | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                               | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                               | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Cost of revenue:                         |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                 |       | $                                | 7,611      |                     |       | $              | 8,317      |   |   |   | $ | (706 | ) |   |   | (8 | )% |   |
| Fixed field support and manufacturing    |       | 6,439                            |       |                     | 8,743      |           |       |   | (2,304 | ) |   |   | (26 | )% |   |
| Program depreciation                     |       | 2,765                            |       |                     | 2,588      |           |       |   | 177 |   |   |   | 7 | % |   |
| Total                                    |       | $                                | 16,815     |                     |       | $              | 19,648     |   |   |   | $ | (2,833 | ) |   |   | (14 | )% |   |
| Cost of revenue (as % of total revenue): |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                 |       | 29                               | %          |                     | 31         | %              |       |   |   |   |   |   |   |   |   |
| Fixed field support and manufacturing    |       | 24                               | %          |                     | 32         | %              |       |   |   |   |   |   |   |   |   |
| Program depreciation                     |       | 10                               | %          |                     | 9          | %              |       |   |   |   |   |   |   |   |   |
| Total                                    |       | 63                               | %          |                     | 72         | %              |       |   |   |   |   |   |   |   |   |

 

Variable costsinclude:

·        theprice of materials and labor to produce an identification card,

·        directcosts of hardware and software delivered, and

·        othercosts that are variable in nature.

The decrease in variable costs for the three-monthperiod was primarily due to decreased, sales of consumables to ourinternational customers combined with improved margins on sales to certaincustomers.

Fixed field supportand manufacturing costs include:

·        fieldoperations and support costs,

·        manufacturingcosts, and

·        supplychain costs.

The decrease in fixed costs for the three-month periodwas primarily due to our focus on improving certain programs during the quarterended March 31, 2006. As a result of these actions, fewer expenditureswere capitalized to the balance sheet and fixed support costs increased for thethree months ended March 31, 2006. After improving the efficiencies inthese programs, our fixed costs returned to more normal levels.

31

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Program depreciation primarily consists ofamortization and depreciation of costs incurred during the delivery process,where such costs are capitalized and then amortized or depreciated over theuseful lives of the assets to which the costs relate.

The slight increase inprogram depreciation was primarily due to delivery of new programs in the laterhalf of 2006 or implemented during the quarter ended March 31, 2007.

*Gross Profit*

| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                         | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                         | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                         | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Gross profit                                       |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Service                                            |       | $                                | 6,584      |                     |       | $              | 5,191      |   |   |   | $ | 1,393 |   |   |   | 27 | % |   |
| Product and subscription                           |       | 3,447                            |       |                     | 2,354      |           |       |   | 1,093 |   |   |   | 46 | % |   |
| Total                                              |       | $                                | 10,031     |                     |       | $              | 7,545      |   |   |   | $ | 2,486 |   |   |   | 33 | % |   |
| Gross profit (as % of related revenue components): |       |                             |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Service                                            |       | 31                               | %          |                     | 23         | %              |       |   |   |   |   |   |   |   |   |
| Product and subscription                           |       | 62                               | %          |                     | 48         | %              |       |   |   |   |   |   |   |   |   |
| Total                                              |       | 37                               | %          |                     | 28         | %              |       |   |   |   |   |   |   |   |   |

 

The changes in grossprofit as a percentage of revenue, for both the revenue components and overallgross profit, for the three-month period ended March 31, 2007 as comparedto the three-month period ended March 31, 2006 was primarily due to thereasons described above under “Cost of Revenue.”

*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                   | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                   | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                   | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Sales and  marketing                         |       | $                                | 4,277      |                     |       | $              | 4,539      |   |   |   | $ | (262 | ) |   |   | (6 | )% |   |
| Sales and marketing (as %  of total revenue) |       | 16                               | %          |                     | 17         | %              |       |   |   |   |   |   |   |   |   |
|                                              |            |                                  |            |                          |            |                |            |  |  |  |  |  |  |  |  |  |  |  |

 

Sales and marketingexpenses consist primarily of:

·        compensation,benefits and related costs of sales and marketing employees, product managersand sales engineers,

·        recruitingexpenses,

·        traveland market research costs, and costs associated with marketing programs, suchas trade shows, public relations and new product launches,

·        stock-basedcompensation expense, and

·        chargesfor infrastructure and centralized costs.

32

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The slight decreasein sales and marketing expense for the three-month period resulted primarilyfrom:

·        decreasedemployee compensation-related expenses of $0.4 million as part of therestructuring initiative that was accelerated in the second quarter of 2006,offset by

·        increasedprofessional fees and marketing costs of $0.3 million in connection withbusiness initiatives relating to the REAL ID Act.

We anticipate that we willcontinue to invest in sales and marketing expenses at current levels.

*Research, development and engineering*

| ** **                                                               | ** ** | **Three Months Ended**             | ** ** | **Dollar**                                   | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| ** **                                                               | ** ** | **March 31,**                           | ** ** | **Increase**                                 | ** ** | **Increase**   | ** ** |
| ** **                                                               | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                                               | ** ** | ** **                                   | ** ** | **(in 000’S)**                     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Research,  development and engineering                                   |       |                                         | $          | 2,042                                        |       |           |       | $ | 3,236 |   |   |   | $ | (1,194 | ) |   |   | (37 | )% |   |
| Research, development  and engineering (as % of total revenue) |       |                                         | 7          | %                                            |       |           | 12         | % |   |   |   |   |   |   |   |   |   |

 

Research,development and engineering expenses consist primarily of :

·        compensation,benefits and related costs of software developers and quality assurancepersonnel

·        paymentsto outside contractors, 

·        thepurchase of materials and services for product development, primarily in thecard systems area,

·        stock-basedcompensation expense, and 

·        chargesfor infrastructure and centralized costs.

The decrease forthe three-month period resulted primarily from:

·        decreasedemployee compensation-related expenses of $0.4 million resulting from therestructuring initiative, and

·        decreasedallocated infrastructure and centralized costs of $0.2 million primarily due tothe redeployment of resources as part of our restructuring initiative duringthe prior year,

We anticipate that we willcontinue to invest in research, development and engineering expenses at currentlevels in the near term to support certain ongoing product initiatives, whileworking to moderate spending in the longer term.

*General and administrative*

| ** **                                          | ** ** | **Three Months Ended**             | ** ** | **Dollar**                                   | ** ** | **Percent**    | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| ** **                                          | ** ** | **March 31,**                           | ** ** | **Increase**                                 | ** ** | **Increase**   | ** ** |
| ** **                                          | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | ** **                                   | ** ** | **(in 000’S)**                     | ** ** | ** **     | ** ** | ** ** | ** ** |
| General and  administrative                         |       |                                         | $          | 4,098                                        |       |           |       | $ | 5,210 |   |   |   | $ | (1,112 | ) |   |   | (21 | )% |   |
| General and  administrative (as % of total revenue) |       |                                         | 15         | %                                            |       |           | 19         | % |   |   |   |   |   |   |   |   |   |

 

33

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General andadministrative expenses consist primarily of:

·        compensation,benefits and related costs of executive, finance and administrative personnel, 

·        legal,human resources and other professional fees, 

·        stock-basedcompensation expense, and 

·        chargesfor infrastructure and centralized costs.

