**UNITED STATES**

**SECURITIES 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

**For the quarterly period ended MARCH 31, 2006**

**OR**

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

**Forthe transition period from               to**

**Commission File Number: 000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     | **94-3342784**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **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

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

Large accelerated filer o                         Acceleratedfiler x                            Non-acceleratedfiler o

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

Asof April 30, 2006, there were 21,074,186 shares of the registrant’s commonstock, par value $0.001 per share, outstanding.

 

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**Tableof Contents**
| **PART I FINANCIAL  INFORMATION** |   |                                                                                                                  |
|----------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------|
| Item 1.                           |   | Financial Statements:                                                                                                 |   |   |
|                                   |   | Condensed  Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005 (Unaudited)         |   | 3 |
|                                   |   | Condensed  Consolidated Statements of Operations for the three-months ended March 31,  2006 and 2005 (Unaudited) |   | 4 |
|                                   |   | Condensed  Consolidated Statements of Cash Flows for the three-months ended March 31,  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                           |   | 20 |
| Item 3.                                |   | Quantitative  and Qualitative Disclosures About Market Risk                                                           |   | 57 |
| Item 4.                                |   | Controls  and Procedures                                                                                              |   | 57 |
| **PART II OTHER INFORMATION**     |   |                                                                                                                  |
| Item 1.                                |   | Legal  Proceedings                                                                                                    |   | 59 |
| Item 6.                                |   | Exhibits                                                                                                              |   | 60 |
| **SIGNATURES**                         |   | 61                                                                                                                    |

 

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**PART I.FINANCIAL INFORMATION**

**Item1.**                        FinancialStatements.

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

| ** **                                                                                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                    | ** ** | **2006**           | ** ** | **2005(1)**           | ** ** |
| **ASSETS**                                                                                                                    |       |               |       |                  |       |   |   |   |   |
| Current assets:                                                                                                               |       |               |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                     |       |               | $          | 23,224                |       |   |   | $ | 23,964 |   |   |
| Short-term investments                                                                                                        |       |               | 1,001      |                  |       |   | 739 |   |   |
| Trade accounts receivable, net                                                                                                |       |               | 6,130      |                  |       |   | 9,469 |   |   |
| Unbilled trade receivables                                                                                                    |       |               | 7,036      |                  |       |   | 6,228 |   |   |
| Inventory, net                                                                                                                |       |               | 5,843      |                  |       |   | 7,451 |   |   |
| Other current assets                                                                                                          |       |               | 2,223      |                  |       |   | 2,828 |   |   |
| Total current assets                                                                                                          |       |               | 45,457     |                  |       |   | 50,679 |   |   |
| Restricted cash                                                                                                               |       |               | 6,780      |                  |       |   | 7,279 |   |   |
| Property and  equipment, net                                                                                                  |       |               | 62,045     |                  |       |   | 64,108 |   |   |
| Intangibles, net                                                                                                              |       |               | 16,591     |                  |       |   | 17,164 |   |   |
| Other assets, net                                                                                                             |       |               | 976        |                  |       |   | 1,009 |   |   |
| Total assets                                                                                                                  |       |               | $          | 131,849               |       |   |   | $ | 140,239 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                 |       |               |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                          |       |               |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                              |       |               | $          | 5,326                 |       |   |   | $ | 6,722 |   |   |
| Accrued payroll and related costs                                                                                             |       |               | 2,901      |                  |       |   | 3,731 |   |   |
| Deferred revenue                                                                                                              |       |               | 5,965      |                  |       |   | 6,809 |   |   |
| Other current liabilities                                                                                                     |       |               | 1,894      |                  |       |   | 2,032 |   |   |
| Total current liabilities                                                                                                     |       |               | 16,086     |                  |       |   | 19,294 |   |   |
| Other long-term  liabilities                                                                                                  |       |               | 1,160      |                  |       |   | 969 |   |   |
| Total liabilities                                                                                                             |       |               | 17,246     |                  |       |   | 20,263 |   |   |
| Commitments and  contingencies (Note 5)                                                                                       |       |               |       |                  |       |   |   |   |   |
| Stockholders’ equity:                                                                                                    |       |               |       |                  |       |   |   |   |   |
| Common stock  (21,074,081 and 20,808,994 shares outstanding at March 31, 2006 and December 31,  2005, respectively) |       |               | 21         |                  |       |   | 21 |   |   |
| Additional  paid-in capital                                                                                                   |       |               | 208,617    |                  |       |   | 209,337 |   |   |
| Deferred stock  compensation                                                                                                  |       |               | —     |                  |       |   | (1,519 | ) |   |
| Accumulated other  comprehensive income                                                                                       |       |               | 137        |                  |       |   | 137 |   |   |
| Accumulated  deficit                                                                                                          |       |               | (94,172    | )                     |       |   | (88,000 | ) |   |
| Total stockholders’ equity                                                                                               |       |               | 114,603    |                  |       |   | 119,976 |   |   |
| Total liabilities  and stockholders’ equity                                                                              |       |               | $          | 131,849               |       |   |   | $ | 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.

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

| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Revenue:                                          |       |                             |       |   |   |
| Service                                           |       | $                                | 22,290     |   | $19,596 |   |
| Product and subscription                          |       | 4,903                            |       | 4,783 |   |
| Total revenue                                     |       | 27,193                           |       | 24,379 |   |
| Cost of revenue:                                  |       |                             |       |   |   |
| Service                                           |       | 17,099                           |       | 13,724 |   |
| Product and subscription                          |       | 2,549                            |       | 2,353 |   |
| Total cost of revenue                             |       | 19,648                           |       | 16,077 |   |
| Gross profit                                      |       | 7,545                            |       | 8,302 |   |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 4,539                            |       | 3,777 |   |
| Research, development and engineering             |       | 3,236                            |       | 2,908 |   |
| General and administrative                        |       | 5,210                            |       | 5,497 |   |
| Amortization of intangibles                       |       | 573                              |       | 811 |   |
| Intellectual property                             |       | 431                              |       | 536 |   |
| Total operating expenses                          |       | 13,989                           |       | 13,529 |   |
| Operating income (loss)                           |       | (6,444                           | )          | (5,227 | ) |
| Other income (expense):                           |       |                             |       |   |   |
| Interest income                                   |       | 325                              |       | 264 |   |
| Interest expense                                  |       | (16                              | )          | (62 | ) |
| Other                                             |       | 48                               |       | (18 | ) |
| Total other income, net                           |       | 357                              |       | 184 |   |
| Income (loss)  before provision for income taxes  |       | (6,087                           | )          | (5,043 | ) |
| Provision for  income taxes                       |       | (85                              | )          | (77 | ) |
| Net income (loss)                                 |       | $                                | (6,172     | ) | $ | (5,120 | ) |
| Net income (loss)  per share—basic           |       | $                                | (0.30      | ) | $ | (0.25 | ) |
| Net income (loss)  per share—diluted         |       | $                                | (0.30      | ) | $ | (0.25 | ) |
| Weighted average shares outstanding—basic    |       | 20,607                           |       | 20,453 |   |
| Weighted average  shares outstanding—diluted |       | 20,607                           |       | 20,453 |   |

``

See Notes to Unaudited Condensed Consolidated Financial Statements.

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

| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Cash flows from  operating activities:                                                     |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (6,172     | ) | $ | (5,120 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                              |       | 3,818                            |       | 3,430 |   |
| Stock-based compensation expense                                                           |       | 794                              |       | 51 |   |
| Increase (decrease) in allowance for doubtful  accounts                                    |       | (64                              | )          | (33 | ) |
| Other non-cash charges                                                                     |       | —                           |       | 17 |   |
| Changes in  operating assets and liabilities:                                              |       |                             |       |   |   |
| Restricted cash                                                                            |       | 499                              |       | (92 | ) |
| Trade and unbilled accounts receivable, net                                                |       | 2,595                            |       | (1,545 | ) |
| Inventory, net                                                                             |       | 1,608                            |       | (147 | ) |
| Other current assets                                                                       |       | 605                              |       | 222 |   |
| Other assets, net                                                                          |       | 33                               |       | 102 |   |
| Accounts payable                                                                           |       | (1,396                           | )          | (2,219 | ) |
| Accrued payroll and related costs                                                          |       | (830                             | )          | 1,265 |   |
| Deferred revenue                                                                           |       | (844                             | )          | (233 | ) |
| Other liabilities                                                                          |       | (214                             | )          | 1 |   |
| Net cash provided by (used in) operating activities                                        |       | 432                              |       | (4,301 | ) |
| Cash flows from  investing activities:                                                     |       |                             |       |   |   |
| Purchase of property and equipment and capitalized  labor costs                            |       | (769                             | )          | (5,195 | ) |
| Intangibles                                                                                |       | —                           |       | (20 | ) |
| Sale or maturity of short-term investments                                                 |       | 33,961                           |       | 42,744 |   |
| Purchase of short-term investments                                                         |       | (34,223                          | )          | (32,467 | ) |
| Net cash provided by (used in) investing activities                                        |       | (1,031                           | )          | 5,062 |   |
| Cash flows from  financing activities:                                                     |       |                             |       |   |   |
| Net proceeds from issuance of common stock                                                 |       | 5                                |       | — |   |
| Principal payments under capital lease obligations                                         |       | (146                             | )          | (117 | ) |
| Net cash provided by (used in) financing activities                                        |       | (141                             | )          | (117 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | (740                             | )          | 644 |   |
| Cash and cash equivalents at beginning of period                                           |       | 23,964                           |       | 18,489 |   |
| Cash and cash equivalents at end of period                                                 |       | $                                | 23,224     |   | $ | 19,133 |   |
| Supplemental disclosure  of cash flow information:                                         |       |                             |       |   |   |
| Cash paid for interest                                                                     |       | $                                | 16         |   | $ | 62 |   |
| Cash paid for income taxes                                                                 |       | $                                | —     |   | $ | 27 |   |
| Summary of non-cash  investing and financing activities:                                   |       |                             |       |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       | $                                | 413        |   | $ | 51 |   |
| Grant of restricted  stock                                                                 |       | $                                | 1,053      |   | $ | 2,025 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

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

**1.**   TheCompany, Basis of Presentation

*Description ofBusiness*

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 (“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. We provide solutions based on this technologydirectly and through our licensees.

As of March 31, 2006, the Company held rights in243 issued U.S. patents and 59 issued foreign patents on this technology andrelated technologies, applications, systems, and processes and had more than500 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 our systemsdesign, integration and materials science expertise, and proprietarytechnologies such as digital watermarking, to implement issuance systems and processesthat improve the security of identity documents and banknotes.

The remainder of our revenues is generated primarilyfrom patent and technology license fees paid by business partners providingmedia and rights management solutions to movie studios and music labels,television and radio broadcasters, creative professionals and other customersaround the world. Private sector media and entertainment industry customers usesecure media management solutions from the Company and its business partners toidentify, track, manage and protect content as it is distributed and consumed—eitherdigitally or physically—and to enable new consumer applications to improveaccess to networks and information from PCs and mobile devices.

In December 2001, theCompany acquired the assets and assumed certain liabilities of the U.S. largegovernment programs identification systems and international digitalidentification systems businesses of Polaroid Corporation and certain otheraffiliated entities of Polaroid Corporation. The acquisition was accounted forusing the purchase method of accounting.

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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 policy for depreciating these assets to the shorter of theoriginal contract term plus 2.75 years or estimated useful life. This change inestimate 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. Thischange had the effect of reducing depreciation expense by $2,146 in the firstquarter of 2006.  This reduction indepreciation increased basic and diluted earnings by $0.10 per share beforetaxes.  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.

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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,intellectual property and amortization of intangibles as shown on the condensedconsolidated statement of operations. The amortization of intangibles categoryincludes amortization costs related to intangible assets, primarily customerrelationship intangibles originally recorded in December 2001. Theintellectual property category includes costs associated with documenting,applying for, and maintaining patents generated through the Company’s researchand development efforts. The infrastructure category includes rent, leaseholdimprovements amortization, insurance expense and infrastructure depreciation.The centralized cost category includes centralized departments that serve alloperations such as our information technology department. The methods employedwere based on headcount, square footage or a combination of both asappropriate.

| ** **                                             | ** ** | ** ** | ** ** | **Intellectual** | ** ** | ** **   | ** ** | **Centralized**    | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------|------------|--------------|------------|--------------------|------------|------------|------------|
| **Quarter ending March 31, 2005,** | ** ** | ** ** | ** ** | **Before**       | ** ** | **Property** | ** ** | **Infrastructure** | ** ** | **Cost**   | ** ** | **After** | ** ** |
| Cost of  revenue—service                          |       | $          | 13,140     |             |       | $            | —     |               |       |       | $          | 140 |   |   |   | $ | 444 |   |   | $ | 13,724 |   |
| Total cost of  revenue                                 |       | 15,493     |       |             | —     |         |       |               | 140        |       |       |   | 444 |   |   | 16,077 |   |
| Gross profit                                           |       | 8,886      |       |             | —     |         |       |               | (140       | )          |       |   | (444 | ) |   | 8,302 |   |
| Sales and  marketing                                   |       | 3,815      |       |             | (311       | )            |       |               | 103        |       |       |   | 170 |   |   | 3,777 |   |
| Research,  development and engineering                 |       | 2,483      |       |             | (220       | )            |       |               | 233        |       |       |   | 412 |   |   | 2,908 |   |
| General and  administrative                            |       | 7,004      |       |             | (5         | )            |       |               | (476       | )          |       |   | (1,026 | ) |   | 5,497 |   |
| Amortization of  Intangibles                           |       | 811        |       |             | —     |         |       |               | —     |       |       |   | — |   |   | 811 |   |
| Intellectual  Property                                 |       | —     |       |             | 536        |         |       |               | —     |       |       |   | — |   |   | 536 |   |
| Total operating expenses                               |       | 14,113     |       |             | —     |         |       |               | (140       | )          |       |   | (444 | ) |   | 13,529 |   |
|                                                        |            |            |            |                  |            |              |            |                    |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**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. For allperiods presented, basic and diluted shares were the same. Shares are expressedin thousands.

Common stock equivalentsrelated to stock options of 5,386 and 6,431 were excluded from diluted net lossper share calculations for the three-month periods ended March 31, 2006and 2005, respectively, as their exercise price was higher than the averagemarket price of the underlying common stock for the period and therefore theirimpact would be anti-dilutive. In addition, common stock equivalents related tostock options and restricted stock of 852 and 157 for the three-month periodsended March 31, 2006 and 2005, respectively, were excluded from dilutednet loss per share as the Company was in a loss position and their inclusionwould be anti-dilutive.

**3.**   Stock-Based Compensation

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 

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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. SFAS 123(R) supersedes previousaccounting 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 our adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s condensed consolidated financial statements for periods prior to thefirst quarter of fiscal 2006 have not been restated to reflect this change.Stock-based compensation recognized during the period is based on the value ofthe portion of the stock-based award that will vest during the period, adjustedfor expected forfeitures. Stock-based compensation recognized in the Company’scondensed consolidated financial statements for the first quarter of fiscal2006 includes compensation cost for stock-based awards granted prior to, butnot fully 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 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 of AccountingPrinciples Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees,*and related interpretations includingFinancial Accounting 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,  *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 stock awardsgranted with an exercise price below fair market value on the date of grant.

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

*Valuationand Amortization Method.**   The Company estimates the fairvalue of stock-based awards granted using the Black-Scholes option valuationmodel. The Company amortizes the fair value of all awards on a straight-linebasis over the requisite service periods, which are generally the vestingperiods.*

*ExpectedLife.*   The expected life of awards grantedrepresents the period of time that they are expected to be outstanding. TheCompany determines the expected life based on historical experience withsimilar awards, giving consideration to the contractual terms, vestingschedules and pre-vesting and 

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post-vestingforfeitures. Stock options granted during the three months ended March 31,2006 and 2005 generally vest over four years and have contractual terms of tenyears. Stock purchases under the Company’s stock purchase plan have an expectedlife of six months to two years, which is equal to the offering period.

*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.

*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.

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model. There were no shares purchased under the Company’s stockpurchase plan during the three months ended March 31, 2006 and 2005,respectively. A summary of the weighted average assumptions and results foroptions granted during the periods presented is as follows:

| ** **               | ** ** | **Three Months  Ended  March 31,** | ** ** |
|--------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                     | ** ** | **2005** | ** ** |
| Expected life (in years) |       | 6.0                                          |       | 4.0 |   |
| Expected volatility      |       | 53                                           | %          | 50 | % |
| Risk-free interest rate  |       | 4.7                                          | %          | 4.5 | % |
| Expected dividend yield  |       | 0                                            | %          | 0 | % |
| Expected forfeiture rate |       | 14                                           | %          | 20 | % |
| Fair value               |       | $                                            | 3.89       |   | $ | 2.85 |   |
|                          |            |                                              |            |  |  |  |  |

 

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

The following tablesummarizes stock-based compensation expense related to stock-based awards underSFAS 123(R) for the three-months ended March 31, 2006 which wasincurred as follows (in thousands):

| ** **                             | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------|------------|
| Stock-based compensation:              |       |                                                   |       |   |   |
| Cost of revenue                        |       |                                                   | $          | 54 |   |   |
| Sales and marketing                    |       |                                                   | 122        |   |   |
| Research, development and  engineering |       |                                                   | 114        |   |   |
| General and administrative             |       |                                                   | 504        |   |   |
| Total stock-based compensation         |       |                                                   | $          | 794 |   |   |

 

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At March 31, 2006 the Company had 1.6 million non-vested stockoptions that had a weighted average grant date price of $6.23. As of March 31,2006, the Company had $6.6 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 1.75 years.

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 threemonths ended March 31, 2006 (in thousands, except per share amounts):

| ** **                                       | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **As Reported**Following FAS 123 (R)       | ** ** | **If Reported**Following APB 25 | ** ** |
| Condensed consolidated statement of operations:  |       |                                                           |       |   |   |   |   |   |   |
| Operating income (loss)                          |       |                                                           | $          | (6,444 | ) |   |   | $ | (5,838 | ) |   |
| Income (loss) before  provision for income taxes |       |                                                           | (6,087     | ) |   |   | (5,481 | ) |   |
| Net income (loss)                                |       |                                                           | (6,172     | ) |   |   | (5,566 | ) |   |
| Net income (loss) per share                      |       |                                                           |       |   |   |   |   |   |   |
| Basic                                            |       |                                                           | (0.30      | ) |   |   | (0.27 | ) |   |
| Diluted                                          |       |                                                           | (0.30      | ) |   |   | (0.27 | ) |   |
|                                                  |            |                                                                |            |  |  |  |  |  |  |  |  |

 

***Stock Option Activity***

As of March 31, 2006, under all of the Company’s stock-basedcompensation plans, options to purchase an aggregate of 7.5 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.

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Options granted,exercised, canceled and expired under the Company’s stock option plans aresummarized as follows (options in thousands):

| ** **                            | ** ** | **Options** | ** ** | **Weighted**AverageExercisePrice | ** ** | **Weighted**AverageRemaining  ContractualLife | ** ** |
|---------------------------------------|------------|-------------|------------|----------------------------------|------------|-----------------------------------------------|------------|
| Outstanding at December 31, 2005 |       | 7,368,636   |       |                             | $          | 16.16                                         |       |   |   |   |
| Options granted                       |       | 693,035     |       |                             | 4.54       |                                          |       |   |   |
| Options exercised                     |       | (1,922      | )          |                             | 2.42       |                                          |       |   |   |
| Options canceled                      |       | (823,248    | )          |                             | 14.20      |                                          |       |   |   |
| Options expired                       |       | —      |       |                             | —     |                                          |       |   |   |
| Outstanding at March 31, 2006    |       | 7,236,501   |       |                             | $          | 14.00                                         |       |   | 6.84 years |   |
| Exercisable at March 31, 2006    |       | 5,617,298   |       |                             | $          | 16.24                                         |       |   | 6.23 years |   |

 

At December 31, 2005, a total of 6.3 million options wereexercisable at a weighted-average exercise price of $16.16.

The following tablesummarizes information about stock options outstanding at March 31, 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 |       |                         | 1,432,768  |                         |       |   | 8.70 |   |   |   | $ | 5.39 |   |   | 307,622 |   |   | $ | 3.45 |   |   |
| $  6.19 - $  9.85 |       |                         | 881,039    |                         |       |   | 7.83 |   |   |   | $ | 7.76 |   |   | 386,982 |   |   | $ | 8.79 |   |   |
| $10.12 - $12.25                       |       |                         | 772,356    |                         |       |   | 7.72 |   |   |   | $ | 11.59 |   |   | 772,356 |   |   | $ | 11.59 |   |   |
| $12.40 - $12.25                       |       |                         | 677,085    |                         |       |   | 6.82 |   |   |   | $ | 12.82 |   |   | 677,085 |   |   | $ | 12.82 |   |   |
| $13.38 - $14.13                       |       |                         | 797,200    |                         |       |   | 4.92 |   |   |   | $ | 14.06 |   |   | 797,200 |   |   | $ | 14.06 |   |   |
| $14.18 - $15.24                       |       |                         | 641,872    |                         |       |   | 6.73 |   |   |   | $ | 15.10 |   |   | 641,872 |   |   | $ | 15.01 |   |   |
| $15.25 - $17.00                       |       |                         | 871,787    |                         |       |   | 6.62 |   |   |   | $ | 16.27 |   |   | 871,787 |   |   | $ | 16.27 |   |   |
| $17.13 - $26.25                       |       |                         | 786,344    |                         |       |   | 5.15 |   |   |   | $ | 20.96 |   |   | 786,344 |   |   | $ | 20.96 |   |   |
| $27.50 - $35.13                       |       |                         | 121,050    |                         |       |   | 4.11 |   |   |   | $ | 31.40 |   |   | 121,050 |   |   | $ | 31.40 |   |   |
| $53.94 - $53.94                       |       |                         | 255,000    |                         |       |   | 3.84 |   |   |   | $ | 53.94 |   |   | 255,000 |   |   | $ | 53.94 |   |   |
| $  0.50 - $53.94            |       |                         | 7,236,501  |                         |       |   | 6.84 |   |   |   | $ | 14.00 |   |   | 5,617,298 |   |   | $ | 16.24 |   |   |
|                                                 |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Pro Forma Information Under SFAS 123 and APB 25***

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 threemonths ended March 31, 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-months ended March 31,2005 would have been changed to the pro forma amounts indicated below (inthousands, except for per share data):

| ** **                                                                                                       | ** ** | **Three Months  Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                       | ** ** | **March 31, 2005** | ** ** |
| Net loss, as  reported                                                                                           |       |                         | $          | (5,120 | ) |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                               |       |                         | 51         |   |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards |       |                         | (1,676     | ) |   |
| Pro forma net  loss                                                                                              |       |                         | $          | (6,745 | ) |   |
| *Earnings per share:*                                                                                            |       |                         |       |   |   |
| Basic—as reported                                                                                           |       |                         | $          | (0.25 | ) |   |
| Diluted—as  reported                                                                                        |       |                         | $          | (0.25 | ) |   |
| Basic—pro forma                                                                                             |       |                         | $          | (0.33 | ) |   |
| Diluted—pro forma                                                                                           |       |                         | $          | (0.33 | ) |   |

 

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 theCompany’s common stock, or 5% of the total number of options of the Companyoutstanding as of December 31, 2004 with remaining vesting schedules, wereaccelerated. Of these 310,057 options, approximately 50,000 options were heldby the Company’s executive officers. No additional compensation expense wasrecorded in the statement of operations as the options that were acceleratedhad an exercise price greater than the fair market value of the shares underlyingthe 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  March 31,** | ** ** |
|---------------|------------|--------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Domestic      |       | $                                                | 20,105     |   | $ | 19,961 |   |
| International |       | 7,088                                            |       | 4,418 |   |
| Total         |       | $                                                | 27,193     |   | $ | 24,379 |   |

 

There was one customer inthe three-month period ended March 31, 2006 that accounted for more than10% of total revenue. There was no single customer in the three-month periodended March 31, 2005 that accounted for more than 10% of total revenue.There was no single customer that accounted for more than 10% of trade andunbilled accounts receivable, net at March 31, 2006. There was onecustomer who accounted for 13% of trade and unbilled accounts receivable, netat March 31, 2005.

**5.**   Commitments and Contingencies

Beginning in September 2004, three purportedclass action lawsuits were commenced against the Company and certain of itscurrent and former directors and officers by or on behalf of persons claimingto have purchased or otherwise acquired the Company’s securities during theperiod from April 17, 2002 to July 28, 2004. These lawsuits werefiled in the United States District Court for the District of Oregon and wereconsolidated into one action for all purposes on December 16, 2004. On May 16,2005, plaintiffs filed an amended complaint. The complaint asserted claimsunder the federal securities laws, specifically Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934, relating to the Company’sannouncement thatit had discovered errors in its accounting for software development costs andproject capitalization and other project cost capitalization accountingpractices, and that it likely would be required to restate its previouslyreported financial statements for full fiscal year 2003 and the first twoquarters of 2004. Specifically, the complaint alleged that the Company issuedfalse and misleading financial statements and created a misperception regardingthe profitability of the Company in order to inflate the value of Digimarcstock, which permitted insider sales of personal holdings at inflated values,and that the Company maintained insufficient accounting controls, which createdan environment where improper accounting could be used to manipulate financialresults. The complaint sought unspecified damages. On November 30, 2005,the Court granted the Company’s motion to dismiss the amended complaint on thegrounds that plaintiffs had failed to allege facts sufficient to support theirallegation that the defendants knowingly or recklessly acted in violation ofthe securities laws. Plaintiffs filed a second amended complaint on January 17,2006. On February 14, 2006, the Company filed a motion to dismiss thesecond amended complaint on the grounds that plaintiffs still fail to allegefacts sufficient to support their allegation that the defendants knowingly orrecklessly acted in violation of the securities laws. This motion is pending.Due to the inherent uncertainties of litigation and because the lawsuits arestill at a preliminary stage, the Company cannot accurately predict theultimate 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 

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consolidated into oneaction for all purposes on March 14, 2005. On July 19, 2005, thecourt granted the Company’s motion to stay these consolidated actions in favorof a shareholder derivative action to be filed by plaintiffs in the CircuitCourt of the State of Oregon for the County of Washington. On August 25,2005, the California plaintiffs filed two new derivative lawsuits in the UnitedStates District Court for the District of Oregon. On October 17, 2005,defendants filed a motion to dismiss these complaints for lack of subjectmatter jurisdiction and failure to state a claim. This motion currently ispending. Separately, on November 8, 2004, a letter was mailed to thechairman of the Company’s Board of Directors by a law firm purporting torepresent a shareholder of the Company, demanding that the Board commence acivil action against each of the directors and officers on behalf of theCompany to recover for damages alleged to have been incurred as a result ofalleged breaches of fiduciary duties. On or about April 6, 2005, thisshareholder filed a purported shareholder derivative suit against certain ofthe Company’s officers and directors, naming the Company as a nominaldefendant, in the Circuit Court of the State of Oregon for the County ofWashington. These suits claim that certain of these officers and directorsbreached their fiduciary duties to the Company’s shareholders and to theCompany. The complaints are derivative in nature and do not seek relief fromthe Company. The Company has appointed a committee to investigate the claimsasserted in the demand letter and in the derivative lawsuits. On August 25,2005, the individual defendants filed a motion to stay this state courtderivative lawsuit, and on September 26, 2005, the Court entered astipulated order granting the motion and staying the case pending the outcomeof an investigation by a committee appointed by the Company’s Board ofDirectors of the claims asserted in the demand letter and in the derivativelawsuits. That stay expired on February 28, 2006, and on March 31,2006 the individual defendants filed a motion to dismiss the lawsuit based onthe recommendation of the Board committee. Plaintiffs subsequently stipulatedto a dismissal of the lawsuit and, on May 5, 2006, Judge Gardner signed astipulated motion and order of dismissal, dismissing the lawsuit with prejudice.The derivative lawsuit filed in the United States District Court for theDistrict of Oregon remains on file, pending a decision on the individualdefendats’ motion to dismiss.

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 the Company, certainof its officers and directors, and certain underwriters of the Company’sinitial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensationarrangements (such as undisclosed commissions or stock stabilization practices)in the Company’s initial public offering registration statement and by engagingin manipulative practices to artificially inflate the price of the Company’sstock in the after-market subsequent to the Company’s initial public offering.The Company and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. Theindividual officer and director defendants entered into tolling agreements and,pursuant to a court order dated October 9, 2002, were dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, acommittee of the Company’s board of directors conditionally approved a proposedpartial settlement with the plaintiffs in this matter. In June 2004, anagreement of settlement was submitted to the court for preliminary approval.The settlement would provide, among other things, a release of the Company andof the individual defendants for the conduct alleged in the amended complaintto be wrongful. The Company would agree to undertake other responsibilitiesunder 

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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 delivery terms of thesecontracts. Such disputes are not uncommon and tend to be resolved over time. Asof March 31, 2006, theCompany has not paid any material contractual damages in connection witha customer dispute. However, theCompany’s failure to meet contractual milestones or other performancerequirements as promised, or to successfully resolve customer disputes, couldresult in the Company incurring liability for damages, as well as increasedcosts, lower margins, or compensatory obligations in addition to other losses,such as harm to its reputation. Such circumstances could have a materialadverse effect on the Company’s business and financial results. The Companyanticipates that future contracts will continue to have such provisions unlessand 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 bedetermined, management believes that, as of March 31, 2006, the finaldisposition of these proceedings will not have a material adverse effect on theconsolidated financial position, results of operations, or liquidity of theCompany. No accrual has been recorded because the amounts are not probable orreasonably estimatable in accordance with SFAS No. 5, *Accounting for Contingencies*.

**6.**   Comprehensive Loss

TheCompany has adopted SFAS No. 130, *ReportingComprehensive Income*, which establishes standards of reporting anddisplaying comprehensive income (loss) and its components of net income (loss)and other comprehensive income (loss). Other comprehensive income (loss) refersto revenues, expenses, gains and losses that are not included in net income(loss) but rather are recorded directly in stockholders’ equity. Comprehensiveincome (loss) is defined as changes in stockholders’ equity exclusive oftransactions with owners. To date, the only adjustments required to be reportedin comprehensive 

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income (loss) are foreign currency translationadjustments. The following table provides a summary of comprehensive loss forthe three-months ended March 31, 2006 and 2005, respectively (inthousands):

| ** **                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Net loss                                 |       | $                                                | (6,172     | ) | $ | (5,120 | ) |
| Foreign currency  translation adjustment |       | —                                           |       | 17 |   |
| Comprehensive loss                       |       | $                                                | (6,172     | ) | $ | (5,103 | ) |

 

**7.**   Recent Accounting Pronouncements

In March 2006, theFASB issued SFAS No. 156, *Accounting for Servicingof Financial Assets, an amendment of SFAS No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.*The statement changes the way entities account for servicing assetsand obligations associated with financial assets acquired or disposed of. SFAS No. 156is effective 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.

**8.**   Revenue Recognition

Revenue from the Company’sgovernment-issued credential systems is generally billed and recognized on aper card produced basis. The Company recognizes revenue on these contractsbased on the actual monthly production, if available, and in limited situationson estimated volume information. When actual production information becomesavailable, typically within one month, the Company bills the customeraccordingly and any differences from the estimates are recognized in the monththe billing occurs. Differences to date have not been significant. Revenueearned which has not been invoiced is classified as unbilled trade receivablesin the consolidated balance sheets. Revenue related to an enhancement of orupgrade to an existing system is deferred and recognized over the remaininglife of the contract.

Revenue for sales ofconsumables and equipment not related to a driver license production contractis recognized when the products have been shipped, ownership has beentransferred, evidence of an arrangement exists, the sales price is fixed anddeterminable, and collectibility is reasonably assured.

Revenue from professionalservices arrangements is generally determined based on time and material or acost plus a profit margin measure. Revenue for professional services isrecognized as the services are performed. Progress towards completion ismeasured using costs incurred compared to the budgeted amounts contained in thecontract. 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.

Royalty revenue isrecognized when the royalty amounts owed to the Company have been earned, aredeterminable, and collection is probable. Subscriptions are paid in advance andrevenue is recognized ratably over the term of the subscription.

Maintenance revenue isrecognized when the maintenance amounts owed to the Company have been earned,are determinable, and collection is probable. Maintenance contracts are, attimes, paid in advance and revenue is recognized ratably over the term of theservice period.

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

The Company also generatesrevenue from the licensing of digital watermarking products and services foruse in authenticating documents, detecting fraudulent documents and deterringunauthorized duplication or alteration of high-value documents, for use incommunicating copyright, asset management 

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andbusiness-to-business image commerce solutions, and for use in connecting analogmedia to a digital environment. Software revenue is recognized in accordancewith AICPA SOP No. 97-2, as amended by AICPA SOP No. 98-9,*Modification of SOP 97-2*, *With Respect to Certain Transactions*.Revenue for licenses of the Company’s software products is recognized upon theCompany meeting the following criteria: persuasive evidence of an arrangementexists; delivery has occurred; the vendor’s fee is fixed or determinable; andcollectibility is probable.

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

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 separateunits of 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 application of EITF Issue No. 00-21,including value allocation among multipledeliverables, determination ofwhether undelivered elements are essential to the functionality of deliveredelements and timing of revenue recognition, among others.

**9.**   Inventory

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

| ** **                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Equipment and  deferred contract costs |       |               | $          | 694                   |       |   |   | $ | 899 |   |   |
| Consumable  materials                  |       |               | 5,149      |                  |       |   | 6,552 |   |   |
| Inventory, net                         |       |               | $          | 5,843                 |       |   |   | $ | 7,451 |   |   |

 

The reserve for slowmoving and obsolete items was $318 and $240 at March 31, 2006 and December 31,2005, respectively. While we do not currently expect to be able to sell orotherwise use the reserved inventory we have on hand based upon our forecastand backlog, it is possible that a customer or customers will decide in thefuture to purchase a portion of the reserved inventory.

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**10.**   Software Development Costs

Under Statement of Financial Accounting Standards (“SFAS”)No. 86, *Accounting for the Cost ofComputer Software 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 ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred inthe preliminary project stage are expensed as incurred and costs incurred inthe application development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. Costs incurred in thepost-implementation stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to cardmanufacturing and control systems software.

**11.**   Related Party Transactions

During the three-month periods ended March 31,2006 and 2005, the Company recognized revenue of $125 and $142, respectively,from a holder of common stock. Net accounts receivable from this holder was$256 at March 31, 2006 and $231 at December 31, 2005.

During the quarter ended March 31, 2005, theCompany entered into a relocation agreement with an executive officer. As partof the relocation package, the Company purchased the personal residence of thatofficer. The purchase price was based on independent appraisals and totaled$825. The Company has assumed all rights and obligations related to theresidence. During the quarter ended March 31, 2006, the Company sold thepersonal residence to an unrelated third party for $710, resulting in a netloss of $115.

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

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

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readersare also urged to carefully review and consider the various disclosures made byus which attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made under the caption “RiskFactors” in this Form 10-Q and the audited consolidated financialstatements and related 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 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. We provide solutions based on this technologydirectly and through our licensees. Our solutions and technologies are deployedby us and our business partners in media objects and digital devices around theworld.

As of March 31, 2006, the Company held rights in243 issued U.S. patents and 59 issued foreign patents on this technology and relatedtechnologies, applications, systems, and processes and had more than 500 U.S.and foreign applications pending.

The substantial majority of our revenue is generated pursuantto long-term contracts with government agencies—primarily State driver licenseissuers, a consortium of leading Central Banks and national governments of anumber of foreign countries. These systems rely on our systems design,integration and materials science expertise, and proprietary technologies suchas digital watermarking, to implement issuance systems and processes thatimprove the security of identity documents and banknotes.

The remainder of ourrevenues is generated primarily from patent and technology license fees paid bybusiness partners providing media and rights management solutions to moviestudios 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 usand our business partners to identify, track, manage and protect content as itis distributed and consumed—either digitally or physically—and to enable newconsumer applications to improve access to networks and information from PCsand mobile devices.

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**Vision and History**

The Company’svision is to improve the value of media content through technology. Our missionis two-fold:

·       Foster large-scale adoption of digital watermarking solutions licensedunder the Company’s intellectual property

·       Be the most desired profitable supplier ofdriver license issuance systems

Digimarc was founded in 1995 to commercialize a signalprocessing innovation known as “digital watermarking.” Digital watermarking isa technology breakthrough that allows our customers to infuse digital data intoany media content that is digitally processed at some point during itslifecycle. The technology can be applied to printed materials, video, audio,and images. The inclusion of such digital data enables a wide range ofimprovements in security and media management, and enables new business modelsfor distribution and consumption of media content. We use digital watermarkingas a value driver and differentiator in nearly all of our product offerings.

Banknote counterfeit deterrence was the firstcommercially successful use of digital watermarking. In cooperation with aninternational consortium of leading Central Banks, we developed a system todeter the use of digital technologies in the unauthorized reproduction ofbanknotes. More recently, innovations based on our digital watermarkingtechnology and experience have been leveraged to create new products to detercounterfeiting and tampering of driver licenses and other government-issuedsecure credentials. In parallel, our business partners, under patent licensefrom us, are delivering digital watermarking solutions to track and monitor thedistribution of music, television, movies and radio to consumers.

On the heels of the terrorist attacks of September 11,2001, we realized that our expertise in security printing, digital imagingtechnologies and systems placed us in a position to understand both the digitalthreats to identity management credentials and the issuer’s environment. Inlate 2001, we acquired the Large Government Programs (“LGP”) business unit ofPolaroid Corporation (“Polaroid”). The primary focus of this business is theproduction of driver licenses and other IDs issued by government agencies. Theacquired assets included all relevant software, hardware, services, materialsscience and distribution assets of Polaroid’s government-issued photoidentification business.

In this strategicacquisition, we saw a unique opportunity to assist in efforts to deter identitytheft and fraud and enhance transportation safety and Homeland Security throughthe combination of a new layer of security using our digital watermarkinginnovations and market-leading competence in secure ID solutions from Polaroid.The resulting business has more than 47 years of experience in the delivery andoperation of secure ID issuance systems, has produced more than 2 billionissued IDs, and has guided customers through numerous major upgrades andtechnology migrations in ID security. We are the leader in deployingnew solutions to meet driver license security and related servicechallenges. This includes being first to:

·       producedriver licenses with digital portraits;

·       deployfacial recognition and State-wide fingerprint matching in 1995 and 1996;

·       introducemarket leading security features, including digital watermarking, Kinegrams,and secure card materials;

·       producedriver licenses in secure, networked central issuance factories;

·       offerdriver license renewal by Internet; and

·       offera comprehensive and modular ID validation and archiving suite toaddress recently enacted Federal legislation, such as the REAL ID Act passed inMay 2005 (the “REAL ID Act”).

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With increasing interestin issues surrounding Homeland Security, prevention of identity theft andfraud, traffic safety, copyright and intellectual property protection andestablishment of new business models for digital distribution and use of mediacontent, Digimarc has evolved from a technology-driven early stage company toan important supplier of critical infrastructure to government agencies and astrategic business partner to solution providers supporting the media andentertainment industry.

**Our Business**

The majority of our revenues is derived from supplyinginfrastructure to government agencies pursuant to long-term contracts,primarily State driver license issuers, a consortium of leading Central Banksand national governments of various foreign countries. The retention rate forour driver license customers is high. Our contract with the Central Banks is inits eighth year. Last year we agreed to a 5-year extension, with twoadditional 3-year extensions that we expect to be implemented.

The remainder of our revenue is generated throughcommercial applications of our digital watermarking and related technologies,primarily from patent and technology license fees paid by business partnersproviding media and rights management solutions to movie studios and musiclabels, television and radio broadcasters, creative professionals and othercustomers around the world. Our licensing business is built upon our extensivepatent portfolio, which contains 243 issued U.S. patents as of March 31,2006. Patent licensing is expected to continue to contribute most of ourrevenues from non-government customers for the foreseeable future.

Digital watermarking is a strategic component ofnearly all of our product offerings. Digital watermarking has already proven tobe a powerful differentiator in banknote security, giving rise to a long-termrelationship with leading Central Banks and many leading companies in the ITindustry. We are working to develop a similar success in secure identitymanagement systems. Today, digital watermarking is incorporated into more than25 million driver licenses as a means to provide cross-jurisdictional machineauthentication.

In recent years, Digimarcand its business partners have successfully propagated digital watermarking inmusic, movies, television and radio broadcasts, images and printed materials,providing improved media rights and asset management, reduced piracy and counterfeitinglosses, improved marketing programs, and more efficient and effectivedistribution of valuable media content.

**Markets and Competition**

*Government*

We believe that the global market for secure identitymanagement solutions is in the early adoption stage characterized by afragmented supply chain with no dominant brands, emerging standards, andincreasing concerns about national and economic security, entitlement programs,and requirements for controlling access to information and physical assets.

We believe that U.S. driver license revenues 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. Forexample, Congress has appropriated $40 million for the fiscal year ending September 30,2006 for grants to States to assist them in making necessary upgrades However,we cannot predict the full extent to which Digimarc will benefit from fundingunder the REAL ID Act until the Department of Homeland Security providesfurther guidance on its future regulations under the REAL ID Act. Theseregulations may impose certain requirements, such as specific cardarchitectures or security features, and may condition funding upon compliancewith such requirements.

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We are diligentlypursuing these funding opportunities and working with customers who are writinggrant proposals to upgrade and expand their operations. For example, the REALID Act mandates certain changes in workflow and business rules. Several Statesare taking advantage of these changes to drive an upgrade of legacy mainframeapplications, and are embarking on business process reengineering and mainframemigration or data center consolidation projects. These data center moves,combined with the availability of Federal dollars, are drawing new competitorsto the U.S. driver license market.

The industry modelfor the U.S. driver license market is characterized by long-term contractsawarded through competitive bids to prime contractors who take fullresponsibility for delivery and maintenance of driver license issuance systems.The retention rate for driver license customers is high. The conditions for availability ofgrant money from the Department of Homeland Security and the Department ofTransportation for projects relating to compliance with the REAL ID Act,commercial driver license systems, and protection of the Homeland may causesome changes in the procurement model, but we cannot predict the likelihood oroutcome of those changes at this time.

We believe that many aspects of our driver license issuancesolutions may 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 largest supplier ofgovernment-issued citizen IDs in the U.S. and Mexico and our extensiveinvestments in research and development provide a good foundation forparticipation in the global market for government programs in establishing theidentities of citizens 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. We believe that theaggregation of these print and digital content markets creates an enormousoverall opportunity for us to address. Each media object enabled by ourtechnology creates the potential for several applications, such as tracking andmonitoring, authentication, anti-counterfeiting, or linking to networks andenhanced services. We believe the market for digital watermarking applicationsis in the early stages of development and that existing solutions representonly a nominal portion of the potential market for our products, services, andtechnologies. We cannot provide reliable estimates of the size of these marketsas of the date of this report.

*Competition*

We compete for governmentbusiness with system integrators, biometrics suppliers, security printers, cardmanufacturers, and smart card and other security technology suppliers,including companies like Viisage Technology, Inc. (biometrics), UnisysCorporation (system integration) and De La Rue plc (security printer). Each ofthese companies is a supplier to U.S. driver license issuers. As U.S. driverlicenses gain utility as general credentials and the Federal government isdemanding higher security and a certain amount of standardization, we expectincreasing competition. For instance, certain aspects of the REAL ID Act mayexpedite an existing trend toward central issuance of driver licenses and SmartCard (“SC”) technologies. While we are proficient at central issuance, thepossible acceleration of this trend has drawn new competition from classicsecurity printers such as Canadian Banknote (CBN) and could draw additionalcompetition from other security printers. In addition, we have seen increasedinterest in the U.S. market from large systems integrators such as ElectronicData Systems Corporation, IBM Global Services, and Bearing Point, Inc.. Smallerapplication providers are also emerging as point-product competition, includingCovansys Corporation and Archon Technologies, Inc..

The possibility of includingSC technologies in driver licenses is generating a great deal of public debate.The SC industry is generally driven by European chip manufacturers such asInfineon Technologies AG and Axalto seeking to monetize investments to createcontact and contactless 

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microprocessorpackages and embedded operating systems, as well as chips for memory cards. Whilesuccessful in bank cards, mobile phone SIMs and phone cards, SCs have onlyrecently begun to gain distribution as government-issued credentials. The U.S.government is a strong advocate. Federal identity standards are embracing SCsfor the military, transportation workers, and government employees andcontractors, and new “ePassports” will carry a portrait in an on-book chip. Despiteconsiderable investment by the federal government, we believe no States haveattempted or even piloted SC driver licenses. We understand that in recentyears, at least two States have expressly considered and rejected SC driverlicenses. Emerging border control and Federal traveler programs are consideringSC concepts, but have not gained traction and face privacy issues. Weanticipate that we will be prepared to support requirements from customers forSC technology if, and when, such requirements arise.

Internationally, Digimarcsupplies credentialing systems, components or supplies to numerous foreigngovernments, including two Canadian provinces, Latvia, Mexico, Colombia andRussia. Competition in international markets, like in the U.S., comes fromsecurity printers, card producers, biometric companies and systems integrators,such as Sagem, De La Rue plc, Gemplus S.A., Siemens-Nixdorf, Inc., UnisysCorporation, and Electronic Data Systems Corporation.

In all markets, our productand account strategy is intended to protect our existing customer base,continue to expand into accounts we do not presently service, and grow ourbusiness and workflow with existing customers. We believe that the key tosuccess is building strong customer relationships, based on delivery ofsuperior solutions and excellent service and a profound understanding ofcustomer needs.

In media andentertainment, Digimarc and our business partners generally compete withapplication-specific alternative technologies for the security budget of theproducers and distributors of the media objects. Such alternatives includetechnologies and solutions based on encryption or on pattern recognition. Goingforward, our competitive position within certain markets may be affected byfactors such as inertia of the status quo and, positively or negatively, bychanges in government regulations.

**Government Productsand Services**

We provide financialdocument security and secure ID solutions to government agencies:

***Financial DocumentSecurity***

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.

***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 the hardware, software, consumablesupplies (such as ribbons, blank or preprinted card materials, and laminates),and on-going support necessary for a “turnkey” solution. They typically involvecustom software and/or hardware development, integration services, andimplementation services. When we provide a full issuance system to a customer,we generally retain title to all assets associated with the system and areresponsible for maintaining the system over the contractual 

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period. A digital driverlicense issuance system typically captures images (photo and signature) anddemographic information, validates applicant identity, produces the actual driverlicense or ID (either at the point of service or at a central productionfacility operated by us), provides or delivers the finished driver license orotherID to 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 onbroadening our security offerings to provide more integrated identityverification and fraud detection capabilities within the issuance workflow ofour customers. Many aspects of our advanced technology solutions anticipateboth the mandate of the REAL ID Act and the emerging consensus on bestpractices consistent with our product and service strategy.**Someof the requirements of the REAL ID Act that may require States to upgrade to bein compliance include:

***ApplicantData Capture***

·       capturedigital images of identity source documents in a transferable format

·       retaincopies of source documents—7 years for paper or 10 years for image

·       conduct mandatory facialimage capture

*Identity Verification*

·       verify,with the issuing agency, the issuance, validity, and completeness of eachdocument

·       verifythe legal residency of a person

·       confirmor verify a renewing applicant’s information

·       confirmwith Social Security Administration all applicant Social Security Numbers usingthe full 9-digit number

·       confirmtermination of previous license in another State before issuance

·       provide electronic accessto all other States to information contained in the motor vehicle database ofthe State

*Secure Credentialand ID Validation*

·       limitvalidity period of IDs

·       implementphysical security features designed to prevent tampering, counterfeiting, orduplication

·       deploycommon machine-readable technology, with defined minimum data elements

Serving government needsfor citizen identity management involves successfully delivering solutions thatspan the secure ID lifecycle, ranging from demographic data capture, identityvalidation, and applicant data and biometric verification systems, to thedesign and secure production of credentials incorporating linked and layeredsecurity features, culminating with effective ID authentication deployedat various points of inspection. It also requires the expertise to integratethese solutions with existing government agency applications and ITinfrastructure, and the service, support and training necessary to effectivelymanage the implementations over the course of long-term customer relationships.We have worked extensively with driver license issuers across the U.S. to strengthentheir issuance systems and secure credential designs. As a result, we haveidentified and implemented numerous “best practices” throughout its processesand developed modular, flexible solutions designed to improve security withineach component of the secure ID lifecycle—from the time an applicant appliesfor or renews his or her 

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driverlicense; to the secure production and issuance of the ID to the legitimatecardholder; to the authentication of that document at a traffic stop, a bank, aborder crossing, a store, or the DMV. The chart below maps Digimarc’s solutionsto an overview of the secure ID lifecycle.

*ApplicantData Capture and Identity Verification.**  *Validation of documents and verification ofapplicant identity are keys to the secure intake and enrollment process, and acritical step toward ensuring that driver licenses are only issued tolegitimate applicants. In 2005, we introduced the Digimarc Identity Validation Suite (“IDVS”)to validate identity documents and verify the biometric and demographic datapresented to establish an applicant’s identity. As identity credentialsbecome more secure and difficult to counterfeit, counterfeiters turn toproducing false breeder documents to fuel attempts to fraudulently obtain validsecure credentials. Thus, the process of validating identity is becomingcentral to secure ID issuance as document quality improves, ensuring that onlyvalid applicants receive genuine IDs. This market development is underscored bythe focus of the REAL ID Act on identity validation. IDVS is our most strategicproduct offering in 2006, enabling migration to compliance with the REAL IDAct, and serving a growing demand by our customers for effective multi-factoridentification of applicants. Our role in the secure ID lifecycle is expandingto one that encompasses identity validation and leads us toward a larger rolein the enrollment application. IDVS works in concert with other aspects of oursolution such as our driver licenseImaging Capture Suite. The Capture Suite enables secure ID and driverlicense issuers to capture high-quality portraits, signatures and fingerprintsneeded to complete the intake and enrollment process. This step is important tosecurity and customer satisfaction, providing high-quality photos and reliablebiometric verification.

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*SecureProduction.**  *Once an applicant’s demographic information andimages have been captured, screened and verified, Digimarc solutions enableissuers to securely produce and personalize a secure and highly-durable driverlicense. We offer several flexible options, including secure over-the-counterinstant issuance systems, central issuance systems, and hybridover-the-counter / central issue systems.

*SecureCredential.**  *An integral part of enhancing ID security isthe design and production of the secure credential itself. Cost-effectivesecurity is achieved through a card architecture that combines multiple layeredand linked security features such as digital watermarks, special printing andKinegrams with durable, counterfeit-resistant materials in our line ofproprietary card products. With our industry-leading Exian card products, wehave developed and incorporated many innovative security features in our driverlicense credentials. Key among these is IDMarc, a Digimarc proprietarysecurity feature built around our proprietary digital watermarking technology.This feature links together elements of the ID in a way that is imperceptibleunder normal use, can be added to existing designs, and is readily detected byenabled software and hardware. IDMarc enables post-issuancecross-jurisdictional validation of documents.**Digimarc secure credentials often contain morethan a dozen separate overt and covert security elements that protect againsttampering or counterfeiting, and digital watermarking provides the coremachine-readable security feature.

*Point of InspectionValidation.**  *The secure ID lifecycle is not complete unlessthat document is routinely validated at the point of use. With the introductionof security features such as IDMarc, our secure IDs carry machine-readablefeatures that allow for low-cost and effective cross-jurisdictionalauthentication, augmenting visual inspection to determine if a presented driverlicense matches one of the more than 240 valid driver license designs.

**Media andEntertainment**

We license ourtechnology and patents and otherwise foster development of the market fordigital watermarking-based solutions for commercial as well as governmentaluses. As of the filing date of this report, these licenses have primarilyinvolved use of our technology and patents in the media and entertainment area.Commercial customers use secure media solutions from our business partners andus to identify, track, manage and protect content as it is distributed andconsumed—either digitally or physically—and to enable new consumer applicationsto access networks and information from PCs and mobile devices. Many moviestudios, record labels, broadcasters, creative professionals and othercustomers rely on digital watermarking as a cost-effective means to:

·       deterpiracy and illegal use of movies, music and images;

·       protectentertainment content from copyright infringement;

·       trackand monitor entertainment content for rights usage and licensing compliance;

·       monitoradvertisements to verify ad placement and measure return on investment; and

·       enablefair and legitimate use of content by consumers.

Our business partners include Activated ContentCorporation, Cinea, Inc., a subsidiary of Dolby Laboratories, Inc.,GCS Research LLC, MediaGrid, Nielsen Media Research, Inc., Royal Philips,Signum Technologies Limited, Thomson Multimedia, S.A., Verance Corporation andVerimatrix, Inc. While each partner addresses particular customer needs,as a whole they are propagating digital watermarking in music, movies, images,and television and radio as a means to improve media rights and assetmanagement, reduce piracy losses, improve marketing programs, and provide moreefficient and effective distribution of valuable media content.

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Our businesspartners’ applications of digital watermarking include the following:

*ForensicTracking:**  *Forensictracking allows content owners to determine when and where a unit of mediacontent leaves its authorized distribution channel. The most common use offorensic tracking is in the entertainment industry, where music and movies areroutinely distributed to executives, critics and other media outlets forpromotion before they are released to the public. In recent years, copies ofthese ‘pre-release’ products have been leaked onto the Internet, or copied ontoCDs and DVDs, and sold as “bootlegs” well ahead of their commercial release.These unauthorized activities result in loss of revenues for the artists, thestudios and the music labels.

To combat pre-release piracy, music companies andmovie studios embed pre-release content with digital watermarks that are uniqueto each authorized recipient. This allows the content creators to forensicallytrack the source of leaks and take appropriate actions. As a result, recipientsof pre-release music and movies have begun to police themselves in order toavoid liability for unauthorized use.

The use of digital watermarking solutions from ourbusiness partners for forensic tracking of pre-release movies and music hasgained a strong foothold in Hollywood. For instance, digital watermarking isincorporated in millions of audio tracks from major record labels to identifyand track leaks of promotional, pre-release music onto the Internet. Customersof these solutions from Digimarc and business partners such as ActivatedContent Corporation and Royal Philips Electronics include Sony BMG MusicEntertainment, Universal Music Group and Warner Music Group Corporation,mastering studios, disk duplicators and online business-to-business musicdistributors. In a similar application for movies, digital watermarking hasbeen identified by representatives of the movie studios as dramaticallyreducing piracy of movies in the Academy Award screener program.

Digital watermarking may also play a role in the movieindustry’s transition from film reel distribution to digital file formatdistribution for theatrical release. In July 2005, the Digital CinemaInitiative, which is supported by Disney, Fox, MGM, Paramount, Sony PicturesEntertainment, Universal and Warner Bros. Studios , released its Digital CinemaSystem Specification, which details industry guidelines designed to help spurdeployment of digital cinema systems for the hundreds of thousands of movietheater screens in the U.S. and around the world while establishing uniformlevels of security, distribution, performance, reliability and quality control.The specification requires that digital cinema systems be capable of applyingdigital watermarks in both the video and audio streams of digital movies uponrequest of the studios or other content providers. The digital watermarks canbe used as a forensic tool to help identify the theater, location, andproduction version and the date and time that a film plays in a specific theater.

*BroadcastMonitoring:**  *Broadcastmonitoring allows clients to identify where, when and how their media contentis being aired. This type of information is important to many different typesof users. For example, every day, thousands of advertisements run in thousandsof markets across the country. With highly regionalized cable, satellite andterrestrial delivery, advertising agencies and their clients need to know thatthe advertisements they pay for are actually being broadcast. By using digitalwatermarking-based services, these companies can monitor broadcasts in majormedia markets around the world, verify compliance by broadcast partners, andmeasure the effectiveness of the campaign. As another example of how suchinformation is used, advertisers such as Coca Cola and Pepsi, and broadcastnetworks such as ABC Television Network, NBC News Channel, BBC and ReutersTelevision, currently apply solutions from Digimarc partners that enablemonitoring of broadcasts on over a thousand channels in more than 50 countriesworldwide, studying the distribution of their content, verifying compliance bybroadcast partners, and measuring the effectiveness of broadcasts.

*CopyPrevention:*   Digital watermarksallow companies to control the use of copyrighted image, audio and videocontent. A digital watermark travels with the content, persisting through thechanges in file format, and through transformation between digital and analogform and back again. This allows the content owner to specify whether or howoften the work can be legally copied or shared without visually or 

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audibly impairing thework. It also allows greater and safer dissemination of copyrighted works whileat the same time ensuring appropriate compensation to the owners. Digitalwatermarking from Verance Corporation, one of our business partners, has beendeployed in conjunction with licensed DVD-audio implementations to preventplayback of unauthorized copies. Digital watermarking is currently underconsideration as an important security layer for additional audiovisual mediacontent and in October of 2005, DVD Copy Control Association (DVD-CCA)issued a Request for Expressions of Interest to evaluate technologies for thepurpose of selecting a technology for use in marking audio-visual content toconvey certain content control information. The selected technology will beused to enhance the Content Scramble System copy protection system foraudio-visual content that is used to protect DVD movies. The DVD-CCA’s earlierwatermarking evaluation efforts concluded in July of 2002 withoutselection of a watermarking technology. According to the Request, it appearsthat the DVD-CCA anticipates that the optimal solution for addressing theirneeds is likely to be audio watermarking. More information can be found at *www.dvdcca.org*.

In addition, the Interim Adopter Agreement for theAdvanced Access Content System (AACS) was made available in February of2006. AACS is designed as the next generation of content protection forprerecorded and recordable optical media such as Blu-Ray and HD DVD. TheInterim Adopter Agreement includes a reference that AACS anticipates that theFinal Adopter Agreement will require certain watermark screening obligations. Moreinformation can be found at*www.aacsla.com.*

*DigitalImage Management:**  *Our owndigital watermarking product portfolio includes our Digimarc ImageBridge andDigimarc MyPictureMarc products, focused on digital image management andcopyright communication.

In addition to these solutions, we believe thatfurther digital watermark media solutions may emerge such as the following:

*RightsManagement:**  *Becausedigital watermarks can be applied and detected at various points betweendistribution and playback, they can be valuable for rights management andre-association. Among other things, new applications could be developed toallow consumers to move their digitally watermarked content through theirvarious playback devices (e.g. personal computers and CD players) and differentDRM encryption and decryption environments while preserving the identity of thecontent through use of a digital watermark and enabling rights re-associationas appropriate in downstream devices.

*Filtering/Classification:**  *The popularity of peer-to-peer (“P2P”) music swappingservices, such as Napster, brought the issue of content and rights managementto a crisis point. Because P2P systems have difficulty determining which mediafiles are copyrighted and which are not, it is relatively easy for content tobe illegally distributed across these networks. Digital watermarks could allowP2P systems to better identify and distinguish copyrighted from non-copyrightedaudio or video files and thereby facilitate legal file sharing. Digitalwatermarks could also enhance P2P systems by enabling them to collaborate withrecord labels and other audio retailers to link to and market legitimatecopyrighted songs. A June 2005 U.S. Supreme Court ruling(Metro-Goldwyn-Mayer Studios vs. Grokster, Ltd.) identified digitalwatermarking as one of the solutions that could help curb copyrightinfringement and illegal distribution of music or movies shared across P2Pnetworks. The ruling recognizes the possibility that digital watermarks couldbe used to identify media content and associated rights and enable downstreamconsumers and systems to act appropriately as they access such content.

Digital watermarking technology can also enableconsumers to more easily access and effectively control digital content.Digital watermarking can be used to sort and search through audio, image andvideo files. For example, digital images could be embedded with digitalwatermarks that allow devices to classify or filter them in order to helpparents better manage the media intake of their children, especially over theweb.

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*RemoteTriggering:**  *Anotherpotential application of digital watermarking is use as a trigger—to make aplayback device, such as a cell phone or a digital video recorder, perform anautomatic action. When images, audio files or video files are distributed orreceived, digital watermarks can signal these playback devices to displaynotification that the content is copyrighted, trip a download counter, ordisplay additional related content and choices to consumers.

*E-Commerce:*   Digimarcbelieves that digital watermarking could also be used to further enhance theconsumer experience through improved electronic- and mobile-commerceapplications. For example, if a digitally watermarked song is played on a cellphone, a content ID could be used to look up information about the artist orfind other songs that can be purchased with the click of a button. In such anapplication, digital watermarking has the potential to give consumers morechoices, better access and faster delivery of the products and entertainmentthey want.

**Recent Developments**

As of the date of thisreport, Digimarc has a contract with the Commonwealth of Virginia Department ofMotor Vehicles (“DMV”) for the issuance of driver licenses. The term of thecontract runs through October 31, 2007, with an option on the part of DMVfor a 6-month extension. On April 5, 2006, DMV issued a notice ofintent to award a contract to Canadian Bank Note Secure Technologies, Inc.(“CBN”) for a new driver license issuance system. On April 17, 2006,Digimarc filed a protest of this award, based in part on certain alleged irregularitiesin the evaluation process and the assertion that the CBN proposal does notrepresent the best value for the Commonwealth and its citizens. OnApril 27, 2006, DMV issued a response, in which it rescinded the Notice ofIntent to Award. The DMV response states that “Digimarc’s protest raises issuesthat DMV believes warrant further consideration and evaluation” and that, “[i]naddition, DMV has determined that certain details pertaining to the agreementwith the proposed contractor were still being addressed when the earlier noticewas posted.” Digimarc cannot at this time predict the outcome of DMV’s furtherevaluation of proposals in connection with this procurement.

**Critical AccountingPolicies and Estimates**

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the UnitedStates of America requires us to make estimates and judgments that affect thereported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to bad debts, inventories,intangible assets, income taxes, restructuring, long-term service contracts,warranties, investments, contingencies and litigation, and inputs related tostock-based compensation calculations. We base our estimates on historicalexperience and on various other assumptions we believe to be reasonable underthe circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions.

Certain of our accounting policies require higherdegrees of judgment than others in their application. These include revenuerecognition on long-term service contracts, impairments and estimation ofuseful lives of long-lived assets, inventory valuation, reserves foruncollectible accounts receivable, contingencies and litigation, and 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 onlong-term service contracts:****  **Werecognize revenue on long-term identification and driver license productioncontracts using primarily a price-per-card method. We use actual monthly volumeamounts, if available, or we estimate the card production volume on a monthlybasis for certain of these contracts in order to recognize revenue earnedduring the period. In the case of estimates, when the actual productioninformation becomes available, which is typically within four 

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weeks, we bill thecustomer accordingly and any differences from the estimates are recognized inthe month the billing occurs. These amounts represent our best estimates ofcards produced and are based on historical trends, known events during theperiod, and discussions with contract representatives. Prior to publiclyreporting results, our practice is to compare the actual production volumes toestimated production volumes and adjust revenue amounts as necessary. Anyestimated amounts are included in unbilled receivables on the balance sheetuntil the actual production information is available and the billing occurs.Any estimation process involves inherent risk. We reduce the inherent riskrelating to production estimation through our approval and monitoring processesrelated to accounting estimates. We also evaluate contracts for multipleelements and account for these items under the appropriate accountingliterature.

Revenue from professionalservices arrangements is generally determined based on time and material or acost plus a profit margin measure. Revenue for professional services isrecognized as the services are performed. Losses on contracts, if any, areprovided for in the period in which the loss becomes determinable. Billing forservices rendered generally occurs within one month following when the servicesare provided. Revenue earned which has not been invoiced is classified asunbilled trade receivables in the consolidated 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. If our estimates of projected future cash flows were too high by 10% orless, we believe there would be no material impact on the reported value ofintangible assets on our Consolidated Balance Sheet. Also, we periodicallyreview the useful lives of long-lived assets whenever events or changes incircumstances indicate that the useful life may have changed. If the estimateduseful lives of such assets do change, we adjust the depreciation oramortization period to a shorter or longer period, based on the circumstancesidentified.

**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 doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust whenappropriate, our allowance for doubtful accounts on at least a quarterly basis.If the financial condition of our customers were to deteriorate, resulting inan impairment of their ability to make payments, additional allowances may berequired. If our estimate of uncollectible accounts were too low by 10% orless, we believe there would be no material impact on the reported value ofaccounts receivable on our consolidated balance sheets.

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**Contingencies andLitigation:**   We periodically evaluate all pending or threatened contingencies orcommitments, if any, that are reasonably likely to have a material adverseeffect on our operations or financial position. We assess the probability of anadverse outcome and determine if it is remote, reasonably possible or probableas defined in accordance with the provisions of SFAS No. 5, *Accounting for Contingencies*. If information available priorto the issuance of our financial statements indicates that it is probable thatan asset has been impaired or a liability has been incurred at the date of ourfinancial statements, and the amount of the loss, or the range of probable losscan be reasonably estimated, then such loss is accrued and charged tooperations. If no accrual is made for a loss contingency because one or both ofthe conditions pursuant to SFAS No. 5 are not met, but the probability ofan adverse outcome is at least reasonably possible, we will disclose the natureof the contingency and provide an estimate of the possible loss or range ofloss, or state that such an estimate cannot be made.

**Stock-Based Compensation:**   On January 1, 2006, weadopted SFAS 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 purchase planbased 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 life ofthe 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.

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**Results ofOperations**

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

| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **March 31,**               | ** ** |
| ** **                                       | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Revenue:                                         |       |                             |       |   |   |   |   |   |   |
| Service                                          |       |                             | 82         | % |   |   | 80 | % |   |
| Product and subscription                         |       |                             | 18         |   |   |   | 20 |   |   |
| Total revenue                                    |       |                             | 100        |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                             |       |   |   |   |   |   |   |
| Service                                          |       |                             | 63         |   |   |   | 56 |   |   |
| Product and subscription                         |       |                             | 9          |   |   |   | 10 |   |   |
| Total cost of revenue                            |       |                             | 72         |   |   |   | 66 |   |   |
| Gross profit                                     |       |                             | 28         |   |   |   | 34 |   |   |
| Operating expenses:                              |       |                             |       |   |   |   |   |   |   |
| Sales and marketing                              |       |                             | 17         |   |   |   | 16 |   |   |
| Research, development and engineering            |       |                             | 12         |   |   |   | 12 |   |   |
| General and administrative                       |       |                             | 19         |   |   |   | 23 |   |   |
| Amortization of intangibles                      |       |                             | 2          |   |   |   | 3 |   |   |
| Intellectual property                            |       |                             | 2          |   |   |   | 2 |   |   |
| Total operating expenses                         |       |                             | 52         |   |   |   | 56 |   |   |
| Operating income (loss)                          |       |                             | (24        | ) |   |   | (22 | ) |   |
| Other income (expense):                          |       |                             |       |   |   |   |   |   |   |
| Interest income                                  |       |                             | 1          |   |   |   | 1 |   |   |
| Interest expense                                 |       |                             | 0          |   |   |   | 0 |   |   |
| Other                                            |       |                             | 0          |   |   |   | 0 |   |   |
| Total other income, net                          |       |                             | 1          |   |   |   | 1 |   |   |
| Income (loss) before  provision for income taxes |       |                             | (23        | ) |   |   | (21 | ) |   |
| Provision for  income taxes                      |       |                             | 0          |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                             | (23        | )% |   |   | (21 | )% |   |

 

*Revenue*

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue:                          |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                           |       | $                                | 22,290     |         | $          | 19,596         |       |   | $ | 2,694 |   |   |   | 14 | % |   |
| Product and subscription          |       | 4,903                            |       | 4,783        |       |           | 120        |   |   |   | 3 | % |   |
| Total                             |       | $                                | 27,193     |         | $          | 24,379         |       |   | $ | 2,814 |   |   |   | 12 | % |   |
| Revenue (as % of  total revenue): |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                           |       | 82                               | %          | 80           | %          |           |       |   |   |   |   |   |   |
| Product and subscription          |       | 18                               | %          | 20           | %          |           |       |   |   |   |   |   |   |
| Total                             |       | 100                              | %          | 100          | %          |           |       |   |   |   |   |   |   |

 

The change in total revenue between the comparablethree-month period of 2006 and 2005 resulted primarily from an increase inservice revenue related to increased production for several programs includingFlorida, Alabama, Haiti and Latvia.

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In addition, we have observed seasonality in ourrevenues, with larger revenues in the second and third quarter of the year, andgenerally lower revenues in the first and fourth quarters. The fourth quarteris usually the seasonally lowest quarter each year. We expect our revenueresults in the second quarter of 2006 to be consistent with this pattern ofseasonality.

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 March 31,2006 will generate more than $220 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectapproximately $50 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:

·       Competitivebid wins,

·       Renewalswith current customers,

·       Add-onsales to current customers, and

·       Contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Some factors thatlead to decreased backlog are:

·       Recognitionof revenue associated with backlog currently in place,

·       Periodsfollowing low bid activity,

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

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

The mix of these factors,  among others, dictates whether our backlogincreases or decreases for any given period. For example, the three-monthperiod ended March 31, 2006 had a low level of bid awards, and as a resultwe have consumed backlog during the quarter without large replenishments 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 the variable revenue model. Two ofour recent domestic driver license issuance system sales were not ourcharacteristic price-per-card model, but instead included hardware andconsumable sales. Although these types of revenue models are positive growthindicators for our business, 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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**International Revenue**

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue by geography:             |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                          |       | $                                | 20,105     |         | $          | 19,961         |       |   | $ | 144 |   |   |   | 1 | % |   |
| International                     |       | 7,088                            |       | 4,418        |       |           | 2,670      |   |   |   | 60 | % |   |
| Total                             |       | $                                | 27,193     |         | $          | 24,379         |       |   | $ | 2,814 |   |   |   | 12 | % |   |
| Revenue (as % of  total revenue): |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                          |       | 74                               | %          | 82           | %          |           |       |   |   |   |   |   |   |
| International                     |       | 26                               | %          | 18           | %          |           |       |   |   |   |   |   |   |
| Total                             |       | 100                              | %          | 100          | %          |           |       |   |   |   |   |   |   |

 

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. The change in total revenue betweenthe comparable three-month period of 2006 and 2005 resulted primarily from anincrease in our international programs such as Yemen, Haiti, and Latvia thatwere either delivered or were at full production in early 2006. Domesticprograms remained relatively flat. Revenue increased from states such asFlorida and Alabama, which offset lower product sales to other domesticcustomers in 2006. 

International sales for us have typically taken theform of an outright sale of equipment and/or consumables to non-U.S. governmentagencies or their prime contractors. These sales often can be large, carryrelatively low margins and may cause variations in quarterly revenue and  gross profit trends. Despite the relativelylow margins, we enter into such contracts from time to time to maintain marketpresence and build customer and partner relationships, as such programs oftentransition to more profitable digital technologies over time. Due to the natureof such international programs and customers, the timing of these sales is lesspredictable than are 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.

*Service**.*   Service revenue consists primarily of card production on aprice-per-card basis, software development services, and hardware and softwaremaintenance. The majority of service revenue arrangements are typicallystructured as price-per-card product agreements, time and materials consultingagreements, or fixed price consulting agreements. