**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 September 30, 2006**

**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.) |
| **9405 SW Gemini Drive, Beaverton, Oregon**                      |   | **97008**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

 

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

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 October 31, 2006, there were 21,194,371 shares of the registrant’scommon stock, par value $0.001 per share, outstanding.

 

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**Table of Contents**
| **PART I FINANCIAL  INFORMATION** |   |                                                                                                                                |
|----------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           |   | Financial  Statements:                                                                                                              |   | 3 |
|                                   |   | Condensed Consolidated Balance Sheets as of  September 30, 2006 and December 31, 2005 (Unaudited)                    |   | 3 |
|                                   |   | Condensed  Consolidated Statements of Operations for the three- and nine-months ended  September 30, 2006 and 2005 (Unaudited) |   | 4 |
|                                   |   | Condensed  Consolidated Statements of Cash Flows for the nine-months ended  September 30, 2006 and 2005 (Unaudited)            |   | 5 |
|                                   |   | Notes  to Condensed Consolidated Financial Statements (Unaudited)                                                                   |   | 6 |
| Item 2.                                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                         |   | 21 |
| Item 3.                                |   | Quantitative  and Qualitative Disclosures About Market Risk                                                                         |   | 54 |
| Item 4.                                |   | Controls  and Procedures                                                                                                            |   | 54 |
| **PART II OTHER INFORMATION**     |   |                                                                                                                                |
| Item 1.                                |   | Legal  Proceedings                                                                                                                  |   | 55 |
| Item 5.                                |   | Other Information                                                                                                                   |   | 56 |
| Item 6.                                |   | Exhibits                                                                                                                            |   | 56 |
| **SIGNATURES**                         |   | 57                                                                                                                                  |

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1.**                        FinancialStatements.

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS(DOLLARS IN THOUSANDS) (UNAUDITED)**

| ** **                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                   | ** ** | **2006**               | ** ** | **2005(1)**           | ** ** |
| **ASSETS**                                                                                                                                   |       |                   |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                              |       |                   |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                    |       |                   | $          | 20,251                |       |   |   | $ | 23,964 |   |   |
| Short-term investments                                                                                                                       |       |                   | 1,001      |                  |       |   | 739 |   |   |
| Trade accounts receivable, net                                                                                                               |       |                   | 8,078      |                  |       |   | 9,469 |   |   |
| Unbilled trade receivables                                                                                                                   |       |                   | 6,894      |                  |       |   | 6,228 |   |   |
| Inventory, net                                                                                                                               |       |                   | 6,016      |                  |       |   | 7,451 |   |   |
| Other current assets                                                                                                                         |       |                   | 2,063      |                  |       |   | 2,828 |   |   |
| Total current assets                                                                                                                         |       |                   | 44,303     |                  |       |   | 50,679 |   |   |
| Restricted cash                                                                                                                              |       |                   | 9,938      |                  |       |   | 7,279 |   |   |
| Property and  equipment, net                                                                                                                 |       |                   | 61,662     |                  |       |   | 64,108 |   |   |
| Intangibles, net                                                                                                                             |       |                   | 15,853     |                  |       |   | 17,164 |   |   |
| Other assets, net                                                                                                                            |       |                   | 908        |                  |       |   | 1,009 |   |   |
| Total assets                                                                                                                                 |       |                   | $          | 132,664               |       |   |   | $ | 140,239 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                               |       |                   |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                                         |       |                   |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                             |       |                   | $          | 4,795                 |       |   |   | $ | 6,722 |   |   |
| Accrued payroll and related costs                                                                                                            |       |                   | 4,095      |                  |       |   | 3,731 |   |   |
| Deferred revenue                                                                                                                             |       |                   | 9,155      |                  |       |   | 6,809 |   |   |
| Other current liabilities                                                                                                                    |       |                   | 1,853      |                  |       |   | 2,032 |   |   |
| Total current liabilities                                                                                                                    |       |                   | 19,898     |                  |       |   | 19,294 |   |   |
| Other long-term  liabilities                                                                                                                 |       |                   | 1,014      |                  |       |   | 969 |   |   |
| Total liabilities                                                                                                                            |       |                   | 20,912     |                  |       |   | 20,263 |   |   |
| Commitments and  contingencies (Note 5)                                                                                                      |       |                   |       |                  |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                  |       |                   |       |                  |       |   |   |   |   |
| Common stock  (21,190,545 and 20,808,994 shares issued and outstanding at  September 30, 2006 and December 31, 2005, respectively) |       |                   | 22         |                  |       |   | 21 |   |   |
| Additional  paid-in capital                                                                                                                  |       |                   | 210,421    |                  |       |   | 209,337 |   |   |
| Deferred stock  compensation                                                                                                                 |       |                   | —     |                  |       |   | (1,519 | ) |   |
| Accumulated other  comprehensive income                                                                                                      |       |                   | 137        |                  |       |   | 137 |   |   |
| Accumulated  deficit                                                                                                                         |       |                   | (98,828    | )                     |       |   | (88,000 | ) |   |
| Total stockholders’ equity                                                                                                              |       |                   | 111,752    |                  |       |   | 119,976 |   |   |
| Total liabilities  and stockholders’ equity                                                                                             |       |                   | $          | 132,664               |       |   |   | $ | 140,239 |   |   |

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(1)          Derived from the Company’sDecember 31, 2005 audited consolidated financial statements

See Notes to Unaudited Condensed Consolidated Financial Statements.

3

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

| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                          |       |                             |       |                            |       |   |   |   |   |
| Service                                           |       | $                                | 22,414     |                            | $          | 22,372 |   | $ | 65,223 |   | $ | 63,584 |   |
| Product and subscription                          |       | 4,319                            |       | 4,409                           |       | 13,610 |   | 12,329 |   |
| Total revenue                                     |       | 26,733                           |       | 26,781                          |       | 78,833 |   | 75,913 |   |
| Cost of revenue:                                  |       |                             |       |                            |       |   |   |   |   |
| Service                                           |       | 15,138                           |       | 15,253                          |       | 47,239 |   | 44,448 |   |
| Product and subscription                          |       | 1,581                            |       | 1,790                           |       | 5,805 |   | 5,232 |   |
| Total cost of revenue                             |       | 16,719                           |       | 17,043                          |       | 53,044 |   | 49,680 |   |
| Gross profit                                      |       | 10,014                           |       | 9,738                           |       | 25,789 |   | 26,233 |   |
| Operating expenses:                               |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                               |       | 3,440                            |       | 4,295                           |       | 12,664 |   | 11,961 |   |
| Research, development and engineering             |       | 2,158                            |       | 3,199                           |       | 8,388 |   | 9,535 |   |
| General and administrative                        |       | 3,684                            |       | 4,852                           |       | 13,066 |   | 15,870 |   |
| Amortization of intangibles                       |       | 537                              |       | 1,147                           |       | 1,660 |   | 3,297 |   |
| Intellectual property                             |       | 460                              |       | 528                             |       | 1,372 |   | 1,531 |   |
| Restructuring charges, net                        |       | —                           |       | —                          |       | 547 |   | — |   |
| Total operating expenses                          |       | 10,279                           |       | 14,021                          |       | 37,697 |   | 42,194 |   |
| Operating income (loss)                           |       | (265                             | )          | (4,283                          | )          | (11,908 | ) | (15,961 | ) |
| Other income (expense):                           |       |                             |       |                            |       |   |   |   |   |
| Interest income                                   |       | 342                              |       | 262                             |       | 1,008 |   | 799 |   |
| Interest expense                                  |       | (29                              | )          | (15                             | )          | (73 | ) | (135 | ) |
| Other                                             |       | 223                              |       | (33                             | )          | 266 |   | 31 |   |
| Total other income, net                           |       | 536                              |       | 214                             |       | 1,201 |   | 695 |   |
| Income (loss)  before provision for income taxes  |       | 271                              |       | (4,069                          | )          | (10,707 | ) | (15,266 | ) |
| Provision for  income taxes                       |       | (58                              | )          | (159                            | )          | (121 | ) | (299 | ) |
| Net income (loss)                                 |       | $                                | 213        |                            | $          | (4,228 | ) | $ | (10,828 | ) | $ | (15,565 | ) |
| Net income (loss)  per share—basic           |       | $                                | 0.01       |                            | $          | (0.21 | ) | $ | (0.52 | ) | $ | (0.76 | ) |
| Net income (loss)  per share—diluted         |       | $                                | 0.01       |                            | $          | (0.21 | ) | $ | (0.52 | ) | $ | (0.76 | ) |
| Weighted average shares outstanding—basic    |       | 20,670                           |       | 20,497                          |       | 20,635 |   | 20,473 |   |
| Weighted average  shares outstanding—diluted |       | 21,470                           |       | 20,497                          |       | 20,635 |   | 20,473 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

4

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

| ** **                                                                                 | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,  2006**    | ** ** | **September 30,  2005** | ** ** |
| Cash flows from  operating activities:                                                     |       |                            |       |   |   |   |   |   |   |
| Net loss                                                                                   |       |                            | $          | (10,828 | ) |   |   | $ | (15,565 | ) |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                            |       |   |   |   |   |   |   |
| Depreciation and amortization                                                              |       |                            | 11,595     |   |   |   | 13,978 |   |   |
| Stock-based compensation expense                                                           |       |                            | 2,283      |   |   |   | 355 |   |   |
| Increase (decrease) in allowance for doubtful  accounts                                    |       |                            | (173       | ) |   |   | (10 | ) |   |
| Other non-cash charges                                                                     |       |                            | (286       | ) |   |   | (11 | ) |   |
| Changes in  operating assets and liabilities:                                              |       |                            |       |   |   |   |   |   |   |
| Restricted cash                                                                            |       |                            | (2,659     | ) |   |   | 993 |   |   |
| Trade and unbilled accounts receivable                                                     |       |                            | 898        |   |   |   | (1,152 | ) |   |
| Inventory, net                                                                             |       |                            | 1,435      |   |   |   | 319 |   |   |
| Other current assets                                                                       |       |                            | 765        |   |   |   | (830 | ) |   |
| Other assets, net                                                                          |       |                            | 101        |   |   |   | 82 |   |   |
| Accounts payable                                                                           |       |                            | (1,927     | ) |   |   | (4,856 | ) |   |
| Accrued payroll and related costs                                                          |       |                            | 364        |   |   |   | 1,846 |   |   |
| Deferred revenue                                                                           |       |                            | 2,346      |   |   |   | (257 | ) |   |
| Other liabilities                                                                          |       |                            | (236       | ) |   |   | 497 |   |   |
| Net cash provided by (used in) operating activities                                        |       |                            | 3,678      |   |   |   | (4,611 | ) |   |
| Cash flows from  investing activities:                                                     |       |                            |       |   |   |   |   |   |   |
| Purchase of property and equipment and capitalized  labor costs                            |       |                            | (6,940     | ) |   |   | (12,639 | ) |   |
| Purchase of intangibles                                                                    |       |                            | (30        | ) |   |   | (20 | ) |   |
| Sale or maturity of short-term investments                                                 |       |                            | 92,350     |   |   |   | 133,247 |   |   |
| Purchase of short-term investments                                                         |       |                            | (92,612    | ) |   |   | (114,484 | ) |   |
| Net cash provided by (used in) investing activities                                        |       |                            | (7,232     | ) |   |   | 6,104 |   |   |
| Cash flows from  financing activities:                                                     |       |                            |       |   |   |   |   |   |   |
| Net proceeds from issuance of common stock                                                 |       |                            | 321        |   |   |   | 211 |   |   |
| Principal payments under capital lease obligations                                         |       |                            | (480       | ) |   |   | (351 | ) |   |
| Net cash provided by (used in) financing activities                                        |       |                            | (159       | ) |   |   | (140 | ) |   |
| Net increase (decrease) in cash and cash equivalents                                       |       |                            | (3,713     | ) |   |   | 1,353 |   |   |
| Cash and cash equivalents at beginning of period                                           |       |                            | 23,964     |   |   |   | 18,489 |   |   |
| Cash and cash equivalents at end of period                                                 |       |                            | $          | 20,251 |   |   |   | $ | 19,842 |   |   |
| Supplemental  disclosure of cash flow information:                                         |       |                            |       |   |   |   |   |   |   |
| Cash paid for interest                                                                     |       |                            | $          | 73 |   |   |   | $ | 135 |   |   |
| Cash paid for income taxes                                                                 |       |                            | $          | 134 |   |   |   | $ | 139 |   |   |
| Summary of  non-cash investing and financing activities:                                   |       |                            |       |   |   |   |   |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       |                            | $          | 582 |   |   |   | $ | 135 |   |   |
| Grant of  restricted stock                                                                 |       |                            | $          | 1,202 |   |   |   | $ | 2,025 |   |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

5

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**DIGIMARC CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)(UNAUDITED)**

**1.**                 TheCompany, Basis of Presentation

*Description ofBusiness*

Digimarc Corporation (“Digimarc” or “the Company”) isa leading supplier of secure identity solutions and advanced technologies foruse in media management. The Company’s solutions enable governments andbusinesses around the world to deter counterfeiting and piracy, enhance trafficsafety and national security, combat identity theft and fraud, facilitate theeffectiveness of voter identification programs, improve the management of mediacontent, and support new digital media distribution models that provideconsumers with more choice and access to media content.

The Company issues more than 60 million identificationdocuments (“IDs”) annually and is the leading supplier of government-issuedcitizen IDs in the United States (“U.S.”), producing more than two-thirds ofall driver licenses issued in the U.S. Digimarc also is a pioneer and leadingowner of intellectual property in a signal processing technology innovationknown as “digital watermarking”, whichallows imperceptible digital information to be embedded in all forms ofdigitally designed, produced or distributed media content, including personalidentification documents, financial instruments, photographs, movies, music andproduct packages. The embedded data within various types of media content canbe detected and read by software or hardware detectors in personal computersand other digital devices. The Company provides solutions based on thistechnology directly and through the Company’s licensees.

As of September 30, 2006, the Company held rightsin 286 issued U.S. patents and over 66 issued foreign patents on thistechnology and related technologies, applications, systems, and processes andhad more than 500 U.S. and foreign applications pending.

Digimarc’s solutions and technologies are deployed bythe Company and its business partners in media objects and digital devicesaround the world.

The substantial majority of the Company’s revenue isgenerated pursuant to long-term contracts with government agencies—primarilyU.S. state government agencies responsible for driver license issuance (“Statedriver license issuers”), a consortium of leading Central Banks and nationalgovernments of a number of foreign countries. These systems rely on the Company’ssystems design, 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.

The remainder of theCompany’s revenue is generated primarily from patent and technology licensefees paid by business partners providing media and rights management solutionsto movie studios and music labels, television and radio broadcasters, creativeprofessionals and other customers around the world. Private sector media andentertainment industry customers use secure media management solutions from theCompany and its business partners to identify, track, manage and protectcontent as it is distributed and consumed—either digitally or physically—and toenable new consumer applications to improve access to networks and informationfrom PCs and mobile devices.

6

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*Interim FinancialStatements*

The condensed consolidated financial statementsinclude the accounts of Digimarc and its wholly-owned subsidiaries. Allsignificant inter-company transactions and balances have been eliminated. Thecondensed consolidated financial statements have been prepared from the Company’srecords without audit and, in management’s opinion, include all adjustments(consisting of only normal recurring adjustments) necessary to fairly reflectthe financial condition and the results for the periods presented. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theU.S. have been condensed or omitted under the rules and regulations of theSecurities and Exchange Commission (the “SEC”).

These condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005, whichwas filed with the SEC on March 13, 2006. The results of operations forthe interim periods presented in these condensed consolidated financialstatements are not necessarily indicative of the results for the full year.

*Use of Estimates*

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the U.S.requires Digimarc to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. Certain of the Company’s accounting policiesrequire higher degrees of judgment than others in their application. Theseinclude revenue recognition on long-term service contracts, impairments andestimation of useful lives of long-lived assets, inventory valuation, reservesfor uncollectible accounts receivable, inputs for stock-based compensationcalculations, and contingencies and litigation. Digimarc bases its estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

Through December 31,2005 the Company depreciated program fixed assets that were specifically usedto provide services under long term contracts over the shorter of the originalcontract term or estimated useful life. Starting January 1, 2006, theCompany changed its useful lives for depreciating these assets to the shorterof the original contract term plus 2.75 years or estimated useful life. This changein estimate was supported by analysis completed by the Company during the firstquarter of 2006 that showed that historically 95% of contracts were extendedbeyond the original contract term, that the average contract had at least twocontract extensions during its life and that these extensions added on average2.75 years to the length of the contracts’ original terms. Sincecontract-specific program assets are tracked on a contract basis, the findingsthat the contract life is routinely significantly longer than the originalcontract term and that these extensions are not generally accompanied bysignificant incremental capital investment indicates that the contract-relatedasset’s useful life was longer than the original term of the contract. Giventhe findings of the analysis, Digimarc concluded that it was appropriate tochange the estimated useful lives so that contract specific assets were beingdepreciated over the Company’s estimate of the useful life of these assets. Inaddition, the change in useful lives would conservatively achieve a bettermatching of the utility of these assets with the resulting revenues. Based onthe analysis, this change would have the effect of reducing depreciationexpense by $1,862 and $6,103 for the three- and nine-month periods ended September 30,2006, respectively, for assets in service at December 31, 2005. Thisreduction in depreciation would increase basic and diluted earnings by $0.09and $0.30 for the three- and nine-month periods ended September 30, 2006,respectively, per share before taxes. Given that the depreciation expenseattributed to contract-specific assets is part of cost of revenue, the decreasein depreciation expense will cause gross margins to increase by the amount ofthe reduction in depreciation expense.

7

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*Reclassifications*

Certain amounts in the 2005 consolidated financialstatements and notes thereon have been reclassified to conform to current yearpresentation. These reclassifications had no material effect on the results ofoperations or financial position for any year presented.

Specifically,certain costs were reclassified from general and administrative to cost ofrevenue, sales and marketing, research, development and engineering andintellectual property as shown on the condensed consolidated statement ofoperations. The intellectual property category includes costs associated withdocumenting, applying for, and maintaining patents generated through theCompany’s research and development efforts. The infrastructure categoryincludes rent, leasehold improvements amortization, insurance expense andinfrastructure depreciation. The centralized cost category includes centralizeddepartments that serve all operations such as the Company’s informationtechnology department. The methods employed were based on headcount, squarefootage or a combination of both as appropriate.

| **Three-months ended September 30, 2005:** | ** ** | ** ** | ** ** | **Before** | ** ** | **Intellectual  Property** | ** ** | **Infrastructure** | ** ** | **Centralized  Cost** | ** ** | **After** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|--------------------|------------|-----------------------|------------|-----------|------------|
| Cost of  revenue—service                                  |       | $          | 14,704     |       |       | $                          | —     |               |       |                  | $          | 131       |       |   |   | $ | 418 |   |   | $ | 15,253 |   |
| Total cost of  revenue                                         |       | 16,494     |       |       | —     |                       |       |               | 131        |                  |       |      | 418        |   |   | 17,043 |   |
| Gross profit                                                   |       | 10,287     |       |       | —     |                       |       |               | (131       | )                     |       |      | (418       | ) |   | 9,738 |   |
| Sales and  marketing                                           |       | 4,291      |       |       | (264       | )                          |       |               | 109        |                  |       |      | 159        |   |   | 4,295 |   |
| Research,  development and engineering                         |       | 2,898      |       |       | (308       | )                          |       |               | 222        |                  |       |      | 387        |   |   | 3,199 |   |
| General and  administrative                                    |       | 6,234      |       |       | 44         |                       |       |               | (462       | )                     |       |      | (964       | ) |   | 4,852 |   |
| Amortization of  intangibles                                   |       | 1,147      |       |       | —     |                       |       |               | —     |                  |       |      | —     |   |   | 1,147 |   |
| Intellectual  property                                         |       | —     |       |       | 528        |                       |       |               | —     |                  |       |      | —     |   |   | 528 |   |
| Total operating expenses                                       |       | 14,570     |       |       | —     |                       |       |               | (131       | )                     |       |      | (418       | ) |   | 14,021 |   |
|                                                                |            |            |            |            |            |                            |            |                    |            |                       |            |           |            |  |  |  |  |  |  |  |  |  |  |  |

 

| **Nine-months ended September 30, 2005:** | ** ** | ** ** | ** ** | **Before** | ** ** | **Intellectual  Property** | ** ** | **Infrastructure** | ** ** | **Centralized  Cost** | ** ** | **After** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|--------------------|------------|-----------------------|------------|-----------|------------|
| Cost of  revenue—service                                 |       | $          | 42,722     |       |       | $                          | —     |               |       |                  | $          | 413       |       |   |   | $ | 1,313 |   |   | $ | 44,448 |   |
| Total cost of  revenue                                        |       | 47,954     |       |       | —     |                       |       |               | 413        |                  |       |      | 1,313      |   |   | 49,680 |   |
| Gross profit                                                  |       | 27,959     |       |       | —     |                       |       |               | (413       | )                     |       |      | (1,313     | ) |   | 26,233 |   |
| Sales and  marketing                                          |       | 12,004     |       |       | (862       | )                          |       |               | 317        |                  |       |      | 502        |   |   | 11,961 |   |
| Research,  development and engineering                        |       | 8,382      |       |       | (748       | )                          |       |               | 683        |                  |       |      | 1,218      |   |   | 9,535 |   |
| General and  administrative                                   |       | 20,237     |       |       | 79         |                       |       |               | (1,413     | )                     |       |      | (3,033     | ) |   | 15,870 |   |
| Amortization of  intangibles                                  |       | 3,297      |       |       | —     |                       |       |               | —     |                  |       |      | —     |   |   | 3,297 |   |
| Intellectual  property                                        |       | —     |       |       | 1,531      |                       |       |               | —     |                  |       |      | —     |   |   | 1,531 |   |
| Total operating expenses                                      |       | 43,920     |       |       | —     |                       |       |               | (413       | )                     |       |      | (1,313     | ) |   | 42,194 |   |
|                                                               |            |            |            |            |            |                            |            |                    |            |                       |            |           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

Net income (loss) per share (or earnings per share (“EPS”))is calculated in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 128, *Earnings per Share*,which provides that basic and diluted net income (loss) per share for allperiods presented are to be computed using the weighted average number ofcommon shares outstanding during each period, with diluted net income (loss)per share including the effect of potentially dilutive common shares.

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Reconciliationof weighted average basic shares to weighted average diluted sharesoutstanding.

| ** **                           | ** ** | **Three Months Ended**        | ** ** | **Nine Months Ended**         | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | **September 30,**                  | ** ** | **September 30,**                  | ** ** |
| ** **                           | ** ** | **2006**                                | ** ** | **2005**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** |
| **Basic EPS**                        | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Weighted average shares outstanding  |       |                                    | 20,670     | ** **                              |       |   | 20,497 | ** ** |   |   | 20,635 | ** ** |   |   | 20,473 | ** ** |   |
| **Effect  of Dilutive Securities**   | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Options                              |       |                                    | 800        | ** **                              |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| **Diluted  EPS**                     | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Weighted  average shares outstanding |       |                                    | 21,470     | ** **                              |       |   | 20,497 | ** ** |   |   | 20,635 | ** ** |   |   | 20,473 | ** ** |   |

 

Common stock equivalents related to stock options of5,428 and 5,144 were excluded from diluted net loss per share calculations forthe three- and nine-month periods ended September 30, 2006, respectively,as their exercise price was higher than the average market price of theunderlying common stock for the period and therefore their impact would beanti-dilutive. In addition, common stock equivalents related to stock optionsand restricted stock of 800 for the three-month period ended September 30,2006 were included in diluted net income per share; however 841 common stockequivalents for the nine-month period ended September 30, 2006 wereexcluded from diluted net loss per share as the Company was in a loss positionand the inclusion would be anti-dilutive.

The effect of 6,371 and6,277 outstanding stock options for the three- and nine-months periods ended September 30,2005, respectively, were excluded from the calculation of diluted net loss pershare because their exercise price was higher than the average market price ofthe underlying common stock for the period and therefore their inclusion wouldbe anti-dilutive. In addition, common stock equivalents related to stock optionsof 455 and 393 for the three- and nine-months periods ended September 30,2005, respectively were excluded from diluted net loss per share as the Companywas in a loss position and their inclusion would 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, *Accounting for Stock Issued to Employees*, for periodsbeginning in fiscal 2006. In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107 relating toapplication of SFAS 123(R). The Company has applied the provisions of SAB 107in 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 condensed consolidated financial statements for periods prior tofiscal year 2006 have not been restated to reflect this change. Stock-basedcompensation recognized in the three- and nine-month periods ended September 30,2006 is based on the value of the portion of the stock-based award that willvest during the period, adjusted for expected forfeitures. Stock-basedcompensation recognized in the Company’s condensed consolidated financialstatements in the three- and nine-month periods ended September 30, 2006includes 

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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 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 notlimited, to the expected life of the award, our expected stock price volatilityover the term of the award and actual and projected exercise behaviors.Although the fair value of stock-based awards is determined in accordance withSFAS 123(R) and SAB 107, the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results.

Prior to January 1,2006, the Company applied the recognition and measurement principles ofAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, *Accounting forCertain Transactions involving Stock Compensation, an Interpretation of APBOpinion No. 25*, as allowed by FASB Statement No. 123, *Accounting for Stock-Based Compensation*.FASB Statement No. 123 and FASB Statement No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, an amendment of FASB Statement No. 123*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. Under APBOpinion No. 25, stock-based compensation expense is recognized for stockawards granted with an exercise price below fair market value on the date ofgrant.

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

*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 life of awards grantedrepresents 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- and nine-months ended September 30, 2006and 2005 generally vest over four years and have contractual terms of tenyears.

*ExpectedVolatility.*   The Company estimates the volatilityof its common stock at the date of grant based on the historical volatility ofits common stock. The volatility factor the Company uses in the Black-Scholesoption valuation model is based on its historical stock prices over the mostrecent period commensurate with the estimated expected life of the award. Thishistorical period excludes portions of time when 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.

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*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  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life (in years) |       | 6.0                                              |       | 4.0                                             |       | 6.0 |   | 4.0 |   |
| Expected volatility      |       | 53                                               | %          | 50                                              | %          | 53 | % | 50 | % |
| Risk-free interest rate  |       | 4.7                                              | %          | 4.5                                             | %          | 4.7 | % | 4.5 | % |
| Expected dividend yield  |       | 0                                                | %          | 0                                               | %          | 0 | % | 0 | % |
| Expected forfeiture rate |       | 14                                               | %          | 20                                              | %          | 14 | % | 20 | % |
| Fair value               |       | $                                                | 3.51       |                                            | $          | 2.75 |   | $ | 3.56 |   | $ | 2.88 |   |
|                          |            |                                                  |            |                                                 |            |  |  |  |  |  |  |  |  |

 

***The Company also recognizes stock-based compensation inconnection with its 1999 Employee Stock Purchase Plan.  The plan allowed employees to purchase sharesof Digimarc common stock through payroll deductions of up to 15% of their basecompensation during each six-month plan period, up to a maximum deduction of$5,312.50 for each plan period.  Planperiods were generally from December 1 to May 31 and from June 1 to November30.  The price an employee paid for theshares was 85% of the lower of (i) the fair market value of Digimarc commonstock at the beginning of the plan period or (ii) the fair market value atthe end of the plan period.  Employeespurchased 52,957 shares under the plan during the three- and nine-month periodsended September 30, 2006 and purchased 32,491 shares under the plan during thethree- and nine-month periods ended September 30, 2005.  The plan was suspended effective June 1,2006.  An amended plan was reinstatedeffective November 2, 2006.***

***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- and nine-months ended September 30, 2006, which was incurred asfollows (in thousands):

| ** **                             | ** ** | **Three Months  Ended  September 30, 2006** | ** ** | **Nine Months  Ended  September 30, 2006** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Stock-based compensation:              |       |                                                       |       |                                                      |       |   |   |   |   |
| Cost of revenue                        |       |                                                       | $          | 76                                                        |       |   |   | $ | 214 |   |   |
| Sales and marketing                    |       |                                                       | 117        |                                                      |       |   | 373 |   |   |
| Research, development and  engineering |       |                                                       | 71         |                                                      |       |   | 261 |   |   |
| General and administrative             |       |                                                       | 434        |                                                      |       |   | 1,408 |   |   |
| Intellectual property                  |       |                                                       | 9          |                                                      |       |   | 27 |   |   |
| Total stock-based compensation         |       |                                                       | $          | 707                                                       |       |   |   | $ | 2,283 |   |   |

 

At September 30, 2006, the Company had 1.6 million non-vestedstock options that had a weighted average grant date price of $6.31. As of September 30,2006, the Company had $7.1 million of total unrecognized compensation costrelated to non-vested stock-based awards granted under all equity compensationplans, including options, restricted stock, and employee stock purchase plan.Total unrecognized compensation cost will be adjusted for any future changes inestimated forfeitures. The Company expects to recognize this cost over aweighted average period of 1.66 years.

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The following tablepresents the impact of the Company’s adoption of SFAS 123(R) on selectedline items from its condensed consolidated financial statements for the three-and nine-month periods ended September 30, 2006 (in thousands, except pershare amounts):

| ** **                                       | ** ** | **Three Months  Ended  September 30, 2006** | ** ** | **Nine Months  Ended  September 30, 2006** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                       | ** ** | **As  Reported**Following  FAS 123 (R)           | ** ** | **If  Reported**Following  APB 25                    | ** ** | **As  Reported**Following  FAS 123 (R) | ** ** | **If  Reported**Following  APB 25 | ** ** |
| Condensed consolidated statement of operations:  |       |                                                       |       |                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Operating income (loss)                          |       |                                                       | $          | (265                                                      | )          |   |   | $ | 212 |   |   |   | $ | (11,908 | ) |   | $ | (10,262 | ) |
| Income (loss) before  provision for income taxes |       |                                                       | 271        |                                                      |       |   | 748 |   |   |   | (10,707 | ) |   | (9,061 | ) |
| Net income (loss)                                |       |                                                       | 213        |                                                      |       |   | 690 |   |   |   | (10,828 | ) |   | (9,182 | ) |
| Net income (loss) per  share                     |       |                                                       |       |                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                            |       |                                                       | 0.01       |                                                      |       |   | 0.03 |   |   |   | (0.52 | ) |   | (0.44 | ) |
| Diluted                                          |       |                                                       | 0.01       |                                                      |       |   | 0.03 |   |   |   | (0.52 | ) |   | (0.44 | ) |
|                                                  |            |                                                            |            |                                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Stock Option Activity***

As of September 30, 2006, under all of the Company’s stock-basedcompensation plans, options to purchase an aggregate of 7.2 million shareswere outstanding, and options to purchase an additional 3.7 million shareswere authorized for future grants under the plans. The Company issues newshares for option exercises.

Options granted,exercised, canceled and expired under the Company’s stock option plans aresummarized as follows:

| ** **                                                     | ** ** | **Options** | ** ** | **Weighted**AverageExercisePrice | ** ** | **Weighted**AverageRemaining  ContractualLife | ** ** |
|----------------------------------------------------------------|------------|-------------|------------|----------------------------------|------------|-----------------------------------------------|------------|
| **Three-months ended September 30, 2006:** | ** ** | ** **  | ** ** | ** **                       | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Outstanding at June 30, 2006                              |       | 7,297,550   |       |                             | $          | 13.82                                         |       |   |   |   |
| Options granted                                                |       | 218,575     |       |                             | 6.32       |                                          |       |   |   |
| Options exercised                                              |       | (13,783     | )          |                             | 4.19       |                                          |       |   |   |
| Options canceled                                               |       | (302,118    | )          |                             | 13.15      |                                          |       |   |   |
| Options expired                                                |       | —      |       |                             | —     |                                          |       |   |   |
| Outstanding at September 30, 2006                         |       | 7,200,224   |       |                             | $          | 13.64                                         |       |   | 6.64 years |   |
| Exercisable at September 30, 2006                         |       | 5,573,319   |       |                             | $          | 15.78                                         |       |   | 5.90 years |   |
|                                                                |            |             |            |                                  |            |                                               |            |  |  |  |  |  |

 

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| ** **                                                    | ** ** | **Options** | ** ** | **Weighted**AverageExercisePrice | ** ** | **Weighted**AverageRemaining  ContractualLife | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|----------------------------------|------------|-----------------------------------------------|------------|
| **Nine-months ended September 30, 2006:** | ** ** | ** **  | ** ** | ** **                       | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Outstanding at December 31, 2005                         |       | 7,368,636   |       |                             | $          | 14.74                                         |       |   |   |   |
| Options granted                                               |       | 1,189,435   |       |                             | 6.41       |                                          |       |   |   |
| Options exercised                                             |       | (19,562     | )          |                             | 3.75       |                                          |       |   |   |
| Options canceled                                              |       | (1,338,285  | )          |                             | 13.42      |                                          |       |   |   |
| Options expired                                               |       | —      |       |                             | —     |                                          |       |   |   |
| Outstanding at September 30, 2006                        |       | 7,200,224   |       |                             | $          | 13.64                                         |       |   | 6.64 years |   |
| Exercisable at September 30, 2006                        |       | 5,573,319   |       |                             | $          | 15.78                                         |       |   | 5.90 years |   |
|                                                               |            |             |            |                                  |            |                                               |            |  |  |  |  |  |

 

The following tablesummarizes information about stock options outstanding at September 30,2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number**Outstanding        | ** ** | **Remaining**Contractual Life  (Years) | ** ** | **Weighted**AveragePrice | ** ** | **Number**Exercisable | ** ** | **Weighted**AveragePrice | ** ** |
| $ 0.50 - $ 6.15         |       |                         | 1,393,077  |                         |       |   | 8.23 |   |   |   | $ | 5.41 |   |   | 510,099 |   |   | $ | 4.48 |   |   |
| $ 6.17 - $ 9.85         |       |                         | 1,232,401  |                         |       |   | 8.75 |   |   |   | $ | 7.38 |   |   | 488,474 |   |   | $ | 8.37 |   |   |
| $10.29 - $12.25                   |       |                         | 712,937    |                         |       |   | 7.25 |   |   |   | $ | 11.60 |   |   | 712,937 |   |   | $ | 11.60 |   |   |
| $12.40 - $13.25                   |       |                         | 602,743    |                         |       |   | 6.31 |   |   |   | $ | 12.82 |   |   | 602,743 |   |   | $ | 12.82 |   |   |
| $13.38 - $14.13                   |       |                         | 792,000    |                         |       |   | 4.42 |   |   |   | $ | 14.07 |   |   | 792,000 |   |   | $ | 14.07 |   |   |
| $14.40 - $15.24                   |       |                         | 596,975    |                         |       |   | 6.22 |   |   |   | $ | 15.10 |   |   | 596,975 |   |   | $ | 15.10 |   |   |
| $15.25 - $17.00                   |       |                         | 733,597    |                         |       |   | 6.16 |   |   |   | $ | 16.23 |   |   | 733,597 |   |   | $ | 16.23 |   |   |
| $17.60 - $26.25                   |       |                         | 762,244    |                         |       |   | 4.66 |   |   |   | $ | 21.01 |   |   | 762,244 |   |   | $ | 21.01 |   |   |
| $27.50 - $35.13                   |       |                         | 119,250    |                         |       |   | 3.61 |   |   |   | $ | 31.35 |   |   | 119,250 |   |   | $ | 31.35 |   |   |
| $53.94 - $53.94                   |       |                         | 255,000    |                         |       |   | 3.34 |   |   |   | $ | 53.94 |   |   | 255,000 |   |   | $ | 53.94 |   |   |
| $ 0.50 - $53.94              |       |                         | 7,200,224  |                         |       |   | 6.64 |   |   |   | $ | 13.64 |   |   | 5,573,319 |   |   | $ | 15.78 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Pro Forma Information Under SFAS 123 and APB25***

Prior to the fiscalyear ending December 31, 2006, the Company accounted for stock-basedcompensation plans using the intrinsic value method prescribed in APB 25 andrelated interpretations. No stock-based compensation related to option grantsor the employee stock purchase plan was reflected in net loss in the three- andnine-months ended September 30, 2005, as all stock options granted under thoseplans had an exercise price equal to or greater than the market value of theunderlying common stock on the date of grant. Had compensation cost for theplans been determined based on the fair value at the grant dates for awardsunder those plans consistent with the method of SFAS 123, the Company’s netloss and basic and diluted net loss per share for the three- and nine-monthperiods ended September 30, 2005 would have been changed to the pro formaamounts indicated below (in thousands, except for per share data):

| ** **                                                                                                             | ** ** | **Three Months  Ended  September 30, 2005** | ** ** | **Nine Months  Ended  September 30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net loss, as  reported                                                                                                 |       |                                                       | $          | (4,228                                                    | )          |   |   | $ | (15,565 | ) |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                     |       |                                                       | 153        |                                                      |       |   | 355 |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards |       |                                                       | (1,280     | )                                                         |       |   | (4,790 | ) |   |
| Pro forma net  loss                                                                                                    |       |                                                       | $          | (5,355                                                    | )          |   |   | $ | (20,000 | ) |   |
| *Earnings per share:*                                                                                                  |       |                                                       |       |                                                      |       |   |   |   |   |
| Basic—as reported                                                                                                 |       |                                                       | $          | (0.21                                                     | )          |   |   | $ | (0.76 | ) |   |
| Diluted—as  reported                                                                                              |       |                                                       | $          | (0.21                                                     | )          |   |   | $ | (0.76 | ) |   |
| Basic—pro forma                                                                                                   |       |                                                       | $          | (0.26                                                     | )          |   |   | $ | (0.98 | ) |   |
| Diluted—pro forma                                                                                                 |       |                                                       | $          | (0.26                                                     | )          |   |   | $ | (0.98 | ) |   |

 

On December 15, 2005,the Board of Directors of the Company approved the acceleration of vesting ofthe Company’s outstanding stock options with option exercise prices equal to orgreater than $9.00. The acceleration applied to all options outstanding as of December 31,2005 under the Company’s Restated 1999 Stock Incentive Plan and 2000Non-Officer Employee Stock Incentive Plan, except for options held by membersof the Company’s Board of Directors. Options to purchase 422,248 shares of theCompany’s common stock, or 6% of the Company’s total outstanding options, witha weighted average exercise price of $11.51 and varying remaining vestingschedules, were subject to this acceleration and became immediately vested andexercisable as of December 31, 2005. Of these 422,248 options, 120,972options are held by the Company’s executive officers.

On December 21, 2004,the Audit, Compensation and Corporate Governance Committees of the Board ofDirectors of the Company approved the acceleration of vesting of the Company’soutstanding stock options with option exercise prices greater than $15.00. Theacceleration applied to all options outstanding under the Company’s Restated1999 Stock Incentive Plan and 2000 Non-Officer Employee Stock Incentive Planthat would not have otherwise vested in full by June 30, 2005 inaccordance with their terms. The effective date of the vesting acceleration wasDecember 31, 2004. Options to purchase 310,057 shares of the Company’scommon stock, or 5% of the total number of options of the Company outstandingas of December 31, 2004 with remaining vesting schedules, wereaccelerated. Of these 310,057 options, approximately 50,000 options wereheld by the Company’s executive officers. No additional compensation expensewas recorded in the statement of operations as the options that wereaccelerated had an exercise price greater than the fair market value of the sharesunderlying the options on the date of the modification.

As a result of theseaccelerations, the Company reduced its exposure to the effects of SFAS 123(R).

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**4.**                 SegmentInformation

The Company derives its revenue from a singlereporting segment, secure identity and media management. Revenue is generatedin this reporting segment through licensing and subscription of its variousproducts and the delivery of contracted and consulting services related tothese products. The Company markets its products in the U.S. and in othercountries through its sales personnel and its subsidiaries.

Revenueby geography is as follows:

| ** **    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Domestic      |       | $                                                    | 22,508     |                                                | $          | 21,273 |   | $ | 63,815 |   | $ | 61,342 |   |
| International |       | 4,225                                                |       | 5,508                                               |       | 15,018 |   | 14,571 |   |
| Total         |       | $                                                    | 26,733     |                                                | $          | 26,781 |   | $ | 78,833 |   | $ | 75,913 |   |

 

There was no customer inthe three- and nine-month periods ended September 30, 2006 or 2005 thataccounted for more than 10% of total revenue. There was no customer thataccounted for more than 10% of trade and unbilled accounts receivable, net at September 30,2006. There was one customer who accounted for 11% of trade and unbilledaccounts receivable, net at December 31, 2005.

**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 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. Plaintiffshave filed a notice of appeal. Due to the inherent uncertainties of litigation,the Company 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 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 Boardcommittee, after completing its investigation, concluded that pursuit of theallegations would not be in the best interests of Digimarc or its shareholders.On August 24, 2006, the court granted defendants’ motion and dismissed thelawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22,2006

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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 to disclosecertain alleged compensation arrangements (such as undisclosed commissions orstock stabilization practices) in the Company’s initial public offeringregistration 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 dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),however, were dismissed. In June 2003, a committee of the Company’s boardof directors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval. The settlement would provide,among other things, a release of the Company and of the individual defendantsfor the conduct alleged in the amended complaint to be wrongful. The Companywould agree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. On August 31, 2005, the courtissued a preliminary order further approving the modifications to thesettlement and certifying the settlement classes. The court also appointed theNotice Administrator for the settlement and ordered that notice of thesettlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearingwas held on April 26, 2006, but the court has not yet rendered itsdecision. If the court determines that the settlement is fair to the classmembers, the settlement will be approved. There can be no assurance that thisproposed settlement will be approved and implemented in its current form, or atall. Due to the inherent uncertainties of litigation and because the settlementapproval process is at a preliminary stage, the Company cannot accuratelypredict the ultimate outcome of the matter.

The Company from time to time experiences delays inidentification system implementation, timely acceptance for identificationsystems programs, concerns regarding identification system program performance,and other contractual disputes. Customers have asserted, and may in the future assert, compensatory orliquidated damages, breach of contract, or other claims alleging that theCompany has failed to meet timing or other delivery requirements and milestonespursuant to the terms of such contracts. From time to time, customershave given notice of their intention to assert claims for liquidated damages.Management believes that these assertions are often part of the resolutionprocess involving commercial disagreements over the terms of these contracts.Such disputes are not uncommon and tend to be resolved over time. However, the Company’s failure to meetcontractual milestones or other performance requirements as promised, or tosuccessfully resolve customer disputes, could result in the Company incurringliability for damages, as well as increased costs, lower margins, orcompensatory obligations in addition to other losses, such as harm to itsreputation. Such circumstances could have a 

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material adverse effect on the Company’s business and financialresults. The Company anticipates that future contracts will continue to havesuch provisions unless and until industry practices change.

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 subjectfrom time to time to other legal proceedings and claims arising in the ordinarycourse of business.Although the ultimate outcome of these matters cannot be determined, managementbelieves that, as of September 30, 2006, the final disposition of theseproceedings will not have a material adverse effect on the consolidatedfinancial position, results of operations, or liquidity of the Company. Noaccrual has been recorded because the amounts are not probable or reasonablyestimatable in accordance with SFAS No. 5, *Accountingfor Contingencies*.

**6.**                 Recent AccountingPronouncements

In March 2006, the FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets, anamendment of SFAS No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities*. The statementchanges the way entities account for servicing assets and obligationsassociated with financial assets acquired or disposed of. SFAS No. 156 iseffective for the first fiscal year beginning after September 15, 2006.The Company does not expect the adoption of this standard to have a materialeffect on the Company’s financial statements.

In July 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,which defines the threshold for recognizing the benefits of tax returnpositions in the financial statements as “more-likely-than-not” to be sustainedby the taxing authority. Interpretation No. 48 applies to all taxpositions accounted for under SFAS No. 109, *Accountingfor Income Taxes*. Interpretation No. 48 is effective as of thebeginning of the first fiscal year beginning after December 15, 2006. Uponadoption, the Company will adjust the financial statements if needed to reflectonly those tax positions that are more-likely-than-not to be sustained asof the adoption date. Any adjustment will be recorded directly to our beginningretained earnings balance in the period of adoption and reported as a change inaccounting principle. The Company is currently analyzing the effects ofadopting Interpretation No. 48.

In September 2006,the SEC issued SAB 108, *Considering the Effects ofPrior Year Misstatements When Quantifying Misstatements in Current YearFinancial Statements*. The bulletin provides interpretive guidance onhow to consider the effects of carryovers or reversals of prior yearmisstatements in quantifying a current year misstatement. SAB 108 is effectivefor the first fiscal year ending after November 15, 2006. The Company doesnot expect the adoption of this interpretive bulletin to have a material effecton the Company’s financial statements.

**7.**                 RevenueRecognition

Revenue from the Company’s government-issuedcredential systems is generally billed and recognized on a per card producedbasis. The Company recognizes revenue on these contracts based on the actualmonthly production, if available, and in limited situations on estimated volumeinformation. When actual production information becomes available, typicallywithin one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Differences to date have not been significant. Revenue earned which has notbeen invoiced at the end of each reporting period, but is generally billed withinthe first two weeks of the following period, is classified as unbilled tradereceivables in the consolidated balance sheets. Revenue related to anenhancement of or upgrade to an existing system is deferred and recognized overthe remaining life of the contract.

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Revenue for sales of consumables and equipment notrelated to a driver license production contract is recognized when the productshave been shipped, ownership has been transferred, evidence of an arrangementexists, the sales price is fixed and determinable, and collectibility isreasonably assured.

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. Progress towards completion is measured using costs incurredcompared to the budgeted amounts contained in the contract. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the consolidated balancesheets.

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

Maintenance revenue is recognized when the maintenanceamounts owed to the Company have been earned, are determinable, and collectionis probable. Maintenance contracts are, at times, paid in advance and revenueis recognized ratably over the term of the service period.

Deferred revenue consists of payments received inadvance for professional services, subscriptions and hardware for which revenuehas not been earned.

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorizedduplication or alteration of high-value documents, for use in communicatingcopyright, asset management and business-to-business image commerce solutions,and for use in connecting analog media to a digital environment. Softwarerevenue is recognized in accordance with 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.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence exists only for undelivered elements. Under the residualmethod, revenue is recognized as follows: (1) the total fair value of undeliveredelements, as indicated by vendor specific objective evidence, is deferred andsubsequently recognized in accordance with the relevant sections of AICPA SOP No. 97-2,and (2) the difference between the total arrangement fee and the amountdeferred for the undelivered elements is recognized as revenue related to thedelivered elements.

Certain customerarrangements encompass multiple deliverables, such as hardware sales,consumables sales, maintenance fees, and software development fees. The Companyaccounts for these arrangements in accordance with Emerging Issues Task ForceIssue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If the deliverables meet the criteria inEITF Issue No. 00-21, the deliverables are divided into separate unitsof accounting and revenue is allocated to the deliverables based on theirrelative fair values. The criteria specified in EITF Issue No. 00-21are as follows (i) the delivered item has value to the customer on astand-alone basis, (ii) there is objective and reliable evidence of thefair value of the undelivered item, and (iii) if the arrangement includesa general right of return relative to the delivered item, delivery orperformance of the undelivered item is considered probable and substantially inthe control of the vendor. For our purposes, fair value is generally defined asthe price at which a customer could purchase each of the elements independentlyfrom other vendors or as the price that the Company has sold the elementseparately to another customer. Applicable revenue recognition criteria isconsidered separately for each separate unit of accounting. Management appliesjudgment to ensure appropriate 

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applicationof EITF Issue 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.

**8.**                 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).

| ** **                             | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Equipment and  deferred contract costs |       |                         | $          | 911                         |       |   |   | $ | 899 |   |   |
| Consumable  materials                  |       |                         | 5,105      |                        |       |   | 6,552 |   |   |
| Inventory, net                         |       |                         | $          | 6,016                       |       |   |   | $ | 7,451 |   |   |

 

The reserve for slowmoving and obsolete items was $240 at both September 30, 2006 and December 31,2005, respectively. While the Company does not currently expect to be able tosell or otherwise use the reserved inventory on hand based upon our forecast andbacklog, it is possible that a customer or customers will decide in the futureto purchase a portion of the reserved inventory.

**9.**                 SoftwareDevelopment Costs

Under Statement of Financial Accounting Standards (“SFAS”)No. 86, *Accounting for the Cost of ComputerSoftware to Be Sold, Leased, or Otherwise Marketed,*softwaredevelopment costs are to be capitalized beginning when a product’stechnological feasibility has been established and ending when a product ismade available for general release to customers. To date, the establishment oftechnological feasibility of the Company’s products has occurred shortly beforegeneral release and, therefore, software development costs qualifying forcapitalization have been immaterial. Accordingly, the Company has notcapitalized any software development costs and has charged all such costs toresearch and development expense.

Internal use softwaredevelopment costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*. Costs incurred in thepreliminary project stage are expensed as incurred and costs incurred in theapplication development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. Costs incurred in thepost-implementation stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to card manufacturingand control systems software.

**10.**          Related PartyTransactions

During the three- andnine-month periods ended September 30, 2006, the Company recognizedrevenue of $168 and $413, respectively, from a holder of common stock pursuantto a license agreement. In addition, the Company recognized revenue of $108 and$363 for the three- and nine-month periods ended September 30, 2005,respectively, from this stockholder. Net accounts receivable from thisstockholder was $88 at September 30, 2006 and $231 at December 31,2005.

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**11.**          Quarterly SelectedFinancial Information—Unaudited

Thefollowing table shows the quarterly reported numbers. The 2006 numbers areconsistent with the 2005 reclassification of certain costs related toamortization of intangibles, intellectual property, infrastructure andcentralized costs.

| **Quarter ended:**                   | ** ** | ** ** | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-------------------------------------------|------------|------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| ***2006***                                |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 27,193            |       |             | $          | 24,907                |       |                 | $          | 26,733 |   |   |   |   |   |   |
| Total cost of  revenue                    |       |       | 19,648     |              |       | 16,677           |       |                  | 16,719     |                 |       |   |   |   |   |
| Sales and  marketing                      |       |       | 4,539      |              |       | 4,685            |       |                  | 3,440      |                 |       |   |   |   |   |
| Research,  development and engineering    |       |       | 3,236      |              |       | 2,994            |       |                  | 2,158      |                 |       |   |   |   |   |
| General and  administrative               |       |       | 5,210      |              |       | 4,172            |       |                  | 3,684      |                 |       |   |   |   |   |
| Amortization of  intangibles              |       |       | 573        |              |       | 550              |       |                  | 537        |                 |       |   |   |   |   |
| Intllectual  property                     |       |       | 431        |              |       | 481              |       |                  | 460        |                 |       |   |   |   |   |
| Restructuring  charges, net               |       |       | —     |              |       | 547              |       |                  | —     |                 |       |   |   |   |   |
| Operating income  (loss)                  |       |       | (6,444     | )                 |       | (5,199           | )          |                  | (265       | )                    |       |   |   |   |   |
| Net income (loss)                         |       |       | (6,172     | )                 |       | (4,869           | )          |                  | 213        |                 |       |   |   |   |   |
| Net income (loss)  per share—basic   |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   |   |   |   |
| Net income (loss)  per share—diluted |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   |   |   |   |
| ***2005***                                |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 24,379            |       |             | $          | 24,753                |       |                 | $          | 26,781 |   |   |   | $ | 25,140 |   |   |
| Total cost of  revenue                    |       |       | 16,077     |              |       | 16,560           |       |                  | 17,043     |                 |       |   | 18,492 |   |   |
| Sales and  marketing                      |       |       | 3,777      |              |       | 3,889            |       |                  | 4,295      |                 |       |   | 3,816 |   |   |
| Research,  development and engineering    |       |       | 2,908      |              |       | 3,428            |       |                  | 3,199      |                 |       |   | 3,596 |   |   |
| General and  administrative               |       |       | 5,497      |              |       | 5,521            |       |                  | 4,852      |                 |       |   | 5,654 |   |   |
| Amortization of  intangibles              |       |       | 811        |              |       | 1,339            |       |                  | 1,147      |                 |       |   | 738 |   |   |
| Intllectual  property                     |       |       | 536        |              |       | 467              |       |                  | 528        |                 |       |   | 483 |   |   |
| Operating income  (loss)                  |       |       | (5,227     | )                 |       | (6,451           | )          |                  | (4,283     | )                    |       |   | (7,639 | ) |   |
| Net income (loss)                         |       |       | (5,120     | )                 |       | (6,217           | )          |                  | (4,228     | )                    |       |   | (7,532 | ) |   |
| Net income (loss)  per share—basic   |       |       | (0.25      | )                 |       | (0.30            | )          |                  | (0.21      | )                    |       |   | (0.37 | ) |   |
| Net income (loss) per  share—diluted |       |       | (0.25      | )                 |       | (0.30            | )          |                  | (0.21      | )                    |       |   | (0.37 | ) |   |
|                                           |            |            |            |                   |            |                  |            |                       |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

 

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**Item 2.**                        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 under the caption “FactorsAffecting Forward-Looking Statements” in this Form 10-Q and under thecaption “Risk Factors” and in the audited consolidated financial statements andrelated notes included in our Annual Report on Form 10-K forthe year ended December 31, 2005 filed on March 13, 2006, and otherreports and filings made with the SEC.*

**Overview**

Digimarc Corporation (“Digimarc,” “the Company,” “our”or “we”) is a leading supplier of secure identity solutions and advancedtechnologies for use in media management. Our solutions enable governments andbusinesses around the world to deter counterfeiting and piracy, enhance trafficsafety and national security, combat identity theft and fraud, facilitate theeffectiveness of voter identification programs, improve the management of mediacontent, and support new digital media distribution models that provideconsumers with more choice and access to media content.

The Company issues more than 60 million identificationdocuments (“IDs”) annually and is the leading supplier of government-issuedcitizen IDs in the United States, producing more than two-thirds of all driverlicenses issued in the U.S.

We are also a pioneer and leading owner ofintellectual property in a signal processing technology innovation known as “digitalwatermarking”, which allowsimperceptible digital information to be embedded in all forms of digitallydesigned, produced or distributed media content, including personalidentification documents, financial instruments, photographs, movies, music andproduct packages. The embedded data within various types of media content canbe detected and read by software or hardware detectors in personal computersand other digital devices.

Digital watermarking is a strategic component ofnearly all of our product offerings. We provide solutions based on thistechnology directly and through our licensees. Digital watermarking has alreadyproven to be a powerful differentiator in banknote security, giving rise to along-term relationship with leading Central Banks and many leadingcompanies in the IT industry. We are working to develop a similar success insecure identity management systems. We anticipate that more than one in threedriver licenses issued in the U.S. in 2006 will carry digital watermarks as ameans to provide cross-jurisdictional machine authentication. In addition,Digimarc and its licensees have successfully propagated digital watermarking inmusic, movies, television and radio broadcasts, images and printed materials.Digital watermarks have been used in these applications to provide improvedmedia rights and asset management, reduced piracy and counterfeiting losses,improve marketing programs, and more efficient and effective distribution ofvaluable media content.

The majority of ourrevenue is derived from supplying infrastructure to government agenciespursuant to long-term contracts, primarily State driver license issuers, aconsortium of leading Central Banks and national governments of various foreigncountries. Theindustry model for the U.S. driver license market is characterized by long-termcontracts awarded through competitive bids to prime contractors who take fullresponsibility for delivery and maintenance of driver license issuance systems.The remainder of our 

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revenueis generated through commercial applications of our digital watermarking andrelated technologies, primarily from patent and technology license fees paid bybusiness partners. Our licensing business is built upon our extensive patentportfolio, which contains 286 issued U.S. patents as of September 30,2006. We expect that patent licensing will continue to contribute most of ourrevenues from non-government customers for the foreseeable future.

**Markets**

***Government***

We believe that the U.S. driver license market willcontinue to grow due to broadening use of the driver license as a securecredential beyond its traditional role as evidence of competence to drive amotor vehicle; technological innovation; desire among issuers to improvesecurity and efficiency; and new governmental regulations such as the REAL IDAct. Weanticipate that these regulations will result in more opportunities for Statesto expand their existing driver license systems using Federal dollars. However,funding under the REAL ID Act, as well as guidance on future regulations thatwill more specifically define the requirements for compliance, have not beenprovided as quickly as we anticipated. We cannot predict the full extent towhich we will benefit from funding under the REAL ID Act until the Departmentof Homeland Security provides such guidance. These future regulations mayimpose certain requirements, such as specific card architectures or securityfeatures, and may condition funding upon compliance with such requirements. Inaddition, the conditions foravailability of grant money from the Department of Homeland Security and theDepartment of Transportation for projects relating to compliance with the REALID Act, commercial driver license systems, and protection of the Homeland maycause some changes in the procurement model, but we cannot predict thelikelihood or outcome of those changes at this time.

We believe that many aspects of our driver license issuancesolutions have value in other forms of credentials and secure personalidentification systems. As the global market for secure personal identificationsolutions develops, we believe that our position as the leading supplier ofgovernment-issued citizen IDs in North America and our extensive investments inresearch and development provide a good foundation for participation in theglobal market for government programs in establishing the identities ofcitizens and issuing associated credentials.

***Media &Entertainment***

Our technology is used invarious products and solutions affecting a variety of media objects, frommovies and music, to banknotes and secure credentials. Each media objectenabled by our technology creates the potential for several applications, suchas counterfeiting and piracy deterrence, media identification and management,authentication, monitoring, or linking to networks and enhanced services insupport of mobile commerce. We believe the market for digital watermarking applicationsis in the early stages of development and that existing solutions representonly a small portion of the potential market for our products, services, andtechnologies. However, we cannot, as of the date of this report, providereliable estimates of the size of these potential markets or predict the extentto which these markets will provide opportunities for revenue growth.

**Products andServices**

***Financial Document Security***

Wehave a multi-year contract with an international consortium of Central Banks inwhich we have developed, deployed, and are supporting and continuing to enhancea system to deter digital counterfeiting of currency using personal computersand digital reprographics. Work on the system began in 1997. Details of thesystem are confidential for security reasons.

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***Secure ID Solutions***

As the leading provider of government-issued secureIDs in North America, our systems produce more than 60 million driver licensesand other secure personal IDs per year. Two-thirds of the U.S. States andmany foreign governments, including Russia, Latvia, Mexico, and Canada, useDigimarc secure ID solutions to issue credentials to citizens.**In North America, we are generally a prime contractor,providing full issuance systems to Federal, State, and Provincial departmentsof motor vehicles or other government issuing authorities. Our North American driverlicense issuance systems vary from jurisdiction to jurisdiction. These systemsare typically provided pursuant to long-term (normally five or more years) contracts.The systems provided include hardware, software, consumable supplies (such as ribbons,blank or preprinted card materials, and laminates), and on-going supportnecessary for a “turnkey” solution. They typically involve custom softwareand/or hardware development, integration services, and implementation services.When we provide a full issuance system to a customer, we generally retain titleto all assets associated with the system and are responsible for maintainingthe system over the contractual period. A digital driver license issuancesystem typically captures images (photo and signature) and demographicinformation, validates applicant identity, produces the actual driver licenseor ID (either at the point of service or at a central production facilityoperated by us), provides or delivers the finished driver license or other IDto the individual licensee, stores the images and associated data in adatabase, and communicates with the issuer’s other systems for completion ofprocessing of the driver license applicants.

We are working on broadening our security offerings toprovide more integrated identity verification and fraud detection capabilitieswithin the issuance workflow of our customers. Many aspects of our solutionsanticipate both the mandate of the REAL ID Act and the emerging consensus onbest practices consistent with our product and service strategy. In 2005, we introduced the Digimarc IdentityValidation Suite (“IDVS”) to validate identity documents and verify thebiometric and demographic data presented to establish an applicant’s identity.As identity credentials become more secure and difficult to counterfeit,counterfeiters turn to producing false breeder documents to fuel attempts tofraudulently obtain valid secure credentials. Thus, the process of validatingidentity is becoming central to secure ID issuance as document qualityimproves, ensuring that only valid applicants receive genuine IDs. This marketdevelopment is underscored by the focus of the REAL ID Act on identity validation.IDVS is our most strategic product offering in 2006, serving a growing demandby our customers for effective multi-factor identification of applicants.

Inthe third quarter of 2006, we introduced two new products—our DigimarcBiometric Identification solution and Digimarc Document Inspector. The DigimarcBiometric Identification solution enables the comparison of driver licenseapplicant portraits against a driver license issuing agency’s image database touncover possible fraudulent duplicates—and to help ensure that driver licensesare only issued to legitimate applicants. Digimarc Document Inspector is asoftware application that works with a variety of scanning devices tofacilitate the inspection of driver licenses and other government-issuedcitizen IDs. This product can be used by driver license and ID issuers, lawenforcement, the Transportation Security Administration (part of the U.S.Department of Homeland Security), border crossing agents, retailers and othersto enable reliable authentication of driver licenses and IDs.

***Media andEntertainment***

We license ourtechnology and patents and otherwise foster development of the market fordigital watermarking-based solutions for commercial as well as governmentaluses. These licenses primarily involve use of our technology and patents in themedia and entertainment area. Commercial customers use secure media solutionsfrom our business partners and us to identify, track, manage and protectcontent as it is distributed and consumed—either digitally or physically—and toenable new consumer applications to access networks and information from PCsand mobile devices. Many movie studios, record labels, 

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broadcasters,creative professionals and other customers rely on digital watermarking as acost-effective means to:

·       deter piracy and illegaluse of movies, music and images;

·       protect entertainmentcontent from copyright infringement;

·       track and monitorentertainment content for rights usage and licensing compliance;

·       monitor advertisements toverify ad placement and measure return on investment; and

·       enable fair and legitimateuse of content by consumers.

Our business partnersinclude Activated Content Corporation, AquaMobile, Cinea, Inc., asubsidiary of Dolby Laboratories, Inc., GCS Research LLC, MediaGrid,Mobile Data Systems, Inc., Nielsen Media Research, Inc., RoyalPhilips, Signum Technologies Limited, Thomson Multimedia, S.A., VeranceCorporation, Verimatrix, Inc. and VCP (an affiliate of VEIL InteractiveTechnologies).

***AdditionalInformation***

A more detailed discussionof our business is contained in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2005 and in our Quarterly Report on Form 10-Qfor the quarter ended March 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 to stock-basedcompensation calculations. We base our estimates on historical experience andon various other assumptions we believe to be reasonable under thecircumstances. Actual results may differ from these estimates under differentassumptions 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 inputsrelated to stock-based compensation calculations. We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our consolidated financial statements:

**Revenue recognition on long-term service contracts:****  **We recognize revenue on long-term identificationand driver license production contracts using primarily a price-per-cardmethod. We use actual monthly volume amounts, if available, or we estimate thecard production volume on a monthly basis for certain of these contracts inorder to recognize revenue earned during the period. In the case of estimates,when the actual production information becomes available, which is typicallywithin four weeks, we bill the customer accordingly and any differences from theestimates are recognized in the month the billing occurs. These amountsrepresent our best estimates of cards produced and are based on historicaltrends, known events during the period, and discussions with contractrepresentatives. Prior to publicly reporting results, our practice is tocompare 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 production informationis available and the billing occurs. Any estimation process involves inherentrisk. We 

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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 when the services are provided. Revenue earned whichhas not been invoiced is classified as unbilled trade receivables in theconsolidated balance sheets.

**Impairments and estimation of useful lives oflong-lived assets:****  **Weperiodically assess long-lived assets for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable, in accordance with the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal of Long-Lived Assets.* Thisstatement requires that long-lived assets and certain identifiable intangiblesbe reviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future net undiscounted cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Fair value is determined based ondiscounted cash flows or appraised values, depending on the nature of theasset. Also, we periodically review the useful lives of long-lived assetswhenever events or changes in circumstances indicate that the useful life mayhave changed. If the estimated useful lives of such assets do change, we adjustthe depreciation or amortization period to a shorter or longer period, based onthe circumstances identified.

**Inventory valuation:****  **Inventory consists primarily of consumablesupplies that are used in the production of driver licenses and products heldfor resale to customers. We value inventory at the lower of cost or marketvalue (which lower amount is the net realizable value). We reduce the value ofour inventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.

**Reserves for uncollectible accounts receivable:****  **We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. We determine the allowance based on historical write-off experienceand current information. We review, and adjust when appropriate, our allowancefor doubtful accounts on at least a quarterly basis. If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required.

**Contingencies andLitigation:**   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 

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contingency and providean estimate of the possible loss or range of loss, or state that such anestimate cannot be made.

**Stock-Based Compensation:**   On January 1, 2006, we adoptedSFAS 123(R), 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-basedawards. Our determination of the fair value of stock-based awards on thedate of grant using an option pricing model is affected by our stock price aswell as assumptions regarding a number of highly complex and subjectivevariables. These variables include, but are not limited, to the expected lifeof the award, 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), the Black-Scholes optionpricing model requires the input of highly subjective assumptions, and otherreasonable assumptions could provide differing results.

**Results ofOperations**

Thefollowing table presents our condensed consolidated statements of operationsdata for the periods indicated as a percentage of total revenue.

| ** **                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                         |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                 | 84         | %                                                   |       |   | 84 | % |   |   | 83 | % |   |   | 84 | % |   |
| Product and subscription                         |       |                                                 | 16         |                                                |       |   | 16 |   |   |   | 17 |   |   |   | 16 |   |   |
| Total revenue                                    |       |                                                 | 100        |                                                |       |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                 | 57         |                                                |       |   | 57 |   |   |   | 60 |   |   |   | 58 |   |   |
| Product and subscription                         |       |                                                 | 6          |                                                |       |   | 7 |   |   |   | 7 |   |   |   | 7 |   |   |
| Total cost of revenue                            |       |                                                 | 63         |                                                |       |   | 64 |   |   |   | 67 |   |   |   | 65 |   |   |
| Gross profit                                     |       |                                                 | 37         |                                                |       |   | 36 |   |   |   | 33 |   |   |   | 35 |   |   |
| Operating expenses:                              |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                                                 | 13         |                                                |       |   | 16 |   |   |   | 16 |   |   |   | 16 |   |   |
| Research, development and engineering            |       |                                                 | 8          |                                                |       |   | 12 |   |   |   | 11 |   |   |   | 13 |   |   |
| General and administrative                       |       |                                                 | 13         |                                                |       |   | 18 |   |   |   | 16 |   |   |   | 21 |   |   |
| Amortization of intangibles                      |       |                                                 | 2          |                                                |       |   | 4 |   |   |   | 2 |   |   |   | 4 |   |   |
| Intellectual property                            |       |                                                 | 2          |                                                |       |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |
| Restructuring charges, net                       |       |                                                 | 0          |                                                |       |   | 0 |   |   |   | 1 |   |   |   | 0 |   |   |
| Total operating expenses                         |       |                                                 | 38         |                                                |       |   | 52 |   |   |   | 48 |   |   |   | 56 |   |   |
| Operating income (loss)                          |       |                                                 | (1         | )                                                   |       |   | (16 | ) |   |   | (15 | ) |   |   | (21 | ) |   |
| Other income (expense):                          |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                  |       |                                                 | 1          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                 |       |                                                 | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Other                                            |       |                                                 | 1          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Total other income, net                          |       |                                                 | 2          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                                                 | 1          |                                                |       |   | (15 | ) |   |   | (14 | ) |   |   | (20 | ) |   |
| Provision for  income taxes                      |       |                                                 | 0          |                                                |       |   | (1 | ) |   |   | 0 |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                                                 | 1          | %                                                   |       |   | (16 | )% |   |   | (14 | )% |   |   | (20 | )% |   |

 

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During the last half of 2005 and continuing during2006, the Company initiated productivity improvement measures and began toreduce fixed costs in our efforts to achieve profitability. During the secondquarter of 2006 we accelerated those activities significantly, including areduction of our workforce by nearly 20% since the beginning of 2006. Overall,our workforce has been reduced by over 30% since the last half of 2005 and ouractions included the redeployment and reallocation of resources to align withour operating strategies. The discussion and analysis of our operationspresented below reflects the improvement in the operating results for thethree- and nine-month periods ended September 30, 2006 as compared to thecorresponding three- and nine-month periods ended September 30, 2005.

*Revenue*

| ** **                        | ** ** | **ThreeMonths  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Nine Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------|------------|------------------------|------------|--------------|------------|----------------|------------|-----------------------------|------------|--------------|------------|--------------|------------|
| ** **                        | ** ** | **September 30,** | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                        | ** ** | **2006**               | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**              | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue:                          |       |                   |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | $                      | 22,414     |         | $          | 22,372         |       |                        | $          | 42           |       |         |       | <1 | % |   | $ | 65,223 |   | $ | 63,584 |   |   | $ | 1,639 |   |   |   | 3 | % |   |
| Product and subscription          |       | 4,319                  |       | 4,409        |       |           | (90        | )                           |       |         | (2         | )%           |       | 13,610 |   | 12,329 |   |   | 1,281 |   |   |   | 10 | % |   |
| Total                             |       | $                      | 26,733     |         | $          | 26,781         |       |                        | $          | (48          | )          |         |       | <(1 | )% |   | $ | 78,833 |   | $ | 75,913 |   |   | $ | 2,920 |   |   |   | 4 | % |   |
| Revenue (as % of  total revenue): |       |                   |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | 84                     | %          | 84           | %          |           |       |                        |       |         |       |         |       | 83 | % | 84 | % |   |   |   |   |   |   |   |   |
| Product and subscription          |       | 16                     | %          | 16           | %          |           |       |                        |       |         |       |         |       | 17 | % | 16 | % |   |   |   |   |   |   |   |   |
| Total                             |       | 100                    | %          | 100          | %          |           |       |                        |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

*Service.*   Service revenue consists primarily ofcard production on a price-per-card basis, software development services, andhardware and software maintenance. The majority of service revenue arrangementsare typically structured as price-per-card product agreements, time andmaterials consulting agreements, or fixed price consulting agreements. Servicerevenue is an umbrella category consisting of both service revenue andcontract-based service revenue. The distinction between these two subcategoriesis that service revenue is generated from long-term identification and driverlicense production contracts, while contract-based service revenue is generatedfrom other time-and-materials service contracts.

Service revenue slightly increased for the three-monthperiod ended September 30, 2006 compared to the corresponding three-monthperiod ended September 30, 2005 primarily due to increased program workfrom the consortium of central banks, offset by decreased card issuance revenuefrom our Mexico voter identification program due to a slower than anticipatedramp up after the national elections. The increase in revenue for thenine-month period ended September 30, 2006 compared to the correspondingnine-month period ended September 30, 2005 resulted primarily fromincreased production for certain programs that reached full production in 2006including Florida, Alabama, Haiti and Latvia, offset by decreased revenue fromthe Mexico program.

In addition, we have observed seasonality in ourservice revenues, with larger revenues in the second and third quarter of theyear, and generally lower revenues in the first and fourth quarters. The fourthquarter is usually the seasonally lowest quarter each year. We expect ourservice revenue results in the fourth quarter of 2006 to be consistent withthis pattern of seasonality.

*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.

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Product and subscription revenue slightly decreasedfor the three-month period ended September 30, 2006 compared to thecorresponding three-month period ended September 30, 2005 primarily due toa product sale to an international customer in 2005, offset by increasedproduct sales to several State programs. The increase in revenue between thenine-month period ended September 30, 2006 and the correspondingnine-month period ended September 30, 2005 resulted primarily from theaddition of a large international program with Yemen, which was offset bydecreased domestic revenue due to lower product sales to certain domesticcustomers in 2006.

*Backlog.**  *Based on projected driver license production volumesand other commitments we have for the periods under contract with ourrespective customers, we anticipate our current contracts as of September 30,2006 will generate more than $255 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectapproximately $22 million of this amount to be recognized as revenue during theremainder of 2006. This amount includes production volumes reasonably expectedto be achieved under currently effective contracts, government orders that arefirm but not yet funded, and government contracts awarded but not yet signed.

Some factors thatlead to increased backlog are:

·       Competitive bid wins,

·       Renewals with currentcustomers,

·       Add-on sales to currentcustomers, and

·       Contracts with longercontractual periods replacing contracts with shorter contractual periods.

Some factors thatlead to decreased backlog are:

·       Recognition of revenueassociated with backlog currently in place,

·       Periods following low bidactivity,

·       Contracts with shortercontractual periods replacing contracts with longer contractual periods, and

·       The revenue model utilizedfor a particular customer (e.g., a “price-per-card” model with a largeassociated backlog vs. a “hardware and consumables” model with a smallassociated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period. For example,the three-month period ended September 30, 2006 had a high level of bidawards, and as a result we have increased our backlog during the quarter fromcompetitive bid wins. Over the next year or so, we anticipate several States torequest bids on their driver license issuance system programs. This period ofexpected high bid activity could lead to additional backlog if we aresuccessful with our bids. Another example is our variable revenue model. Fromtime to time we have sales to our customers that are not characteristic of ourprice-per-card model, but instead included hardware and consumable sales.Although these types of revenue models are positive growth indicators for ourbusiness, they can lead to lower reported backlog.

There can be no assurancethat our backlog will result in actual revenue in any particular period,because the orders, awards and contracts included in our backlog may be subjectto modification, cancellation or suspension. We may not realize revenue oncertain contracts, orders or awards included in our backlog or the timing ofsuch recognition may change.

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*Revenue by Geography*

| ** **                            | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Nine Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|---------------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|-----------------------------|------------|--------------|------------|--------------|------------|
| ** **                            | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                            | ** ** | **2006**                     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**              | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue by  geography:                |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                              |       | $                            | 22,508     |         | $          | 21,273         |       |                        | $          | 1,235        |       |         |       | 6 | % |   | $ | 63,815 |   | $ | 61,342 |   |   | $ | 2,473 |   |   |   | 4 | % |   |
| International                         |       | 4,225                        |       | 5,508        |       |           | (1,283     | )                           |       |         | (23        | )%           |       | 15,018 |   | 14,571 |   |   | 447 |   |   |   | 3 | % |   |
| Total                                 |       | $                            | 26,733     |         | $          | 26,781         |       |                        | $          | (48          | )          |         |       | <(1 | )% |   | $ | 78,833 |   | $ | 75,913 |   |   | $ | 2,920 |   |   |   | 4 | % |   |
| Revenue (as % of total revenue): |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                              |       | 84                           | %          | 79           | %          |           |       |                        |       |         |       |         |       | 81 | % | 81 | % |   |   |   |   |   |   |   |   |
| International                         |       | 16                           | %          | 21           | %          |           |       |                        |       |         |       |         |       | 19 | % | 19 | % |   |   |   |   |   |   |   |   |
| Total                                 |       | 100                          | %          | 100          | %          |           |       |                        |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

The increase in domestic revenue for the three-monthperiod ended September 30, 2006 as compared to the correspondingthree-month period ended September 30, 2005 resulted primarily from increasedproduct sales to various States. The increase in revenue for the nine-monthperiod ended September 30, 2006 as compared to the correspondingnine-month period ended September 30, 2005 was due primarily to increasedrevenue from the Florida and Alabama programs as they reached full productionlevels, offset by lower production revenues in certain States that occur fromtime to time.

The decrease in international revenue for thethree-month period ended September 30, 2006 compared to the correspondingthree-month period ended September 30, 2005 was due primarily to a slowerthan anticipated ramp up of our Mexico program after the national elections anda product sale to another international customer 2005. The increase ininternational revenue for the nine-month period ended September 30, 2006as compared to the corresponding nine-month period ended September 30,2005 was due primarily to increased revenue from Yemen, Haiti and Latviaprograms that were non-recurring in nature and were either delivered orachieved full production in early 2006, offset by reduced revenue from ourMexico program.

In non-U.S. markets, where we provide driver license,national identification, and voter identification systems, services, andcomponents in partnership with local card producers, security printers, systemintegrators, and others, we may serve as prime contractor or sub-contractor,depending on the circumstances. As a sub-contractor, we are responsible fordelivering hardware, software, or consumables to the prime contractor; and, asa prime contractor, we are responsible for integrating the components of thesystem to the customer’s specifications.

International sales havetypically taken the form of an outright sale of equipment and/or consumables tonon-U.S. government agencies or their prime contractors. These sales often canbe large, carry relatively low margins and may cause variations in quarterlyrevenue and gross profit trends. Despite the relatively low margins, we enterinto such contracts from time to time to maintain market presence and buildcustomer and partner relationships, as such programs often transition to moreprofitable digital technologies over time. Due to the nature of suchinternational programs and customers, the timing of these sales is lesspredictable than our service revenues provided by domestic customers and,consequently, international sales can occur unevenly during the course of ayear. We believe that international growth opportunities exist for us, and weexpect to continue to invest in personnel and resources to support ourpotential revenue growth outside of the U.S.

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*Cost of Revenue*

| ** **                                                  | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Nine Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-------------------------------------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|-----------------------------|------------|--------------|------------|--------------|------------|
| ** **                                                  | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                                  | ** ** | **2006**                     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**              | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of Revenue:                                            |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                     |       | $                            | 15,138     |         | $          | 15,253         |       |                        | $          | (115         | )          |         |       | (1 | )% |   | $ | 47,239 |   | $ | 44,448 |   |   | $ | 2,791 |   |   |   | 6 | % |   |
| Product and subscription                                    |       | 1,581                        |       | 1,790        |       |           | (209       | )                           |       |         | (12        | )%           |       | 5,805 |   | 5,232 |   |   | 573 |   |   |   | 11 | % |   |
| Total                                                       |       | $                            | 16,719     |         | $          | 17,043         |       |                        | $          | (324         | )          |         |       | (2 | )% |   | $ | 53,044 |   | $ | 49,680 |   |   | $ | 3,364 |   |   |   | 7 | % |   |
| Cost of Revenue (as % of related revenue  components): |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                     |       | 68                           | %          | 68           | %          |           |       |                        |       |         |       |         |       | 72 | % | 70 | % |   |   |   |   |   |   |   |   |
| Product and  subscription                                   |       | 37                           | %          | 41           | %          |           |       |                        |       |         |       |         |       | 43 | % | 42 | % |   |   |   |   |   |   |   |   |

 

*Service.*   Cost of service revenue primarilyincludes costs of consumables used in delivering a service, compensation forsoftware developers, quality assurance personnel, product managers, field operationspersonnel, business development personnel and outside contractors, depreciationcharges for machinery, equipment and capitalized software, deployment costsused specifically for service delivery, provisions for obsolete and excessinventories, travel costs directly attributable to service and developmentcontracts, and charges for infrastructure and centralized costs.

Cost of servicerevenue slightly decreased for the three-month period ended September 30,2006 compared to the corresponding three-month period ended September 30,2005 primarily due to:

·       decreased program costsrelated to cost reduction initiatives of $1.1 million, offset by

·       redeployment of resourcesto program activities of $0.5 million as part our restructuring initiativeundertaken throughout the current year, and

·       increased allocatedinfrastructure and centralized costs of $0.3 million primarily due to systemupgrades and enhancements in our information technology operations.

Cost of service revenue increased for the nine-month periodended September 30, 2006 compared to the corresponding nine-month periodended September 30, 2005 primarily due to the increased support cost of$3.2 million. During the first two quarters of the fiscal year the Companyallocated additional resources to fixing and improving existing programs andexperienced delays in initiation of certain capital projects. As a result,support costs increased and fewer expenditures were capitalized to the balancesheet.

*Productand subscription.*   Cost of product and subscription revenue primarilyincludes compensation for operations personnel, costs of consumables sold tothird parties, costs of machinery sold to third parties, and Internet serviceprovider connectivity charges and image search data fees to support theservices offered to our subscription customers.

Cost of product and subscription revenue slightlydecreased for the three-month period ended September 30, 2006 compared tothe corresponding three-month period ended September 30, 2005 primarilydue to decreased variable costs of $0.2 million related to hardware andconsumable sales.

Cost of product andsubscription revenue increased for the nine-month period ended September 30,2006 compared to the corresponding nine-month period ended September 30,2005 primarily due to:

·                  increasedinternational material costs of $0.8 million, offset by

·                  lowerdomestic material costs of $0.4 million related to hardware and consumablesales.

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Thecosts components included in our cost of revenue are comprised of threecategories as described below:

*Cost ofRevenue Components*

| ** **                                    | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Nine Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|-----------------------------|------------|--------------|------------|--------------|------------|
| ** **                                    | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                    | ** ** | **2006**                     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**              | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                              |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                      |       | $                            | 7,295      |         | $          | 6,877          |       |                        | $          | 418          |       |         |       | 6 | % |   | $ | 22,066 |   | $ | 21,008 |   |   | $ | 1,058 |   |   |   | 5 | % |   |
| Fixed field support and manufacturing    |       | 6,754                        |       | 6,371        |       |           | 383        |                        |       |         | 6          | %            |       | 23,092 |   | 18,908 |   |   | 4,184 |   |   |   | 22 | % |   |
| Program depreciation                          |       | 2,670                        |       | 3,795        |       |           | (1,125     | )                           |       |         | (30        | )%           |       | 7,886 |   | 9,764 |   |   | (1,878 | ) |   |   | (19 | )% |   |
| Total                                         |       | $                            | 16,719     |         | $          | 17,043         |       |                        | $          | (324         | )          |         |       | (2 | )% |   | $ | 53,044 |   | $ | 49,680 |   |   | $ | 3,364 |   |   |   | 7 | % |   |
| Cost of revenue (as % of total revenue): |       |                         |       |         |       |           |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                      |       | 28                           | %          | 26           | %          |           |       |                        |       |         |       |         |       | 28 | % | 27 | % |   |   |   |   |   |   |   |   |
| Fixed field support and manufacturing    |       | 25                           | %          | 24           | %          |           |       |                        |       |         |       |         |       | 29 | % | 25 | % |   |   |   |   |   |   |   |   |
| Program depreciation                          |       | 10                           | %          | 14           | %          |           |       |                        |       |         |       |         |       | 10 | % | 13 | % |   |   |   |   |   |   |   |   |
| Total                                         |       | 63                           | %          | 64           | %          |           |       |                        |       |         |       |         |       | 67 | % | 65 | % |   |   |   |   |   |   |   |   |

 

Variable costs include the price of materials andlabor to produce an identification card, direct costs of hardware and softwaredelivered and other costs that are variable in nature. The changes in variablecosts as a percentage are primarily due to a sales mix that included lowermargin sales of hardware and consumable products that occur from time to time,partially offset by pricing improvement with vendors and improved yields duringthe manufacturing process.

Fixed field support and manufacturing includes fieldoperations, field support, manufacturing, and supply chain costs. These costsare considered fixed with respect to supporting current contracts. As newcontracts are entered into and delivered, the overall level of fixed costsincreases. The increase in fixed costs are primarily due to newer contractsrequiring additional headcount, as well as travel costs to support them. Duringthe first two quarters of the fiscal year, we focused on fixing and improvingcertain existing programs and as a result fewer expenditures were capitalizedto the balance sheet. As a result of these actions, fixed support costsincreased.

Program depreciation primarilyconsists of amortization and depreciation of costs incurred during the deliveryprocess, where such costs are capitalized and then amortized or depreciatedover the useful lives of the assets to which the costs relate. Programdepreciation decreased in relation to the other components of cost of revenueprimarily due to the change in the estimated useful lives of program-related fixedassets. Through December 31, 2005, we depreciated program fixed assetsthat were specifically used to provide services under long term contracts overthe shorter of the original contract term or estimated useful life. StartingJanuary 1, 2006, we changed our policy for depreciating these assets tothe shorter of the original contract term plus 2.75 years or estimated usefullife. This change in estimate was supported by analysis we completed during thefirst quarter of 2006 which showed that historically 95% of contracts wereextended beyond the original contract term, that the average contract had atleast two contract extensions during its life and that these extensions addedon average 2.75 years to the length of the contracts’ original terms. Since contract-specificprogram assets are tracked on a contract basis, the findings that the contractlife is routinely significantly longer than the original contract term and thatthese extensions are not generally accompanied by significant incremental capitalinvestment indicates that the contract-related assets’ useful life was longerthan the original term of the contract. Given the findings of the analysis, weconcluded that it was appropriate to change the estimated useful lives so thatcontract specific assets were being 

31

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depreciated over our mostaccurate estimate. In addition, the change in useful lives would conservativelyachieve a better matching of the utility of these assets with the resultingrevenues.

Thefollowing table shows the effect of this policy of reducing depreciationexpense in 2006 for assets in place at December 31, 2005, as well as theexpected effect in the future periods specified:

| ** **                         | ** ** | **Q1 2006**         | ** ** | **Q2 2006** | ** ** | **Q3 2006** | ** ** | **Q4 2006** | ** ** | **2006** | ** ** | **2007** | ** ** |
|------------------------------------|------------|--------------------------|------------|------------------|------------|------------------|------------|------------------|------------|----------|------------|----------|------------|
| ** **                         | ** ** | **(in 000’S)** | ** ** |
| Previous  estimated depreciation   |       |                     | $          | 4,540            |       |             |       | $                | 4,464      |     |       |     | $          | 4,177 |   |   |   | $ | 4,199 |   |   | $ | 17,380 |   | $ | 16,067 |   |
| Updated estimated  depreciation    |       |                     | 2,394      |             |       |             | 2,369      |             |       |     | 2,315      |     |       |   | 2,298 |   |   | 9,376 |   | 9,787 |   |
| Reduction in  depreciation expense |       |                     | $          | 2,146            |       |             |       | $                | 2,095      |     |       |     | $          | 1,862 |   |   |   | $ | 1,901 |   |   | $ | 8,004 |   | $ | 6,280 |   |

 

The change in estimating the useful lives ofprogram-related fixed assets would have the effect of reducing depreciationexpense by $1,862 and $6,103 for the three- and nine-month periods endedSeptember 30, 2006, respectively. This reduction in depreciation wouldincrease basic and diluted earnings per share by $0.09 and $0.30 for the three-and nine-month periods ended September 30, 2006, respectively. Given thatthe depreciation expense attributed to contract-specific assets is included incost of revenue, the decrease in depreciation expense will cause gross marginsto increase by the amount of the reduction in depreciation expense.

The primary factor offsetting the reduction in programdepreciation was higher than average costs to deploy certain new programs wherewe provided a complete system replacement using advanced technologies. Theseprograms have recently been completed and are now in production. Theseinstallations were particularly challenging for us, representing a moreexpanded scope than that of our historical system deliveries. We weresuccessful in delivering these programs, but at higher costs than have beencustomary. In another case, we bid a program aggressively as part of a broadermarket development strategy that we believe will yield good long-termperformance. The fixed costs for these systems, which include amortization anddepreciation of costs capitalized during the delivery process, as well as fieldservice and operational costs to manage and maintain them, are higher thanaverage and, thus, reduce reported margins. We anticipate that we will be ableto improve profit margins in these accounts over time and earn a better returnon investment over the life of the account relationship.

We use the straight line method of depreciation andamortization for program-related assets. The combination of the seasonality ofour revenues and straight line depreciation and amortization can causesignificant variations in quarterly gross margin trends, generally increasingmargins as a percentage of revenue in the second and third quarters when ourrevenues are higher and decreasing margins as a percentage of revenue in thefirst and fourth quarters when our issuance revenues are typically lower, whilehaving a neutral effect on a yearly basis.

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*Gross Profit*

|               | ** ** | **Three  Months  Ended  September 30,**                         | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine  Months  Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|---------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **    | ** ** | **     2006**      | ** ** | **     2005**      | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                              | ** ** | **     2006**      | ** ** | **     2005**      | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Gross Profit: |       |                                                                 |       |                                                                 |       |                  |       |                                        |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|               |            |                                                                      |            |                                                                      |            |                       |            |                                             |            |                                                                      |            |                                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Service                                             |   |   | $      | 7,276  |   |   |   | $      | 7,119  |   |   |   | $      | 157    |   |   |   | 2      | %      |   |   | $      | 17,984 |   |   |   | $      | 19,136 |   |   |   | $      | (1,152 | ) |   |   | (6 | )% |   |
|-----------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|----|----|--------|
| Product and subscription                            |   |   | 2,738  |   |   |   | 2,619  |   |   |   | 119    |   |   |   | 5      | %      |   |   | 7,805  |   |   |   | 7,097  |   |   |   | 708    |   |   |   | 10     | %      |   |
| Total                                               |   |   | $      | 10,014 |   |   |   | $      | 9,738  |   |   |   | $      | 276    |   |   |   | 3      | %      |   |   | $      | 25,789 |   |   |   | $      | 26,233 |   |   |   | $      | (444   | ) |   |   | (2 | )% |   |
| Gross Profit (as % of related revenue  components): |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                             |   |   | 32     | %      |   |   | 32     | %      |   |   |   |   |   |   |   |   |   |   | 28     | %      |   |   | 30     | %      |   |   |   |   |   |   |   |   |   |
| Product and subscription                            |   |   | 63     | %      |   |   | 59     | %      |   |   |   |   |   |   |   |   |   |   | 57     | %      |   |   | 58     | %      |   |   |   |   |   |   |   |   |   |
| Total                                               |   |   | 37     | %      |   |   | 36     | %      |   |   |   |   |   |   |   |   |   |   | 33     | %      |   |   | 35     | %      |   |   |   |   |   |   |   |   |   |

 

Overall gross profit as apercentage of revenue was 37% and 33%, respectively, for the three- andnine-month periods ended September 30, 2006, compared to 36% and 35% forthe three- and nine-month periods ended September 30, 2005. The changes ingross profit as a percentage of revenue, for both the revenue components andoverall gross profit, for the three- and nine-month periods ended September 30,2006 as compared to the three- and nine-month periods ended September 30,2005 was primarily due to the reasons described above under the “Cost of Revenue”section.

*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Three  Months  Ended  September 30,**                         | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine  Months  Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **     **2006      | ** ** | **     **2005      | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                              | ** ** | **     **2006      | ** ** | **     **2005      | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Sales and marketing                          |       |                                                                 | $          | 3,440                                                                |       |                  |       | $                                           | 4,295      |                                                                 |       |                                                                 | $          | (855 | ) |   |   | (20 | )% |   |   | $ | 12,664 |   |   |   | $ | 11,961 |   |   |   | $ | 703 |   |   |   | 6 | % |   |
| Sales and marketing  (as % of total revenue) |       |                                                                 | 13         | %                                                                    |       |                  | 16         | %                                           |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 16 | % |   |   | 16 | % |   |   |   |   |   |   |   |   |   |

 

Sales and marketing expenses consist primarily ofcompensation, benefits and related costs of sales and marketing employees,product managers and sales engineers, as well as recruiting, travel, marketresearch, costs associated with marketing programs, such as trade shows, publicrelations and new product launches, and charges for infrastructure andcentralized costs.

The decrease insales and marketing expense for the three-month period ended September 30,2006, as compared to the corresponding three-month period ended September 30,2005, resulted primarily from:

·       decreased employeecompensation-related expenses of $0.6 million as part of the restructuringinitiative,

·       decreased other sales andmarketing administration costs of $0.2 million related to cost cuttinginitiatives, offset by

·       increasedcosts related to tradeshows, advertising, consulting fees and event sponsorshipof $0.2 million.

The increase insales and marketing expense for the nine-month period ended September 30,2006, as compared to the corresponding nine-month period ended September 30,2005, resulted primarily from:

·       increased costs related totradeshows, advertising, consulting fees and event sponsorship of$0.5 million, and

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·       increasedstock option expense of $0.4 million.

*Research, development and engineering*

| ** **                                                      | ** ** | **Three  Months  Ended  September 30,**                         | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine  Months  Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                              | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Research, development and engineering                           |       |                                                                 | $          | 2,158                                                                |       |                  |       | $                                           | 3,199      |                                                                 |       |                                                                 | $          | (1,041 | ) |   |   | (33 | )% |   |   | $ | 8,388 |   |   |   | $ | 9,535 |   |   |   | $ | (1,147 | ) |   |   | (12 | )% |   |
| Research,  development and engineering  (as % of total revenue) |       |                                                                 | 8          | %                                                                    |       |                  | 12         | %                                           |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 11 | % |   |   | 13 | % |   |   |   |   |   |   |   |   |   |

 

Research, development and engineering expenses consistprimarily of compensation, benefits and related costs of software developersand quality assurance personnel and payments to outside contractors, thepurchase of materials and services for product development, primarily in thecard systems area, and charges for infrastructure and centralized costs.

The decrease for the three-month period ended September 30,2006, as compared to the corresponding three-month period ended September 30,2005, resulted primarily from decreased employee compensation-related expensesof $0.9 million as part of the restructuring initiative.

The decrease forthe nine-month period ended September 30, 2006, as compared to thecorresponding nine-month period ended September 30, 2005, resultedprimarily from:

·       decreased employeecompensation-related expenses of $1.2 million as part of the restructuringinitiative, offset by

·       increasedstock option expense of $0.3 million.

*General and administrative*

| ** **                                          | ** ** | **Three Months Ended  September 30,**                 | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                      | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| General and administrative                          |       |                                                                 | $          | 3,684                                                                |       |                  |       | $                                                   | 4,852      |                                                                 |       |                                                                 | $          | (1,168 | ) |   |   | (24 | )% |   |   | $ | 13,066 |   |   |   | $ | 15,870 |   |   |   | $ | (2,804 | ) |   |   | (18 | )% |   |
| General and  administrative (as % of total revenue) |       |                                                                 | 13         | %                                                                    |       |                  | 18         | %                                                   |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 16 | % |   |   | 21 | % |   |   |   |   |   |   |   |   |   |

 

The decrease forthe three-month period ended September 30, 2006, as compared to thecorresponding three-month period ended September 30, 2005, resultedprimarily from:

·       decreased audit, consultingand legal fees of $0.8 million related to our audit and review, Sarbanes-Oxleyaudit, compliance and remediation efforts in 2005,

·       decreased other administrationcosts such as travel related expenses, supplies and insurance of$0.3 million related to cost cutting initiatives, offset by

·       increased stock optionexpense of $0.3 million.

The decrease forthe nine-month period ended September 30, 2006, as compared to thecorresponding nine-month period ended September 30, 2005, resultedprimarily from:

·       decreased audit, consultingand legal fees of $2.5 million related to our audit and review, Sarbanes-Oxleyaudit, compliance and remediation efforts in 2005,

·       decreased otheradministration costs such as travel related expenses, supplies and insurance of$0.8 million related to cost cutting initiatives,

·       decreasedreserves for bad debts of $0.2 million, offset by

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·       increasedstock option expense of $1.1 million.

*Amortization of intangible assets*

| ** **                                                | ** ** | **Three Months Ended  September 30,**                 | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                      | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Amortization of intangibles                               |       |                                                                 | $          | 537                                                                  |       |                  |       | $                                                   | 1,147      |                                                                 |       |                                                                 | $          | (610 | ) |   |   | (53 | )% |   |   | $ | 1,660 |   |   |   | $ | 3,297 |   |   |   | $ | (1,637 | ) |   |   | (50 | )% |   |
| Amortization of  intangibles (as % of total revenue) |       |                                                                 | 2          | %                                                                    |       |                  | 4          | %                                                   |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 2 | % |   |   | 4 | % |   |   |   |   |   |   |   |   |   |

 

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 purchaseaccounting rules, and require the amortization of such intangible assets overtheir expected useful life. As a result, in December 2001, we recorded$29.5 million of intangible assets related to the acquisition of certain assetsand certain liabilities from Polaroid and affiliates. These intangible assetswere set 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 decrease in amortizationof intangible assets for the three- and nine-month periods ended September 30,2006 compared to the corresponding three- and nine-month periods ended September 30,2005 resulted primarily from extended amortization periods from contractextensions on several domestic customers and the increased amortization in 2005related to a domestic customer who awarded their contract to a competitor. Theintangible asset related to this customer was fully amortized by the fourthquarter of 2005.

*Intellectual property*

| ** **                                     | ** ** | **Three Months Ended  September 30**                  | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                      | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Intellectual property                          |       |                                                                 | $          | 460                                                                  |       |                  |       | $                                                   | 528        |                                                                 |       |                                                                 | $          | (68 | ) |   |   | (13 | )% |   |   | $ | 1,372 |   |   |   | $ | 1,531 |   |   |   | $ | (159 | ) |   |   | (10 | )% |   |
| Intellectual  property (as % of total revenue) |       |                                                                 | 2          | %                                                                    |       |                  | 2          | %                                                   |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 2 | % |   |   | 2 | % |   |   |   |   |   |   |   |   |   |

 

Intellectual property costs primarily consist ofemployee-related expenses, such as salaries, benefits, recruiting costs, and incentiveplans, as well as costs associated with documenting, applying for, andmaintaining patents.

The slight decrease in intellectual property expensesfor the three-month period ended September 30, 2006, as compared to thecorresponding three-month period ended September 30, 2005, resultedprimarily from a decrease of $0.1 million in consulting fees paid tothird-party agents and government fees related to patent and other intellectualproperty work.

The slight decrease inintellectual property expenses for the nine-month period ended September 30,2006, as compared to the corresponding nine-month period ended September 30,2005, resulted primarily from a decrease of $0.1 million related as part of therestructuring initiative.

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*Restructuring charges, net.*

| ** **                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                            | ** ** |
| Cost of revenue                        |       |                                                | $          | 159 |   |   |
| Sales and marketing                    |       |                                                | 93         |   |   |
| Research, development  and engineering |       |                                                | 248        |   |   |
| General and  administrative            |       |                                                | 47         |   |   |
| Total                                  |       |                                                | $          | 547 |   |   |

* *

*In the second quarter, we accelerated productivityimprovement initiatives and significantly reduced fixed costs in order tofacilitate our effort to achieve profitability. The reduction in fixed costsincluded reduction of our workforce by nearly 20% since the beginning of 2006.The restructuring charge for the nine-month period ended September 30,2006 totaled $547, primarily due to employee severance and related costs. Theserestructuring charges were allocated out of the departments as noted above.*

*Stock-based compensation.  **Stock-based compensation includesexpense charges for all stock-based awards to employees and directors. Suchawards include option grants, restricted stock awards, and shares expected tobe purchased under an employee stock purchase plan. On January 1, 2006,the Company adopted Statement of Financial Accounting Standards No. 123(R),*Share-Based Payment (Revised 2004),*which requires the measurement andrecognition of compensation for all stock-based awards made to employees anddirectors including stock options and employee stock purchases under a stockpurchase plan based on estimated fair values. SFAS 123(R) supersedesprevious accounting under Accounting Principles Board Opinion No. 25,*Accountingfor Stock Issued to Employees,*for periods beginning in fiscal 2006. In March 2005,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107relating to application of SFAS 123(R). The Company has applied the provisionsof SAB 107 in our adoption of SFAS 123(R).*

The Company adopted SFAS 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s condensed consolidated financial statements for periods prior tofiscal year 2006 have not been restated to reflect this change. Stock-basedcompensation recognized in the three- and nine-month periods ended September 30,2006 is based on the value of the portion of the stock-based award that willvest during the period, adjusted for expected forfeitures. Stock-basedcompensation recognized in the Company’s condensed consolidated financialstatements in the three- and nine-month periods ended September 30, 2006includes compensation cost for stock-based awards granted prior to, but notfully vested as of, December 31, 2005 and stock-based awards grantedsubsequent to December 31, 2005. The compensation cost for awards grantedprior to January 1, 2006 is based on the grant date fair value estimatedin accordance with the pro forma provisions of SFAS 123 while awards granted onor after January 1, 2006 follow the provisions of SFAS 123(R) todetermine the grant date fair value and compensation cost. Compensation costfor all stock-based awards is recognized using 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 the award,our expected stock price volatility over the term of the award and actual andprojected exercise behaviors. Although the fair value of stock-based awards isdetermined in accordance with SFAS 123(R) and SAB 107, the Black-Scholesoption pricing model requires the input of highly subjective assumptions, andother reasonable assumptions could provide differing results.

36

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Prior to January 1, 2006, the Company applied therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees,*and related interpretations including FinancialAccounting Standards Board (“FASB”) Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation, an Interpretation of APB Opinion No. 25*, asallowed by FASB Statement No. 123, *Accountingfor Stock-Based Compensation*. FASB Statement No. 123 and FASB StatementNo. 148, *Accounting for Stock-BasedCompensation—Transition and Disclosure, an amendment of FASB Statement No. 123*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. Under APBOpinion No. 25, stock-based compensation expense is recognized for stockawards granted with an exercise price below fair market value on the date ofgrant.

Theexpense was recorded in the respective statement of operations expense categoriesfor the employees to which it applies, as set forth in the table below.

| ** **                             | ** ** | **Three Months Ended  September 30,**                 | ** ** | **Nine Months Ended  September 30,**                  | ** ** |
|----------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                             | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| Cost of revenue                        |       |                                                                 | $          | 76                                                                   |       |   |   | $ | — |   |   |   | $ | 214 |   |   |   | $ | — |   |   |
| Sales and  marketing                   |       |                                                                 | 117        |                                                                 |       |   | — |   |   |   | 373 |   |   |   | — |   |   |
| Research,  development and engineering |       |                                                                 | 71         |                                                                 |       |   | — |   |   |   | 261 |   |   |   | — |   |   |
| General and  administrative            |       |                                                                 | 434        |                                                                 |       |   | 153 |   |   |   | 1,408 |   |   |   | 355 |   |   |
| Intellectual  property                 |       |                                                                 | 9          |                                                                 |       |   | — |   |   |   | 27 |   |   |   | — |   |   |
| Total                                  |       |                                                                 | $          | 707                                                                  |       |   |   | $ | 153 |   |   |   | $ | 2,283 |   |   |   | $ | 355 |   |   |

 

We anticipate an additional $7.1 million instock-based compensation expense through fiscal 2010 for awards outstanding asof September 30, 2006. Additional impact resulting from adoption of thisstatement on our financial position and results of operations will bedetermined by stock-based awards granted in future periods and the assumptionson which the value of those stock-based awards is based. Our tax accounting mayalso be impacted by actual exercise behavior and the relative market prices atexercise.

On December 15, 2005, the Board of Directors ofthe Company approved the acceleration of vesting of the Company’s outstandingstock options with option exercise prices equal to or greater than $9.00. Theacceleration applied to all options outstanding as of December 31,2005 under the Company’s Restated 1999 Stock Incentive Plan and 2000Non-Officer Employee Stock Incentive Plan, except for options held by membersof the Company’s Board of Directors. Options to purchase 422,248 shares of theCompany’s common stock, or 6% of the Company’s total outstanding options, witha weighted average exercise price of $11.51 and varying remaining vestingschedules, were subject to this acceleration and became immediately vested andexercisable as of December 31, 2005. Of these 422,248 options, 120,972options are held by the Company’s executive officers.

On December 21, 2004, the Audit, Compensation andCorporate Governance Committees of the Board of Directors of the Companyapproved the acceleration of vesting of the Company’s outstanding stock optionswith option exercise prices greater than $15.00. The acceleration applied toall options outstanding under the Company’s Restated 1999 Stock Incentive Planand 2000 Non-Officer Employee Stock Incentive Plan that would not haveotherwise vested in full by June 30, 2005 in accordance with their terms.The effective date of the vesting acceleration was December 31, 2004.Options to purchase 310,057 shares of the Company’s common stock, or 5% ofthe total number of options of the Company outstanding as of December 31,2004 with remaining vesting schedules, were accelerated. Of these310,057 options, approximately 50,000 options were held by the Company’sexecutive officers. No additional compensation expense was recorded in thestatement of operations as the options that were accelerated had an exerciseprice greater than the fair market value of the shares underlying the optionson the date of the modification.

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As a result of these accelerations, the Companyreduced its exposure to the effects of SFAS 123(R).

*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.5 and $1.2 million for the three- and nine-month periodsended September 30, 2006, respectively, compared to $0.2 and $0.7 millionfor the three- and nine-month periods ended September 30, 2005. Theincrease resulted primarily from higher interest earned on cash andinvestment balances, which was partially offset by higher interest expenserelated to capitalized leases. In addition, we experienced a foreign currencytranslation gain of approximately $0.2 million in connection with theconsolidation of our international subsidiaries.

*Provision for IncomeTaxes.*   The provision for income taxes reflects expected tax expense fromprofitability in certain foreign jurisdictions. We have recorded a fullvaluation allowance against our net deferred tax assets at September 30,2006 due to the uncertainty of realization of the Company’s net operatinglosses, both domestic and foreign, and including those generated in the current period. We will continue toevaluate the realizability of our net deferred tax assets in future periods andmay recognize income tax benefits in future earnings if we determine therealization of these assets is more likely than not.

**Liquidity andCapital Resources**

As of September 30, 2006, we had cash and cashequivalents, restricted cash, and short-term investments of $31.2 million,representing a decrease of approximately $0.8 million from $32.0 million at December 31,2005. The decrease primarily resulted from the increase in restricted cash dueto a large number of performance bond renewals on various government contractsand the capital investments in new program implementations, including thepurchase of fixed assets. As of September 30, 2006, $9.9 million of cashand cash equivalents is restricted as a result of the requirements ofperformance bonds that we are obligated to maintain in connection with some ofour long-term contracts in our personal identification systems business.Working capital at September 30, 2006 was $24.4 million, compared toworking capital of $31.4 million at December 31, 2005. The decrease inworking capital resulted primarily from investments made in new programs andinfrastructure assets, and to a lesser extent the change in restricted cashdiscussed above.

The$3.7 million of cash provided by operations for the nine-months ended September 30,2006 compares favorably to the $4.6 million of cash used in operations for thenine-months ended September 30, 2005. The components of operating cashflows were:

| ** **                                           | ** ** | **Nine Months Ended  September 30,**      | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                           | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Net loss                                             |       | $                                                        | (10,828    | ) | $ | (15,565 | ) |
| Non-cash items                                       |       | 13,419                                                   |       | 14,312 |   |
| Changes in  operating assets and liabilities         |       | 1,087                                                    |       | (3,358 | ) |
| Net cash provided  by (used in) operating activities |       | $                                                        | 3,678      |   | $ | (4,611 | ) |

 

The major changesin the non-cash charges related to:

·       decreasesin depreciation and amortization from $14.0 million to $11.6 millionprimarily related to the change in estimated useful lives of our programassets, and

·       increasein stock-based compensation expense from $0.4 million to $2.3 million primarilyrelated to the implementation of FAS 123R.

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The major changesin the operating assets and liabilities for the nine-month period ended September 30,2006 primarily related to:

·       increasein deferred revenue of $2.3 million related in an increased backlog of futurerevenues, and

·       decreasesof $0.9 million in accounts receivable and $1.4 million in inventory, netreflecting improved asset management while increasing revenues, offset by

·       increasein restricted cash of $2.7 million associated with renewals of our performancebonds for our major state programs, and

·       decreasein accounts payable of $1.9 million reflecting lower level of operatingexpenses and inventory during 2006.

The major changes in operating assets and liabilitiesfor the nine-month period ended September 30, 2005 primarily reflecthigher operating expenses.

The $7.2 million of cash used in investing activitiesfor the nine-month period ended September 30, 2006 primarily related to$0.3 million in net purchase of short-term investments and $6.9 million for thepurchase of property and equipment, including capitalization of labor costs of$2.6 million. The $6.1 million of cash provided by investing activitiesfor the nine-months ended September 30, 2005 primarily related to $18.8million in net sale or maturity of short-term investments partially offset by$12.7 million for the purchase of property and equipment, includingcapitalization of labor costs.

The $0.2 million of cash used in financing activitiesfor the nine-month periods ended September 30, 2006 resulted primarilyfrom the principal payments on capital leases, partially offset by the proceedsfrom the issuance of stock. The $0.1 million of cash used in financingactivities for the nine-month period ended September 30, 2005 resultedprimarily from the principal payments on capital leases, partially offset bythe proceeds from the issuance of stock.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $7.3 million as of September 30,2006, and are payable in monthly installments through October 2010. Ourobligations under non-cancelable capital leases, which totaled $0.8 million asof September 30, 2006, are payable in monthly installments through April 2009.

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 $14 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 capitalexpenditures may constitute a material use of our cash resources. In addition,we expect that we will continue to utilize cash in the upcoming few quarters aswe complete program implementations. We may utilize cash resources to fundacquisitions or investments in complementary businesses, technologies orproduct lines.

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

**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 March 2006, the FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets, anamendment of SFAS No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities*. The statementchanges the way entities account for servicing assets and obligationsassociated with financial assets acquired or disposed of. SFAS No. 156 iseffective for the first fiscal year beginning after September 15, 2006.The Company does not expect the adoption of this standard to have a materialeffect on the Company’s financial statements.

In July 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,which defines the threshold for recognizing the benefits of tax return positionsin the financial statements as “more-likely-than-not” to be sustained by thetaxing authority. Interpretation No. 48 applies to all tax positionsaccounted for under SFAS No. 109, *Accounting for IncomeTaxes*. Interpretation No. 48 is effective as of the beginningof the first fiscal year beginning after December 15, 2006. Upon adoption,the Company will adjust the financial statements if needed to reflect onlythose tax positions that are more-likely-than-not to be sustained as of theadoption date. Any adjustment will be recorded directly to our beginningretained earnings balance in the period of adoption and reported as a change inaccounting principle. The Company is currently analyzing the effects ofadopting Interpretation No. 48.

In September 2006,the SEC issued SAB 108, *Considering the Effects ofPrior Year Misstatements When Quantifying Misstatements in Current YearFinancial Statements*. The bulletin provides interpretive guidance onhow to consider the effects of carryovers or reversals of prior yearmisstatements in quantifying a current year misstatement. SAB 108 is effectivefor the first fiscal year ending after November 15, 2006. The Company doesnot expect the adoption of this interpretive bulletin to have a material effecton the Company’s financial statements.

**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 below or elsewhere in this Report on Form 10-Q orincorporated 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 

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harborprovided by Section 21E of the Securities Exchange Act of 1934 and Section 27Aof the Securities Act of 1933. Such forward-looking statements include but arenot limited to statements relating to:

·       trends and expectations inrevenue growth, including, but not limited to, statements regarding thetemporary nature of the decrease in ID systems bid activity and the expectedincrease of such activity in the future, statements regarding anticipated growthin U.S. driver license revenues due to broadening use of the driver license asa secure credential, statements regarding opportunities to facilitate effortsof state government agencies to comply with the REAL ID Act;

·       the success of newproducts, such as IDVS;

·       our future level ofinvestment in our business, including investment in development of products andtechnology, acquisition of new customers and development of new marketopportunities;

·       our ability to improvemargins;

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

·       anticipated revenue to begenerated from current contracts, patent and license technology fees and as aresult of new programs;

·       the investments required tocomplete certain driver license programs and our ability to recoup thoseexpenses under the relevant contract;

·       our profitability in futureperiods;

·       the development and growthof the market for digital watermarking technology;

·       momentum in the recognitionof the benefits offered by digital watermarking and in the adoption of digitalwatermarking;

·       business opportunities thatcould require that we seek additional financing;

·       opportunities for increasedparticipation in the global market for ID systems;

·       the size and growth of ourmarkets, including the U.S. driver license market;

·       the existence ofinternational growth opportunities and our future investment in suchopportunities;

·       the source of a majority ofour future revenue;

·       our expected short-term andlong-term liquidity positions;

·       our ability to fund ourcapital needs through cash flow from operations;

·       our use of cash in upcomingquarters;

·       anticipated levels ofbacklog in future periods;

·       anticipated extensions ofthe term of our contract with the central banks; and

·       the likelihood or outcomeof legal proceedings and claims and their effect on our business.

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 our digitalwatermarking technology to develop as anticipated, the adoption of alternativetechnologies within these markets, as well as changes in economic, business,competitive, technology and/or regulatory factors and trends, and the otherfactors described in this Form 10-Q or in our other documents filedwith the SEC. All forward-looking statements are necessarily only estimates offuture results and there can be no assurance 

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thatactual results will not differ materially from expectations, and, therefore, investorsare cautioned 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.

**Factors AffectingForward Looking Statements**

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

*Given our history of losses, we cannot guaranteesustained profitability, particularly if we were to lose large contracts.*

Except for the year 2003,we have incurred significant net losses from inception. Our accumulated deficitas of September 30, 2006 was $98.8 million. In order to attainsustained profitability, we will need to generate higher revenue than we havein prior years while controlling expenditures. Achieving sustained profitabilitywill depend upon a variety of factors, including the impact of new financialaccounting mandates requiring us to expense stock options, as well as theextent to which we may be required to increase the size of our workforce inorder to execute our business strategy and capitalize on new opportunities. Inaddition, we evaluate our strategy and market opportunities on an ongoing basisand will adjust our approach to market conditions that prevail from time totime. Finally, various adverse developments including the loss of largecontracts or cost overruns on our existing contracts could have a negativeimpact on our revenue or our margins. Accordingly, increases in our expensesmay not be offset by revenue increases and as a result we may not be able toregain and/or sustain profitability.

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

Contracts betweengovernment agencies and 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. If we were to lose a contract dueto cancellation or in a competitive bidding situation, then, in addition to theloss of revenue and margin on a prospective basis, we could also incuraccelerated amortization expense or impairment of intangible assets related tothe customer, which could adversely affect our financial results. We have notexperienced the early termination of any driver license issuance contracts andare not aware of any early terminations of such contracts of our competitors.

*The market for our products is highly competitive, andas a result, alternative technologies or larger companies may undermine, limitor eliminate the market for our products’ technologies, which would decreaseour 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 our applications.Because our digital watermarking business is new and emerging, we also may facecompetition from unexpected sources. Alternative technologies that may directlyor indirectly compete with particular applications of our watermarkingtechnologies include:

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

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

·       DataGlyphs®—a slightly visible modification of thecharacteristics of an image or document that is machine-readable;

·       Scrambled Indicia®—an optical refraction-baseddata-hiding technique that is inserted into an image and can be read with alens;

·       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;

·       Radio frequency tags—embeddinga chip that emits a signal when in close proximity with a receiver, which isbeing used in photo identification credentials, labels and tags;

·       Internet technologies—numerousexisting and potential Internet access and search methods are competitive withthe Digimarc MediaBridge system and the searching capabilities of DigimarcImageBridge;

·       Digital fingerprints andsignatures—a metric, or metrics, computed solely from a source image or audioor video track, that can be used to uniquely identify an image or track, orauthenticate the image or track;

·       Smart cards—badges andcards including a semiconductor memory and/or processor used for authenticationand related purposes; and

·       Bar codes—a data-carryingcode, typically visible in nature (but invisible if printed in ultraviolet- orinfrared-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 watermarking technologies,and our products and services using these technologies, will gain widespreadmarket acceptance.

New developments areexpected to continue, and we cannot assure you that discoveries by others,including current and potential competitors, will not render our services andproducts noncompetitive. Moreover, because of rapid technological changes, wemay be required to expend greater amounts of time and money than currentlyanticipated to develop new products and services, which in turn may necessitateus to require greater revenue streams on such products and services to coverdevelopmental costs. Many of the companies that currently compete with us forsome of our business, as well as other companies with whom we may compete inthe future, are larger and national or international in scope and may havegreater technical, financial, marketing, and political resources than we do.These resources could enable these companies to initiate severe price cuts ortake other measures in an effort to gain market share or otherwise impede ourprogress. We cannot assure you that we will be able to compete successfullyagainst current or future participants in our market or against alternativetechnologies, nor can we assure you that the competitive pressures we face willnot decrease our revenue and profits in the future.

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

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Despitetesting, defects or errors in our products and services may occur, which couldresult in delays in the development and implementation of products and systems,inability to meet customer requirements or expectations in a timely manner,loss of revenue or market share, increased implementation and support costs,failure to achieve market acceptance, diversion of development resources,injury to our reputation, increased insurance costs, increased service andwarranty costs and warranty or breach of contract claims. Although we attemptto reduce the risk of losses resulting from warranty or breach of contractclaims through warranty disclaimers and liability limitation clauses in oursales agreements when we can, these contractual provisions are sometimes notincluded and may not be enforceable in every instance. If a court refuses toenforce the liability-limiting provisions of our contracts for any reason, orif liabilities arose that were not contractually limited or adequately coveredby insurance, the expense associated with defending such actions or paying theresultant claims could be significant.

*If leading companies in our industry orstandard-setting bodies or institutions downplay, minimize, or reject the useof digital watermarking, its deployment may be slowed and we may be unable toachieve revenue growth—particularly in the media and entertainment sector.*

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 standard-setting bodies or institutionsdownplaying, minimizing or rejecting the value or use of watermarkingtechnology or any of our other technologies. Such a negative position by thesecompanies, bodies or institutions, if taken, may result in obstacles for usthat we would be incapable of overcoming and may block or impede the adoptionof digital watermarking—particularly in the media and entertainment market. Inaddition, potential customers in the media and entertainment industry may delayor reject initiatives that relate to deployment of digital watermarking. Such adevelopment would make the achievement of our business objectives in thismarket difficult or impossible.

*If we are unable to respond to regulatory or industrystandards effectively, or if we are unable to develop and integrate newtechnologies effectively, our growth and the development of our products andservices 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.

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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:

·       enhance and improve theresponsiveness, functionality and other features of the products and serviceswe offer or plan to offer;

·       continue to develop ourtechnical expertise; and

·       develop and introduce newservices, applications and technologies to meet changing customer needs andpreferences and to integrate new technologies.

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

*We may need to retain additional employees or contractlabor in the future in order to take advantage of new business opportunitiesarising from increased demand, which could impede our ability to achieve orsustain profitability.*

In the second half of 2005and the first half of 2006, we made significant reductions in our workforce aspart of our efforts to reach quarterly profitability in the second half of 2006or early in 2007. These reductions did not impede our ability to meet demandbecause they were accompanied by improvements in our internal businessprocesses and coincided with a period of relatively low bid activity withrespect 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.

*We depend on our senior management and key employeesfor our future success. If we are not able to retain, hire or integrate theseemployees, we may not be able to meet our commitments.*

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 negativeimpact on the market price of our common stock, and employees 

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andprospective employees may factor in the uncertainties relating to our stabilityand the value 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 clauses generally.If these clauses were not fully enforced, our employees could be able to freelyjoin our competitors. Although we generally attempt to control access to anddistribution of our proprietary information by our employees, there can be noassurances that the confidential nature of our proprietary information will bemaintained in the course of such future employment. Any of these events couldhave a material adverse effect on our financial and business prospects.

*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:

·       delays in projectimplementation;

·       failure to achieve add-onsales to existing customers;

·       governmental regulation ofcredentials and issuance policies;

·       private sector usage trendsfor driver licenses and other credentials;

·       level of commodity vs. proprietarycomponents applicable to customer system specifications;

·       whether contracts have beenextended or renewed; and the amount of capital expenditure associated with suchextension or renewal;

·       price competition incompetitive bids, contract renewals and contract extensions;

·       variations in costs ofmaterials and manufacturing;

·       varying levels ofefficiency of our workforce in delivering, implementing, and servicingcontracts;

·       seasonality of issuancevolumes;

·       sales mix related to cardissuance revenues compared to product sales;

·       sales mix related todomestic sales compared to international sales;

·       sales mix related toadoption of new products compared to sales of current products;

·       strategic decisions on newbusiness;

·       depreciation and amortizationof capitalized project costs related to new or upgraded programs; and

·       variability in the extentto which we are able to allocate personnel expenses to capital projects andthereby amortize such costs over the life of the relevant contract, rather thanexpensing such costs in the quarter in which they are incurred.

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. Weare continually refining our predictive tools and increasing our understandingof what drives these various 

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factors.For reasons such as those listed above, we expect that there will befluctuations in our future operating results as a result of the variability inmargins from period to period in the secure ID systems business.

*The majority of our revenue is subject to governmentprocurement processes that may involve unpredictable delays and otherunexpected changes which might limit our actual revenue in any given quarter.*

We derive substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new revenueare tied to procurement schedules, which could shift as the needs of 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 bepredictable, could result in delays in bookings forecasted for any particularfinancial period, could impact the predictability of our quarterly results, andmight limit our actual revenue in any given quarter, resulting in reduced andless predictable revenue and lower profitability.

*Our future growth will depend to some extent on oursuccessful implementation of our intellectual property in solutions provided bythird parties, including partners and suppliers.*

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 (offered by vendors including Adobe, Corel and Ulead) topermit users of these products to read watermarks embedded in imagery, andthereby discern the identities of image owners. Another form of our digitalwatermark reader is used in our anti-counterfeiting product offerings. Weanticipate entering into additional agreements with third-party vendors tocreate, promote and service products that incorporate, embed, integrate orbundle our technologies. If third parties who include such technologies intheir products cease to do so, or we fail to obtain other partners that willincorporate, embed, integrate or bundle such technologies, or these partnersare unsuccessful 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.

*Some of our revenue models relating to anticipatedproducts and services are under development. If these revenue models andpricing structures do not gain market acceptance, the corresponding anticipatedproducts and services may fail to attract or retain customers and we may not beable 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 such customers. We have not fully developed revenue models forcertain of our future digital watermarking applications and licensingendeavors. Because some of our products and 

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servicesare not yet well-established in the marketplace, and because some such productsand services will not directly displace existing solutions, we cannot becertain that the pricing structure for these products and services will gainmarket acceptance or be sustainable over time or that the marketing for suchproducts and services will be effective.

*The security systems used in our product and serviceofferings may be circumvented or sabotaged by third parties, which could resultin the disclosure of sensitive government information or private personalinformation or cause other business interruptions that could damage ourreputation and disrupt our business.*

Our business relies on computers and other informationtechnologies, both in-house 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.

*As international customers have accounted forapproximately 16% of our total revenue during the quarter ended September 30,2006, the loss of these customers or the failure to find new customers mayresult in a decline in our international revenue, which could lower ourprofitability 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, includingthe following:

·       changes in foreigngovernment regulations and security requirements;

·       export licenserequirements, tariffs and taxes;

·       trade barriers;

·       difficulty in protectingintellectual property;

·       difficulty in collectingaccounts receivable;

·       currency fluctuations;

·       longer payment cycles thanthose for customers in the United States;

·       difficulty in managingforeign operations; and

·       political and economicinstability.

If we are affected by these risks, our sales ofproducts and services to customers outside the U.S. could be reducedsignificantly. In addition, if foreign customers, in particular foreigngovernment authorities, 

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terminate or delay theimplementation of our products and services, we may have limited recourseagainst them to recover any potential losses.

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 significant portion of our business depends oncontracts that are subject to a variety of terms and conditions, includingdamage payment obligations, as well as a variety of other provisions that maycause our quarterly results to fluctuate and our anticipated revenue topotentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and related products typically include termsrelating to, time-based performance, development and delivery schedulescustomer acceptance and testing, and other performance milestones. Suchprovisions are common in large scale government contracts at the state andfederal levels. Because procedures often require compliance over extendedperiods of time, they give rise to an increased risk that we may fail to meettiming or other delivery requirements and milestones pursuant to the terms ofsuch contracts. If we failed to meet such requirements or milestones, customersmay assert against us compensatory or liquidated damages, breach of contract,or other claims. Consequently, our failure to meet contractual milestones orother performance requirements as promised could result in our having to incurincreased costs, lower margins, or compensatory obligations, in addition toother losses, such as harm to our reputation. Such unexpected increases incosts to meet our contractual obligations or any other requirements necessaryto address claims and damages with regard to our customer contracts could havea material adverse effect on our business and financial results. We anticipatethat future contracts will continue to have such provisions unless and untilindustry practices change.

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 inappropriations cycles, and protests of contract awards. Additionally, somegovernmental authorities require performance bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bondsrequire that we maintain large restricted cash reserves as a guarantee,reducing our ability to use these funds for our other business purposes. Evenwith the availability of such cash reserve guarantees, we may not be able toobtain such performance bond underwriting at a favorable rate or at all. Ourfailure to be able to provide such performance bonds may preclude our abilityto bid on new government contracts or maintain our existing contracts for theirfull terms. The size, nature and purpose of, and the risks and uncertaintiesassociated with, public sector contracts can potentially cause our quarterlyresults to fluctuate and anticipated revenue to decrease significantly.

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*A significant portion of our business depends oncontracts with fixed price terms. In the event of cost overruns in connectionwith such contracts, our margins may be adversely 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. Such contracts involvegreater financial risks because we bear the risk if actual project costs exceedthe amounts we are paid under the contracts.

*We may decline to pursue new, or renew existing,business opportunities in secure ID systems markets due to objectionable termsrequired by the contracting agencies, or we may agree to objectionable contractterms 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 toterminate the contract for convenience. Similarly, in connection withintellectual property rights, a contract may require that our pre-existingissuance system software be written in a different language and a state maythen argue that it falls within the class of works for which it owns thecopyright, enabling the state to turn the Digimarc-authored software over toone of our competitors, dedicate it to the public domain, or otherwise use thesoftware in a manner detrimental to our business. Objectionable contract termsmay lead us to decline to bid on identification issuance systems to new customers,or to decline to retain business with customers we have historically served,which could reduce our market share and lower our revenues or profits. Inaddition, if we decline to retain business with customers we have historicallyserved, it could 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 a material supplier could have a materialadverse effect on our ability to perform effectively under some of ourcontracts.*

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. While we strive to havealternative suppliers provide us with many of our products, a loss of one ormore of such suppliers could have a material adverse effect on our ability toperform effectively, if at all, under some of our contracts.

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

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

·       We may be unable to developsources of new revenue or sustainable growth in revenue because our current andanticipated technologies, products and services may be inadequate or may beunable to attract or retain customers;

·       The intense competition andrapid technological change in our industry could adversely affect the market’sacceptance of our existing and new products and services; and

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·       We may be unable to developand maintain new technologies upon which our existing and new products andservices are dependent in order for our products and services to be sustainableand competitive and in order for us to expand our revenue 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 reduce or eliminate our profitability.

*We may not be able to protect adequately ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could adversely affect our business.*

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.

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

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.

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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 ourconfidentiality procedures, we generally enter into non-disclosure agreementswith our employees, directors, consultants and corporate partners, and attemptto control 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 United States where laws or law enforcement practices may notprotect our proprietary rights as fully as in the United States.

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

We have 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. At present, our newproducts include Digimarc Camera Tower, Digimarc Capture Software, DigimarcImage Server, Digimarc ID Validation Suite (IDVS), Digimarc IDMarc,Digimarc Biometric Identification solution and Digimarc Document Inspector. Ifwe do not experience a timely, positive reaction from issuing authorities toour new offerings, our projected revenues, margins and earnings may benegatively impacted.

*Recent and ongoing leadership, staffing andorganizational changes may result in disruptions and inefficiencies in ourbusiness during transition periods, may require process changes in ourbusiness, and will likely cause additional costs to our business beforebenefits from such changes may be realized.*

During the second quarterof 2004, we made significant changes in our management and staff as a result ofa detailed review of our business processes. Many of these changes wereinitiated following the hiring of our new Chief Financial Officer in June 2004and other senior managers, and in conjunction with the continuingimplementation of our new accounting and material requirements planning systemsand 

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work onSarbanes-Oxley compliance. In 2005, we made certain organizational changesdesigned to better consolidate the secure ID systems and digital watermarkinggroups into a single business unit and thereby improve our business executionand operational efficiencies. In addition, we appointed a new President ofGovernment Programs and made considerable changes to the management team thatreports to him. While we anticipate that these changes in leadership and staffingwill improve operations, there is a risk that these changes may disrupt theoperations of our business and, consequently, may result in some short-terminefficiencies as personnel complete their transitions and new leadersimplement their new plans and procedures. We also expect that these changes mayrequire further modifications of our finance and business processes and willlikely cause additional costs to our business in the short term before anybenefits from such changes, if any, may be realized.

*We are engaged in several lawsuits alleging violationsof securities law and cannot predict the outcome or ultimate cost of theseactions with certainty.*

We currently are engagedin litigation relating to the initial public offering of our securities, inaddition to the class actions filed against us in connection with ourpreviously announced accounting errors. Such litigation is expensive andlengthy. These matters are discussed in greater detail in Part II, Item 1(Legal Proceedings) of this Quarterly Report on Form 10-Q and inNote 5 (Commitments and Contingencies) of the Notes to Consolidated FinancialStatements included in this Quarterly Report on Form 10-Q. We haveincurred significant costs relating to these matters. Due to the inherentuncertainties of such litigation, the ultimate cost and outcome cannot bepredicted.

*If a judgment were to be entered against the Companyand our director and officer liability insurance was inadequate or unavailable,the obligation to pay the judgment may materially harm our business andfinancial 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 and officerliability insurance.

*We may be required to invest significant additionaltime and resources to comply with the requirements of Section 404 of theSarbanes-Oxley Act of 2002, which may increase our operating expenses andreduce our profitability in the near future.*

In 2004, we discoveredcertain material weaknesses in our internal controls and procedures and sincethen have deployed significant resources to design and implement new andenhanced controls and procedures. As we monitor the regulatory requirements inthe future, we may discover additional problems that require furthermodifications to our controls, review processes and financial management, whichcould result in our company experiencing additional costs and expenses that mayreduce our profitability in the near future.

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**Item 3.**                        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, 2005 have not changed materially.

**Item 4.**                        Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

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 theCommissions’ 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. Our management, with the participation ofour principal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) ofthe Securities Exchange Act of 1934) as of September 30, 2006, whichincluded an evaluation of disclosure controls and procedures applicable to theperiod covered by the filing of this periodic report. Based on the evaluationof the effectiveness of our disclosure controls and procedures by ourmanagement as of September 30, 2006, our principal executive officer andprincipal financial officer have concluded that our disclosure controls andprocedures were effective to ensure that information required to be disclosedby us in the reports that we file or submit under the Securities Exchange Actof 1934 is accumulated and communicated to our management, including ourprincipal executive and principal financial officers, or persons performingsimilar functions, as appropriate to allow timely decisions regarding requireddisclosure.

**Changes in InternalControls**

Our management, with the participation of ourprincipal executive officer and principal financial officer, conducted anevaluation of our internal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934) to determinewhether any changes occurred during the period covered by this report. Based onthat evaluation, our principal executive officer and principal financialofficer concluded that there has been no change in internal control overfinancial reporting that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting for the periodcovered by this report.

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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. Due to the inherent uncertainties oflitigation, the Company cannot accurately predict the ultimate outcome of thematter.

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 matter jurisdictionand failure to state a claim. In May of 2006, the Board committee, aftercompleting its investigation, concluded that pursuit of the allegations wouldnot 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.

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 dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),

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however, were dismissed.In June 2003, a committee of the Company’s board of directorsconditionally approved a proposed partial settlement with the plaintiffs inthis matter. In June 2004, an agreement of settlement was submitted to thecourt for preliminary approval. The settlement would provide, among otherthings, a release of the Company and of the individual defendants for theconduct alleged in the amended complaint to be wrongful. The Company would agreeto undertake other responsibilities under the partial settlement, includingagreeing to assign away, not assert, or release certain potential claims theCompany may have against its underwriters. Any direct financial impact of theproposed settlement (other than defense costs incurred and expensed prior to May 31,2003) is expected to be borne by the Company’s insurers. The court granted thepreliminary approval motion on February 15, 2005, subject to certainmodifications. On August 31, 2005, the court issued a preliminary orderfurther approving the modifications to the settlement and certifying thesettlement classes. The court also appointed the Notice Administrator for thesettlement and ordered that notice of the settlement be distributed to all settlementclass members beginning on November 15, 2005 and completed by January 15,2006. The settlement fairness hearing was held on April 26, 2006, but thecourt has not yet rendered its decision. If the court determines that thesettlement is fair to the class members, the settlement will be approved. Therecan be no assurance that this proposed settlement will be approved andimplemented in its current form, or at all. Due to the inherent uncertaintiesof litigation and because the settlement approval process is at a preliminarystage, the Company cannot accurately predict the ultimate outcome of thematter.

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 September 30, 2006, the finaldisposition of these proceedings will not have a material adverse effect on ourconsolidated financial position, results of operations, or liquidity.

**Item5**                           OtherInformation.

*ExecutiveCompensation*

On November 2, 2006, our Board of Directors approvedpayment of a $100,000 aggregate bonus to our named executive officers as anaward for achieving profitability during the third quarter.  A second $100,000 aggregate bonus has beenapproved and will be awarded to our named executive officers if we areprofitable during the fourth quarter of 2006. The third quarter bonus wasallocated as follows (in dollars): 

| **Name and Principal Positions**                              | ** ** | ** ** | ** ** | **Third Quarter  Bonus** | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|
| Bruce Davis, Chief Executive Officer and Chairman of  the Board of Directors |       |       | $          | 32,489                        |       |   |
| Robert Eckel, President, Government Programs                                 |       |       | 14,240     |                          |       |
| Michael McConnell, Chief Financial Officer and  Treasurer                    |       |       | 13,713     |                          |       |
| J. Scott Carr, Executive Vice President                                      |       |       | 13,186     |                          |       |
| Robert P. Chamness, Chief Legal Officer and  Secretary                       |       |       | 13,186     |                          |       |
| Reed Stager, Executive Vice President                                        |       |       | 13,186     |                          |       |
|                                                                         |       |       | $          | 100,000                       |       |   |

 

**Item 6.**                        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:  November 7, 2006 | 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)                                            |
| 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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