The decrease forthe three-month period resulted primarily from:

·        decreasedaudit, consulting and legal fees of $0.8 million.

We anticipate that we willcontinue to invest in our general and administrative expenses at current levelsin the near term while continuing to examine means to gain efficiencies toreduce general and administrative spending as a percentage of revenue in thelonger term.

*Amortization of intangible assets*

| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                            | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                            | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Amortization of  intangibles                          |       |                             | $          | 500                      |       |           |       | $ | 573 |   |   |   | $ | (73 | ) |   |   | (13 | )% |   |
| Amortization of  intangibles (as % of total  revenue) |       |                             | 2          | %                        |       |           | 2          | % |   |   |   |   |   |   |   |   |   |

 

We account for intangible assets resulting fromacquisitions in accordance with FASB Statement Nos. 141, *Business Combinations*and 142, *Goodwill and Other Intangible Assets*.These statements require the recording of intangible assets under purchase accountingrules, and require the amortization of such intangible assets over theirexpected useful life. As a result, in December 2001, we recorded $29.5million of intangible assets related to the acquisition of certain assets andcertain liabilities from Polaroid and affiliates. These intangible assets wereset up to amortize over a 12-year period, representing the expecteduseful life. Changes in contract status and customer relationships may lengthenor shorten the expected useful life of such intangible assets, or cause animpairment charge related to the intangible asset, so some variability isexpected to exist related to intangibles depending on internal and externalfactors.

The slight decrease in amortizationof intangible assets for the three-month period resulted primarily fromextended amortization periods from contract extensions with several domesticcustomers.

*Intellectual property*

| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                     | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                     | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                     | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Intellectual  Property                         |       |                             | $          | 499                      |       |           |       | $ | 431 |   |   |   | $ | 68 |   |   |   | 16 | % |   |
| Intellectual Property  (as % of total revenue) |       |                             | 2          | %                        |       |           | 2          | % |   |   |   |   |   |   |   |   |   |

 

Intellectualproperty costs primarily consist of:

·        employee-relatedexpenses, such as salaries, benefits, recruiting costs, and incentive plans, 

·        costsassociated with documenting, applying for, maintaining patents 

·        stock-basedcompensation expense, and 

·        chargesfor infrastructure and centralized costs.

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The slight increase in intellectual property expensesfor the three-month period resulted primarily from expenses related toconsulting fees paid to third-party agents and government fees related topatent and other intellectual property work, industry specific software andcharges for infrastructure and centralized costs.

*Stock-basedcompensation.  **Stock-based compensation includes expense charges forall stock-based awards to employees and directors. Such awards include optiongrants, restricted stock awards, and shares expected to be purchased under anemployee stock purchase plan. We account for stock-based compensation inaccordance with SFAS No. 123(R),*Share-Based Payment (Revised2004),*whichrequires the measurement and recognition of compensation for all stock-basedawards made to employees and directors including stock options and employeestock purchases under a stock purchase plan based on estimated fair values.SFAS 123(R) supersedes previous accounting under Accounting PrinciplesBoard Opinion No. 25,*Accounting for Stock Issued to Employees,*for periods beginning in fiscal 2006.In March 2005, the SEC issued Staff Accounting Bulletin No. 107relating to application of SFAS 123(R). The Company has applied the provisionsof Staff Accounting Bulleting (“SAB”) 107 in our adoption of SFAS 123(R).*

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the three-month periods ended March 31, 2007 and 2006 is basedon the value of the portion of the stock-based award that will vest during theperiod, adjusted for expected forfeitures. Stock-based compensation recognizedin the Company’s consolidated financial statements in the three-month periodsended March 31, 2007 and 2006 includes compensation cost for stock-basedawards granted prior to, but not fully vested as of, December 31, 2005 andstock-based awards granted subsequent to December 31, 2005. Thecompensation cost for awards granted prior to January 1, 2006 is based onthe grant date fair value estimated in accordance with the pro forma provisionsof SFAS 123 while awards granted on or after January 1, 2006 follow theprovisions of SFAS 123(R) to determine the grant date fair value andcompensation cost. Compensation cost for all stock-based awards is recognizedusing the straight-line method.

Upon adoption of SFAS 123(R), the Companycontinued to use the Black-Scholes option pricing model as its method ofvaluation for stock-based awards. The Company’s determination of the fairvalue of stock-based awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofhighly complex and subjective variables. These variables include, but are not limitedto the expected life of the award, our expected stock price volatility over theterm of the award and actual and projected exercise behaviors. Although thefair value of stock-based awards is determined in accordance with SFAS 123(R) andSAB 107, the Black-Scholes option pricing model requires the input of highlysubjective assumptions, and other reasonable assumptions could providediffering results.

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Theexpense was recorded in the respective statement of operations expensecategories for the employees to which it applies, as set forth in the tablebelow: 

| ** **                             | ** ** | **Three Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |           |
|----------------------------------------|------------|----------------------------------|------------|--------------------------|------------|----------------|------------|----------------|
| ** **                             | ** ** | **March 31,**               | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |           |
| ** **                             | ** ** | **2007**                         | ** ** | **2006**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |   |
| ** **                             | ** ** | ** **                       | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** **     | ** ** |   |
| Cost of revenue                        |       | $                                | 106        |                     |       | $              | 54         |           |   |   | $ | 52 |   |   |   | 96 | % |   |
| Sales and marketing                    |       | 207                              |       |                     | 122        |           |       |           | 85 |   |   |   | 70 | % |   |
| Research,  development and engineering |       | 72                               |       |                     | 114        |           |       |           | (42 | ) |   |   | (37 | )% |   |
| General and  administrative            |       | 608                              |       |                     | 496        |           |       |           | 112 |   |   |   | 23 | % |   |
| Intellectual  property                 |       | 12                               |       |                     | 8          |           |       |           | 4 |   |   |   | 50 | % |   |
| Total                                  |       | $                                | 1,005      |                     |       | $              | 794        |           |   |   | $ | 211 |   |   |   | 27 | % |   |
|                                        |            |                                  |            |                          |            |                |            |                |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in stock-based compensation expense wasprimarily due to the increase in the Company’s stock price and the effect ofthe timing of grants of stock-based awards.

We anticipate an additional $9.9 million instock-based compensation expense through fiscal 2011 for awards outstanding asof March 31, 2007. The future effect of the adoption of this statement onour financial position and results of operations will be determined bystock-based awards granted in future periods and the assumptions on which the valueof those stock-based awards is based. Our tax accounting may also be affectedby actual exercise behavior and the relative market prices at exercise.

*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.38 million for the three-month period ended March 31,2007, compared to $0.36 million for the three-month period ended March 31,2006. The slight increase resulted primarily from higher interest earnedon cash and investment balances, which was partially offset by higher interestexpense related to capitalized leases. 

*Provision for IncomeTaxes.*   The provision for income taxes reflectsexpected tax expense from profitability in certain foreign jurisdictions. Wehave recorded a full valuation allowance against domestic net deferred taxassets at March 31, 2007 due to the uncertainty of realization of theCompany’s net domestic operating losses. The Company did record a $124 foreigndeferred tax asset that it believes is more likely then not to be recognized inthe future. We will continue to evaluate the realizability of our domestic andforeign net deferred tax assets in future periods and may recognize income taxbenefits in future earnings if we determine the realization of these assets ismore likely than not.

**Liquidity andCapital Resources**

As of March 31, 2007, we had cash and cashequivalents, restricted cash, and short-term investments of $31.5 million,representing a decrease of approximately $1.6 million from $33.1 million at December 31, 2006.The decrease primarily resulted from the increase in capital investments in newprogram implementations, including the purchase of fixed assets. As of March 31,2007, $9.6 million of cash and cash equivalents is restricted as a result ofthe requirements of performance bonds that we are obligated to maintain inconnection with some of our long-term contracts in our personal identificationsystems business. Working capital at March 31, 2007 was $29.5 million,compared to working capital of $29.9 million at December 31, 2006. 

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The$5.4 million of cash provided by operations for the three-month period ended March 31,2007 compares favorably to the $0.4 million of cash provided by operations forthe three-months ended March 31, 2006. The components of operating cashflows were:

| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in 000’S)**                         | ** ** |
| Net loss                                             |       | $                                                | (1,022     | ) | $ | (6,172 | ) |
| Non-cash items                                       |       | 4,898                                            |       | 4,548 |   |
| Changes in  operating assets and liabilities         |       | 1,533                                            |       | 2,056 |   |
| Net cash provided  by (used in) operating activities |       | $                                                | 5,409      |   | $ | 432 |   |

 

The major changesin the non-cash charges related to:

·        increasesin depreciation and amortization from $3.8 million to $3.9 millionprimarily related to delivery of new programs in the later half of 2006 orimplemented during the quarter ended March 31, 2007, offset by the changein estimated useful lives of our program assets, and

·        increasedstock-based compensation expense from $0.8 million to $1.0 million primarilyrelated to the increase in the Company’s stock price and the effect of thetiming of grants of stock-based awards.

The major changesin the operating assets and liabilities for the three-month period ended March 31, 2007primarily related to:

·        increasein deferred revenue of $2.5 million resulting from an increased backlog offuture revenues, offset by

·        decreasein accrued payroll and related costs of $2.2 million reflecting payment ofaccrued benefits related to the prior year.

The major changesin operating assets and liabilities for the three-month period ended March 31, 2006primarily related to:

·        decreasesof $2.6 million in trade and unbilled accounts receivable, net and $1.6 millionin inventory, net reflecting improved asst management, offset by

·        decreasein accounts payable of $1.4 million reflecting lower level of operatingexpenses.

The $6.9 million of cash used in investing activitiesfor the three-month period ended March 31, 2007 primarily related to thepurchase of property and equipment on new contracts signed over the prior year,including capitalization of labor costs of $1.6 million.

The $ 1.0 million of cash provided by investingactivities for the three-month period ended March 31, 2006 primarilyrelated to $0.3 million in net purchase of short-term investments and $0.8million for the purchase of property and equipment, including capitalization oflabor costs of $0.3 million.

The $0.3 million of cash provided by financingactivities for the three-month periods ended March 31, 2007 resultedprimarily from the net issuance of stock of $0.4 million, offset by principalpayments on capital leases of $0.1 million.

The $0.1 million of cash used in financing activitiesfor the three-month period ended March 31, 2006 resulted primarily fromthe principal payments on capital leases of $0.1 million, partially offset bythe proceeds from the issuance of stock.

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Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $7.5 million as of March 31,2007, and are payable in monthly installments through November 2010. Ourobligations under non-cancelable capital leases, which totaled $0.9 million asof March 31, 2007, are payable in monthly installments through June 2011.

Many of our secure identity management contracts havesignificant capital requirements. The general industry model for supplyingdriver license issuance systems to state driver license issuers is for thesystem supplier to develop and install the issuance system using the supplier’scapital and to charge the customer on a per-card issued basis. As a result,during times of substantial competitive wins and/or substantial systemupgrades, the Company may experience significant working capital needs that mayexceed cash flow from operations. To date, the Company has relied upon cashreserves to fund such expenditures.

We have driver license contracts with various statesthat are not yet fully deployed and we have pending add-on and upgrade orders.In order to complete these contracts and pending orders, we estimate we willincur approximately $9 million of expenditures. The estimates are derivedfrom information known to us as of quarter end, the time the estimates wereprepared. Actual expenditures may vary from our estimates. We anticipate thatthese expenditures will be recouped through receipts from the related long-termprice-per-card agreements and from the value of the add-on andupgrade orders we have received.

Our planned operating expenses and capital expendituresmay constitute a material use of our cash resources. In addition, we expectthat we will continue to utilize cash in the upcoming few quarters as wecomplete program implementations. We may utilize cash resources to fundacquisitions or investments in complementary businesses, technologies orproduct 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.Thereafter, we anticipate continuing to use cash, cash equivalents, andshort-term investment balances to satisfy our projected working capital andcapital expenditure requirements. However, in the event that we were to wincontracts requiring significant capital investment, we may need to seekadditional financing.

In order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, orcredit facilities, although at this time we believe that our long-term workingcapital is sufficient to cover our foreseeable capital expenditures. If it werenecessary to obtain additional financings or credit facilities, we may not beable to do so, or if these funds are available, they may not be available on satisfactoryterms.

On April 13, 2007, wefiled a shelf registration with the SEC. The shelf registration is intended toprovide us flexibility to raise funds from time to time over a period of up to3 years, subject to market conditions and our capital needs.

**Off-Balance SheetArrangements**

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 our business.

**Recent AccountingPronouncements**

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,*which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair value. Thisstatement does not require any new fair value measurements, but providesguidance on how to measure fair value by providing a fair value hierarchy usedto classify the source of the information. SFAS No. 157 is effective forfirst fiscal year beginning after 

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November 15, 2007.The Company is currently assessing the potential impact that adoption of thisstandard will have on our financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Option for theFinancial Assets and Financial Liabilities,*which permits entitiesto choose to measure certain financial assets and liabilities at fair value. SFASNo. 159 is effective for first fiscal year beginning after November 15,2007. The Company has not determined whether it will adopt the fair valueoption method permitted by SFAS No. 159.

**Safe HarborStatement under the Private Securities Litigation Reform Act of 1995**

Because this Reporton Form 10-Q contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995, any of the riskfactors set forth in Item 1A or elsewhere in this Report on Form 10-Qor incorporated herein by reference could cause our actual results to differmaterially from those results projected or suggested in such forward-lookingstatements. Statements that are not historical facts are hereby identified as “forward-lookingstatements” for the purposes of the safe harbor provided by Section 21E ofthe Securities Exchange Act of 1934 and Section 27A of the Securities Actof 1933. Such forward-looking statements include but are not limited tostatements relating to:

·       trendsand expectations in revenue growth, including, but not limited to, statementsregarding the temporary nature of the decrease in ID systems bid activity in2006 and the expected increase of such activity in the future, and statementsregarding anticipated growth in U.S. driver license revenues due to broadening useof the driver license as a secure credential;

·       ourfuture level of investment in our business, including investment in developmentof products and technology, acquisition of new customers and development of newmarket opportunities;

·       ourability to improve margins;

·       anticipatedexpenses, costs, margins and investment activities in the foreseeable future;

·       anticipatedrevenue to be generated from current contracts and as a result of new programs;

·       theinvestments required to complete certain driver license programs and ourability to recoup those expenses under the relevant contract;

·       ourprofitability in future periods;

·  business opportunities that could require thatwe seek additional financing;

·       opportunitiesfor increased participation in the global market for ID systems;

·       thesize and growth of our markets, including the U.S. driver license market;

·       theexistence of international growth opportunities and our future investment insuch opportunities;

·       thesource of our future revenue;

·       ourexpected short-term and long-term liquidity positions;

·       ourability to fund our capital needs through cash flow from operations;

·       ouruse of cash in upcoming quarters;

·       anticipatedlevels of backlog and bid activity in future periods;

·       anticipatedlevels of stock-based compensation expense in future periods and the futureeffect of our adoption of SFAS 123(R); and

·       thelikelihood or outcome of legal proceedings and claims and their effect on ourbusiness.

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Such forward-lookingstatements also include other statements containing words such as “anticipate,”“estimate,” “expect,” “management believes,” “we believe,” “we intend,” “should”and similar words or phrases, which are intended to identify forward-lookingstatements. Actual results may vary materially due to, among other things, ourfailure to become profitable, the failure of the potential markets for ourdigital watermarking technology to develop as anticipated, the adoption ofalternative technologies within these markets, as well as changes in economic,business, competitive, technology and/or regulatory factors and trends, and theother factors described in this Form 10-Q or in our other documentsfiled with the SEC. All forward-looking statements are necessarily onlyestimates of future results and there can be no assurance that actual resultswill not differ materially from expectations, and, therefore, investors arecautioned not to place undue reliance on such statements. Investors shouldunderstand that it is not possible to predict or identify all risk factors andthat the risks discussed below should not be considered a complete statement ofall potential risks and uncertainties. We do not intend to update anyforward-looking statements as a result of future events or developments.

**Item3.**                        Quantitativeand Qualitative Disclosures About Market Risk.

The market riskdisclosures as set forth in Item 7A of our Annual Report on Form 10-Kfor the year ended December 31, 2006 have not changed materially.

**Item4.**                        Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer, haveevaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act).Based on that evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures, as of theend of the period covered by this report, were effective in ensuring thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is (i) recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms, and (ii) accumulated and communicated to our management, includingour principal executive officer and principal financial officer, as appropriateto allow timely decisions regarding required disclosure.

**Changes in InternalControls**

There was no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) ofthe Exchange Act) that occurred during our fiscal quarter ended March 31,2007 that has materially affected, or is reasonably likely to materially affect,our internal control over financial reporting.

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**PART II. OTHERINFORMATION.**

**Item 1.**                        LegalProceedings.

Beginning in September 2004, three purportedclass action lawsuits were filed in the U.S. District Court for the District ofOregon against the Company and certain of its current and former directors andofficers on behalf of purchasers of the Company’s securities during the period April 17,2002 to July 28, 2004. These lawsuits were later consolidated into oneaction for all purposes. The amended complaint, which sought unspecifieddamages, asserted claims under the federal securities laws relating to theCompany’s restatement of its financial statements for 2003 and the first twoquarters of 2004 and alleged that the Company issued false and misleadingfinancial statements and issued misleading public statements about the Company’soperations and prospects. On August 4, 2006, the court granted our motionto dismiss the lawsuit with prejudice and entered judgment in our favor.Plaintiffs have filed a notice of appeal in the Ninth Circuit Court of Appeals.The appeal has been stayed pending the U.S. Supreme Court’s determination inanother case of issues relating to the Private Securities Litigation ReformAct. Due to the inherent uncertainties of litigation, the Company cannotaccurately predict the ultimate outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company.The Board of Directors appointed an independent committee to investigate theclaims asserted in this derivative lawsuit. On July 19, 2005, the courtgranted the Company’s motion to stay these consolidated actions in favor of ashareholder derivative action to be filed by plaintiffs in the Circuit Court ofthe State of Oregon for the County of Washington. On August 25, 2005, theCalifornia plaintiffs filed two new derivative lawsuits in the United StatesDistrict Court for the District of Oregon. On October 17, 2005, defendantsfiled a motion to dismiss these complaints for lack of subject matterjurisdiction and failure to state a claim. In May of 2006, the Board committee,after completing its investigation, concluded that pursuit of the allegationswould not be in the best interests of Digimarc or its shareholders. On August 24,2006, the court granted defendants’ motion and dismissed the lawsuit withprejudice. Plaintiffs filed a notice of appeal on September 22, 2006. Plaintiffs’appellate brief is due on April 27, 2007. We expect to file our appellatebrief in late May of 2007. Due to the inherent uncertainties oflitigation, the Company cannot accurately predict the ultimate outcome of thematter.

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 the Company’s initialpublic offering as defendants. The complaints have since been consolidated intoa single action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-marketsubsequent to the Company’s initial public offering. The Company and certain ofits officers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were 

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dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, a committeeof the Company’s board of directors conditionally approved a proposed partialsettlement with the plaintiffs in this matter. In June 2004, an agreementof settlement was submitted to the court for preliminary approval. Thesettlement would have provided, among other things, a release of the Companyand of the individual defendants for the alleged wrongful conduct in theamended complaint in exchange for a guarantee from the Company’s insurersregarding recovery from the underwriter defendants and other consideration fromthe Company regarding its underwriters, including agreeing to assign away, notassert, or release certain potential claims the Company may have against itsunderwriters. The plaintiffs have continued to litigate against the underwriterdefendants. The district court directed that the litigation proceed within anumber of “focus cases” rather than in all of the 310 cases that have beenconsolidated. The Company’s case is not one of these focus cases. On October 13,2004, the district court certified the focus cases as class actions. Theunderwriter defendants appealed that ruling, and on December 5, 2006, theCourt of Appeals for the Second Circuit reversed the district court’s classcertification decision. On April 6, 2007, the Second Circuit deniedplaintiffs’ petition for rehearing. In light of the Second Circuit opinion, wehave informed the district court that this settlement cannot be approvedbecause the defined settlement class, like the litigation class, cannot becertified. We cannot predict whether we will be able to renegotiate asettlement that complies with the Second Circuit’s mandate. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the matter.

We are subject, from timeto time, to other legal proceedings and claims arising in the ordinary courseof business. Although the ultimate outcome of these other matters cannot bedetermined, management believes that, as of March 31, 2007, the finaldisposition of these proceedings will not have a material adverse effect on ourconsolidated financial position, results of operations, or liquidity.

**Item1A.**                Risk Factors

Our business, financialcondition, results of operation and cash flows may be affected by a number offactors, including the factors set forth below.

*We have a historyof losses and we may not achieve or sustain profitability, particularly if wewere to lose large contracts.*

Except for the year 2003,we have incurred significant net losses from inception. Our accumulated deficitas of March 31, 2007 was $100.6 million. In the second half of 2005 andcontinuing through 2006, we restructured our operations to improve productivityand reduce fixed costs. During the second quarter of 2006, we accelerated thoseactivities significantly, resulting in a reduction of our workforce by nearly20%. Overall, our workforce has been reduced by 30% since mid 2005. Theseactions resulted in an increase in earnings to a near break even level in thesecond half of 2006. However, in order to achieve sustained profitability, wewill need to generate higher revenue than we have in prior years whilecontrolling expenditures. Achieving sustained profitability will depend upon avariety of factors, including the impact of financial accounting mandatesrequiring us to expense stock options, as well as the extent to which we may berequired to increase the size of our workforce in order to execute our businessstrategy and capitalize on new opportunities. In addition, we evaluate ourstrategy and market opportunities on an ongoing basis and will adjust ourapproach to market conditions that prevail from time to time. Finally, variousadverse developments including the loss of large contracts or cost overruns onour existing contracts could have a negative impact on our revenue or ourmargins. Accordingly, increases in our 

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expensesmay not be offset by revenue increases and as a result we may not be able toachieve or sustain profitability.

*The loss of anylarge contract may result in loss of revenue and potential acceleration ofamortization expense or impairment of intangible assets.*

Contracts betweengovernment agencies and Digimarc have varying duration, generally five or moreyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. We anticipate that several of oursignificant customers will award new contracts through such a competitivebidding process in 2007. If we were to lose a contract due to cancellation orin a competitive bidding situation, then, in addition to the loss of revenueand margin on a prospective basis, we could also incur accelerated amortizationexpense or impairment of intangible assets related to the customer, which couldadversely affect our financial results.

*The market for ourproducts is highly competitive, and as a result, alternative technologies orlarger companies may undermine, limit or eliminate the market for our products’technologies, which would decrease our revenue and profits.*

The markets inwhich we compete for business are intensely competitive and rapidly evolving.We expect competition to continue from both existing competitors and new marketentrants. We face competition from other companies and from alternativetechnologies. The potential for an influx of federal funds into our core U.S.driver license market has drawn new competition and is likely to continue to doso. As we expand the applications for our technologies, we will experience morecompetition from products and services that are substitutes for ourapplications. Because our digital watermarking business is still in an earlystage of development, we also may face competition from unexpected sources. Alternativetechnologies that may directly or indirectly compete with particularapplications 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®—a slightlyvisible modification of the characteristics of an image or document that ismachine-readable;

·       ScrambledIndicia®—anoptical refraction-based data-hiding technique that is inserted into an imageand 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 credentials,labels and tags;

·       Internettechnologies—numerous existing and potential Internet access and search methodsare competitive with the Digimarc MediaBridge system and the searchingcapabilities of Digimarc ImageBridge;

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·       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 digitalwatermarking technologies to the Internet through new commercial solutionsapplications, we may begin to compete with a wide range of other types ofcompanies beyond those companies using digital watermarking technologies andalternative technologies. We cannot assure you that digital watermarkingtechnologies, and our products and services using these technologies, will gainwidespread market acceptance.

New developments areexpected to continue, and we do not 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 requiregreater revenue streams from such products and services to cover developmentalcosts. Many of the companies that currently compete with us for some of ourbusiness, as well as other companies with whom we may compete in the future,are larger and national or international in scope and may have greatertechnical, financial, marketing, and political resources than we do. Theseresources could enable these companies to initiate severe price cuts or takeother measures in an effort to gain market share or otherwise impede ourprogress. We do not assure you that we will be able to compete successfullyagainst current or future participants in our market or against alternativetechnologies, or that the competitive pressures we face will not decrease ourrevenue and profits in the future.

*Our products couldhave unknown defects or errors, which may give rise to claims against us,divert application of our resources from other purposes or increase our projectimplementation and support costs.*

Products and systems ascomplex as those we offer or develop may contain undetected defects or errors.Furthermore, we often provide complex implementation, integration,customization, consulting and other technical services in connection with theimplementation and ongoing maintenance of our products. Despite testing,defects or errors in our products and services may occur, which could result indelays in the development and implementation of products and systems, inabilityto meet customer requirements or expectations in a timely manner, loss ofrevenue or market share, increased implementation and support costs, failure toachieve market acceptance, diversion of development resources, injury to ourreputation, increased insurance costs, increased service and warranty costs andwarranty or breach of contract claims. Although we attempt to reduce the riskof losses resulting from warranty or breach of contract claims through warrantydisclaimers and liability limitation clauses in our sales agreements when wecan, these contractual provisions are sometimes not included and may not beenforceable in every instance. If a court refuses to enforce the liability-limitingprovisions of our contracts for any reason, or if liabilities arose that werenot contractually limited or adequately covered by insurance, the expenseassociated with defending such actions or paying the resultant claims could besignificant.

*If leadingcompanies in our industry or standard-setting bodies or institutions downplay,minimize, or reject the use of digital watermarking, its deployment may beslowed and we may be unable to achieve revenue growth—particularly in the mediaand entertainment sectors.*

Many of our businessendeavors, such as our licensing of intellectual property in support of audioand video copy-control applications, can be impeded or frustrated by larger,more influential companies or by 

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standard-settingbodies or institutions downplaying, minimizing or rejecting the value or use ofwatermarking technology or any of our other technologies. Such a negativeposition by these companies, bodies or institutions, if taken, may result inobstacles for us that we would be incapable of overcoming and may block orimpede the adoption of digital watermarking—particularly in the media andentertainment market. In addition, potential customers in the media andentertainment industry may delay or reject initiatives that relate to deploymentof digital watermarking. Such a development would make the achievement of ourbusiness objectives in this market difficult or impossible.

*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 products and services could be delayed or limited.*

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 industry and governmental standards, such as futureregulations under the REAL ID Act, in a timely and cost-effective manner. If weare unable to influence these or other standards or respond to such standardseffectively, our growth and the development of certain products and servicescould be delayed or limited.

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 do not 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 andthe deployment of our watermarking technology could be adversely affected.

*We may need toretain additional employees or contract labor in the future in order to takeadvantage of new business opportunities arising from increased demand, whichcould impede our ability to achieve or sustain profitability.*

In the second half of 2005and in 2006, we made significant reductions in our workforce as part of ourefforts to reach profitability. These reductions did not impede our ability tomeet demand because they were accompanied by improvements in our internalbusiness processes and coincided with a period of relatively low bid activitywith respect to development and deployment of new systems. We believe that thisdecrease in bid activity is temporary and that the U.S. driver license marketwill demonstrate increased demand in future periods. Our current reducedstaffing levels could affect our ability to respond to increased demand for ourservices. In addition, to meet any increased demand and take advantage of newbusiness opportunities in the future, we may need to increase our workforcethrough additional employees or contract labor, which would increase our costs.If we experience such an increase in costs, we may not succeed in achieving orsustaining profitability.

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*We depend on oursenior management and key employees for our future success. If we are not ableto retain, hire or integrate these employees, we may not be able to meet ourcommitments.*

Our success depends to a significant extent on theperformance and continued service of our senior management. Except for ourChief Executive Officer, our senior management does not have employmentagreements. The loss of the services of any of our senior management coulddelay projects or undermine customer relationships.

Due to the high level oftechnical expertise that our industry requires, our ability to successfullydevelop, market, sell, license and support 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.Similarly, without the continued contributions of our key finance personnel, webelieve that our ability to meet our reporting obligations and operatesuccessfully as a public company may be limited. We believe our future successwill depend in large part upon our ability to retain our current key employeesand our ability to attract, integrate and retain such personnel in the future.It may not be practical for us to match the compensation certain of ouremployees could garner at other employment. In addition, we may encounterdifficulties in hiring and retaining employees because of concerns related toour financial performance. In addition, these circumstances may have a negativeeffect on the market price of our common stock, and employees and prospectiveemployees may factor in the uncertainties relating to our stability and thevalue of any equity-based incentives in their decisions regardingemployment opportunities and decide to leave our employ. In addition, 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. Although our employees generally haveexecuted agreements containing non-competition clauses, there is no assurancethat a court would enforce all of the terms of these clauses or the clausesgenerally. If these clauses were not fully enforced, our employees could beable to freely join our competitors. Although we generally attempt to controlaccess to and distribution of our proprietary information by our employees,there are no assurances that the confidential nature of our proprietaryinformation will be maintained in the course of such future employment. Any ofthese events could have a material adverse effect on our financial and businessprospects.

*We expect oursecure ID systems business to experience variability in gross margins.*

We are likely toexperience variability in gross margins on our government contracts due tonumerous factors, including, among other things, the following:

·       delaysin project implementation;

·       failureto achieve add-on sales to existing customers;

·       governmentalregulation of credentials and issuance policies;

·       privatesector usage trends for driver licenses and other credentials;

·       levelof commodity vs. proprietary components applicable to customer systemspecifications;

·       whethercontracts have been extended or renewed, and the amount of capital expenditureassociated with such extension or renewal;

·       pricecompetition in competitive bids, contract renewals and contract extensions;

·       variationsin costs of materials and manufacturing;

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·       varyinglevels of efficiency of our workforce in delivering, implementing, andservicing contracts;

·       seasonalityof issuance volumes;

·       salesmix related to card issuance revenues compared to product sales;

·       salesmix related to domestic sales compared to international sales;

·       salesmix related to adoption of new products compared to sales of current products;

·       strategicdecisions on new business;

·       depreciationand amortization of capitalized project costs related to new or upgradedprograms; and

·       variabilityin the extent to which we are able to allocate personnel expenses to capitalprojects and thereby amortize such costs over the life of the relevantcontract, rather than expensing such costs in the quarter in which they areincurred.

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. We arecontinually refining our predictive tools and increasing our understanding ofwhat drives these various factors. For reasons such as those listed above, weexpect that there will be fluctuations in our future operating results as aresult of the variability in margins from period to period in the secure ID systemsbusiness.

*The majority of ourrevenue is subject to government procurement processes that may involveunpredictable delays and other unexpected changes which might limit our actualrevenue 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 therelated government procurement agencies change. Many of these governmentalcustomers are facing continued budget pressures introducing added uncertainty.In addition, the Department of Homeland Security’s initiatives in passports andborder crossing cards, as well as delays in disbursement of funding for REAL IDAct projects, could create confusion within the U.S. driver license market thatmay delay purchase decisions by government customers. Any shift in thegovernment procurement process, which is outside our control and may not be predictable,could result in delays in bookings forecasted for any particular financialperiod, could affect the predictability of our quarterly results, and mightlimit our actual revenue in any given quarter, resulting in reduced and lesspredictable revenue and an adverse affect on profitability.

*Our future growthwill depend to some extent on our successful implementation of our intellectualproperty in solutions provided by third parties, including partners andsuppliers.*

Our business and strategyrely, in part, on deployment of our digital watermark reader technology bythird-party software developers and original equipment manufacturers. Forexample, one form of our digital watermark reader is commonly deployed in imageediting applications to permit users of these products to read watermarksembedded in imagery, and thereby discern the identities of image owners.Another form of our digital watermark reader is used in our anti-counterfeitingproduct offerings. If third parties who include our technologies in theirproducts cease to do so, or we fail to obtain other partners that willincorporate, embed, integrate or bundle our technologies, or these partners areunsuccessful in their efforts, our efforts to expand deployment of ourtechnologies would be adversely affected and, consequently, our ability toincrease revenues would be adversely affected and we may suffer other adverseeffects to our business. In addition, if our technologies do not performaccording to market expectations, our future sales would suffer as customersseek other providers.

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*Some of our revenuemodels relating to anticipated products and services are under development. Ifthese revenue models and pricing structures do not gain market acceptance, thecorresponding anticipated products and services may fail to attract or retain customersand we may not be able to generate new or sustain existing revenue.*

Some of our businessinvolves embedding digital watermarks in traditional and digital media,including identification documents, secure documents, audio, video and imagery,and licensing our intellectual property. Through 2001, our revenue stream wasbased primarily on a combination of development, consulting, subscription andlicense fees 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 providing security-related applications relatingto secure personal identification, copyright protection, and counterfeitdeterrence to these customers. We have not fully developed revenue models forcertain of our future digital watermarking applications and licensingendeavors. Because some of our products and services are not yetwell-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure for these products and services will gain marketacceptance or be sustainable over time or that the marketing for such productsand services will be effective.

*The securitysystems used in our product and service offerings may be circumvented orsabotaged by third parties, which could result in the disclosure of sensitivegovernment information or private personal information or cause other businessinterruptions that could damage our reputation and disrupt our business.*

Our business relies on computers and other informationtechnologies, both internal and at customer and vendor locations. In addition,many of the systems we sell manage private personal information and protectinformation involved in sensitive government functions. The protective measuresthat we use in these systems may not prevent security breaches, and failure toprevent security breaches may disrupt our business, damage our reputation, andexpose us to litigation and liability. A party who is able to circumventsecurity measures used in these systems could misappropriate sensitive orproprietary information or materials or cause interruptions or otherwise damageour products, services and reputation, and the property of our customers. Ifunintended parties obtain sensitive data and information, or create bugs orviruses or otherwise sabotage the functionality of our systems, 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. Further, our insurance coverage may be insufficient to cover lossesand liabilities that may result from such events.

In addition, we may berequired to expend significant capital and other resources to protect ourselvesagainst the threat of security breaches or to alleviate problems caused bythese breaches. Such protection or remedial measures may not be available at areasonable price or at all, or may not be entirely effective if commenced.

*The loss ofinternational customers or the failure to find new international customerscould adversely affect our profitability and slow our growth.*

We expect revenuefrom sales of products and services to governments and other customers outsidethe U.S. to represent a growing percentage of our total revenue in the future.International sales and services are subject to a number of risks that canadversely affect our sales of products and services to customers outside of theUnited States, including the following:

·       changesin foreign government regulations and security requirements;

·       exportlicense requirements, tariffs and taxes;

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·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       longerpayment cycles than those for customers in the U.S.;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

In addition, our experience with large internationalissuance programs is more limited than our experience with domestic programs.We do not have an extensive operational infrastructure for our internationalbusiness. We generally act as a subcontractor or depend on local orinternational business partners and subcontractors for performance ofsubstantial portions of these programs. These factors may result in greaterrisk of performance problems or of reduced profitability with respect to our internationalprograms. In addition, if foreign customers, in particular foreign governmentauthorities, terminate or delay the implementation of our products andservices, we may have limited recourse against them to recover any potentiallosses.

We generally do notinvoice our foreign sales in U.S. dollars, and, consequently, we are exposed tocurrency exchange fluctuations. We currently do not engage in foreign currencyhedging transactions. We may in the future choose to limit our exposure by thepurchase of forward foreign exchange contracts, collared options, currency swapagreements or through similar hedging strategies. However, no currency hedgingstrategy can fully protect against exchange-related losses.

*A significantportion of our business depends on contracts that are subject to a variety ofterms and conditions, including damage payment obligations, as well as avariety of other provisions that may cause our quarterly results to fluctuateand our anticipated revenue to potentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and related products typically include termsrelating to time-based performance, development and delivery schedules,customer acceptance and testing, and other performance milestones. Becauseprocedures often require compliance over extended periods of time, they giverise to an increased risk that we may fail to meet timing or other deliveryrequirements and milestones pursuant to the terms of such contracts. If we failto meet such requirements or milestones, customers may assert against uscompensatory or liquidated damages, breach of contract, or other claims.Consequently, our failure to meet contractual milestones or other performancerequirements as promised could result in our having to incur increased costs,lower margins, or compensatory obligations, in addition to other losses, suchas harm to our reputation. Such unexpected increases in costs to meet ourcontractual obligations or any other requirements necessary to address claimsand damages with regard to our customer contracts could have a material adverseeffect on our business and financial results. We anticipate that futurecontracts will continue to have such provisions.

A significant portion of our business depends on alimited number of large, public-sector contracts, which are generally subjectto termination for convenience, as determined by the subject agency, or forlack of budgetary appropriation provided for the subject agency. Somegovernment contracts also 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 revenue thatmay not be subject to future renewal. Moreover, government contracts resultfrom purchasing decisions made by public sector agencies that may be subject topolitical influence, unusual procurement procedures, strict legal requirements,budget changes and cutbacks during economic downturns, variations in appropriationscycles, and protests of contract awards. Additionally, some governmentalauthorities require performance 

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bonds that we areobligated to maintain during the life of the contract. Often, the terms ofthese bonds require that we maintain large restricted cash reserves as aguarantee, reducing our ability to use these funds for our other businesspurposes. Even with the availability of such cash reserve guarantees, we maynot be able to obtain such performance bond underwriting at a favorable rate orat all. In addition, these performance bonds may provide for security interestscovering our receivables or other assets, which could cause additionalfinancing to be more difficult or more expensive to obtain.

Our failure to be able toprovide such performance bonds may preclude our ability to bid on newgovernment contracts or maintain our existing contracts for their full terms.The size, nature and purpose of, and the risks and uncertainties associatedwith, public sector contracts can potentially cause our quarterly results tofluctuate and anticipated revenue to decrease significantly.

*A significantportion of our business depends on contracts with fixed price terms. In theevent of cost overruns in connection with such contracts, our margins may beadversely affected.*

In addition to our normalprice-per-card issuance contracts, we occasionally enter into agreements tosell entire systems or portions of a system for an agreed upon price. Thesecontracts normally do not have clauses that allow for recovery of costoverruns. Under these contracts, we provide specific tasks for a specific priceand are typically paid on a milestone basis. We have experienced low margins orlosses on some of these contracts in the recent past. These contracts involvegreater financial risks because we bear the risk if actual project costs exceedthe amounts we are paid under the contracts.

*We may decline topursue new, or renew existing, business opportunities in secure ID systemsmarkets due to objectionable terms required by the contracting agencies, or wemay agree to objectionable contract terms for competitive reasons.*

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure ID issuance systems. For example, it is customary for state agencies torequire that a vendor fund the capital-intensive initial deployment of a driverlicense issuance system (the costs of which the vendor normally recoups overthe life of the contract in per-card fees), while reserving the right to terminatethe contract for convenience. Similarly, in connection with intellectualproperty rights, a contract may require that our pre-existing issuance systemsoftware be written in a different language and a state may then argue that itfalls within the class of works for which it owns the copyright, enabling thestate to turn the Digimarc-authored software over to one of our competitors,dedicate it to the public domain, or otherwise use the software in a mannerdetrimental to our business. Objectionable contract terms may lead us todecline to bid on identification issuance systems to new customers, or todecline to retain business with customers we have historically served, whichcould reduce our market share and lower our revenues or profits. In addition, ifwe decline to retain business with customers we have historically served, itcould result in the accelerated depreciation of intangible assets.Alternatively, we may decide to accept at least some level of objectionableterms rather than cede an important contract to a competitor, which could alsolower our revenues or profits.

*A loss of amaterial supplier could have a material adverse effect on our ability toperform effectively under some of our contracts.*

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. The loss of one or more ofthese suppliers could have a material adverse effect on our ability to performeffectively, if at all, under some of our contracts.

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*We are subject torisks encountered by companies developing and relying upon new technologies,products and services for substantial 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 in the development stage. Consequently, products incorporatingthese key technologies are undergoing technological change and are in the earlystage of introduction in the marketplace. Delays in the adoption of theseproducts or adverse competitive developments may result in delays in thedevelopment of new revenue sources or the growth in our revenue. In addition,we may be required to incur unanticipated capital expenditures in the eventproduct changes or improvements are required. Additionally, new industrystandards might redefine the products that we are able to sell, especially ifthese products are only in the prototype stage of development. If productchanges or improvements are required, success in marketing these products andachieving profitability from these products could be delayed or halted. We alsomay be required to fund such changes or improvements out of operating income,which could adversely affect our profitability.

*We may not be ableto protect adequately our intellectual property, and we may be subject toinfringement claims and other litigation, which could adversely affect ourbusiness.*

Our success depends in part on licensing ourproprietary technologies. To protect our growing intellectual propertyinvestments, we rely on a combination of patent, copyright, trademark and tradesecret rights, confidentiality procedures and licensing arrangements.Unlicensed copying and use of our intellectual property or illegalinfringements of our intellectual property rights represent losses of revenueto us.

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, and thepossibility that third parties will be able to compete against us withoutinfringing our patents. Budgetary concerns may cause us not to file, orcontinue, litigation against known infringers of our patent rights, or maycause us not to file for, or pursue, patent protection for all of our inventivetechnologies in jurisdictions where they may have value. Some governmentalentities that might infringe our intellectual property rights may enjoysovereign immunity from such claims. Failure to reliably enforce our patentrights against infringers may make licensing more difficult. If we fail toprotect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to ourinterests, or if we become involved in litigation relating to our intellectualproperty rights and proprietary technologies or relating to the intellectualproperty rights of others, our business could be seriously harmed because thevalue ascribed to our intellectual property could diminish and result in alower stock price or we may incur significant costs in bringing legalproceedings against third parties who are infringing our patents.

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Effective protection of intellectual property rightsmay be unavailable or limited, both in the U.S. and in other countries. Patentprotection throughout the world is generally established on a country-by-countrybasis. We have applied for patent protection both in the U.S. and in variousother countries. However, we do not assure you that pending patents will beissued or that issued patents will be valid or enforceable. Failure to obtainsuch patents or failure to enforce those patents that are obtained may resultin a loss of revenue to us. We do not assure you that the protection of ourproprietary rights will be adequate or that our competitors will notindependently develop similar technologies, duplicate our services or designaround any of our patents or other intellectual property rights we hold.

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 even though we rely on some of these technologies for our products.

As more companies engage in business activitiesrelating to personal identification technologies and digital watermarking, anddevelop corresponding intellectual property rights, it is increasingly likelythat claims may arise which assert that some of our products or servicesinfringe upon other parties’ intellectual property rights. These claims couldsubject us to costly litigation, divert management resources and result in theinvalidation of our intellectual property rights. These claims may require usto pay significant damages, cease production of infringing products, terminateour use of infringing technologies or develop non-infringing technologies. Inthese circumstances, continued use of our technologies may require that weacquire licenses to the intellectual property that is the subject of thealleged infringement, and we might not be able to obtain these licenses oncommercially reasonable terms or at all. Our use of protected technologies mayresult in liability that threatens our continuing operation.

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. Asdeployment of our technology increases, and more companies enter our markets,the likelihood of a third party lawsuit resulting from such indemnificationincreases. If an infringement arose in a context governed by such a contract,we may have to refund to our customer amounts already paid to us or paysignificant damages, or we may be sued by the party allegedly infringed upon.Similarly, as we seek to broaden the number of companies licensed under ourpatent portfolio, some may seek contractual assurances that we will pursue—bylitigation if necessary—their competitors who use our patented technology butare not licensed to do so. Compliance with any such contract provisions mayrequire that we pursue litigation where our costs exceed our likely recovery.

As part of our confidentialityprocedures, we generally enter into non-disclosure agreements with ouremployees, directors, consultants and corporate partners, and attempt tocontrol access to and distribution of our technologies, solutions,documentation and other proprietary information. Despite these procedures,third parties could copy or otherwise obtain and make unauthorized use of ourtechnologies, solutions or other proprietary information or independentlydevelop similar technologies, solutions or information. The steps that we havetaken to prevent misappropriation of our solutions, technologies or otherproprietary information may not prevent their misappropriation, particularlyoutside the U.S. where laws or law enforcement practices may not protect ourproprietary rights as fully as in the U.S..

*Products that weare developing for new secure identification markets and components andsubsystems markets may not be accepted as quickly as we have projected or atall, which may negatively impact our revenues, margins, earnings and stockprice.*

We have investedsignificant time and resources in product development activities for new secureidentification markets, including designing and developing numerousenhancements to our driver license systems and improving our cards’ ability towithstand intrusions or alterations without detection. If we do not experiencea timely, positive reaction from issuing authorities to our new offerings, ourprojected revenues, margins and earnings may be negatively impacted.

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*We are engaged inseveral lawsuits alleging violations of securities law and cannot predict theoutcome or ultimate cost of these actions with certainty.*

We currently are engagedin litigation relating to the initial public offering of our securities, inaddition to the actions filed against us in connection with our previouslyannounced accounting errors. These matters are discussed in greater detail in Part II,Item 1 (Legal Proceedings) of this Quarterly Report on Form 10-Q andin Note 8 (Commitments and Contingencies) of the Notes to ConsolidatedFinancial Statements included in this Quarterly Report on Form 10-Q.We have incurred significant costs relating to these matters. Due to theinherent uncertainties of such litigation, the ultimate cost and outcome cannotbe predicted.

*If a judgment wereto be entered against the Company and our director and officer liabilityinsurance was inadequate or unavailable, the obligation to pay the judgment maymaterially harm our business and financial condition.*

Our director and officerliability insurance policies provide protection against certain liabilitiesrelating to the securities class action and derivative lawsuits against us andcertain of our officers and directors up to prescribed policy limits. If thesepolicies do not adequately cover expenses and certain liabilities relating tothese lawsuits, our financial condition could be materially harmed. Inaddition, if this insurance coverage becomes unavailable to us or premiumsincrease significantly in the future, it could make it more difficult for us toretain and attract officers and directors and could expose us to potentiallyself-funding certain future liabilities ordinarily mitigated by director andofficer liability insurance.

*We may be requiredto invest significant additional time and resources to comply with therequirements of Section 404 of the Sarbanes-Oxley Act of 2002, which couldharm our operating results or cause us to fail to meet our reportingobligations.*

In 2004, we discoveredcertain material weaknesses in our internal controls and procedures, which weremediated. Since then, we have deployed significant resources to design andimplement new and enhanced controls and procedures. We cannot be certain,however, that other deficiencies will not arise or be identified in the future,particularly if we experience rapid growth or change in our business, includinggrowth or change resulting from any future acquisition. Any failure tomaintain adequate controls or to adequately implement required new or improved controlscould harm our operating results or cause us to fail to meet our reportingobligations in a timely and accurate manner.

*There is noassurance that our disclosure controls and procedures will succeed in achievingtheir stated goals under all potential future conditions, regardless of howremote.*

The SEC defines the term “disclosurecontrols and procedures” to mean a company’s controls and other procedures thatare designed to ensure that information required to be disclosed in the reportsthat it files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported, within the time periods specified in theCommission’s rules and forms. While our disclosure controls and proceduresare designed to provide reasonable assurance of achieving their objectives, thedesign of any system of controls is based in part upon certain assumptionsabout the likelihood of future events, and there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions, regardless of how remote. If our disclosure controls and proceduresdo not succeed in achieving their stated goals, our operating results could beharmed or we could fail to meet our reporting obligations in a timely and accuratemanner.

**Item6.**                        Exhibits.

See attached exhibit index.

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**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: May 4, 2007 | By:                   | /s/  MICHAEL MCCONNELL |
|                   |                  | Michael McConnell |
|                   | * *              | *Chief Financial  Officer and Treasurer  (Duly Authorized Officer  and Principal Financial Officer)* |

 

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**EXHIBITINDEX**
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                   | ** ** | **Document** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| 3.1             |       | Second Amended and  Restated Certificate of Incorporation of the Registrant, as amended  (incorporated by reference to Exhibit 3.1 of Exhibits to the  Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006) |
| 3.2             |       | Amended and  Restated Bylaws of the Registrant (incorporated by reference to  Exhibit 3.3 of Exhibits to Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on August 9, 2005)                                            |
| 10.1            |       | Registrant’s 1999  Non-Employee Director Stock Incentive Program, as amended and restated on  March 7, 2007                                                                                                                                                                        |
| 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                                                                                                                                                                                                                                  |

** **

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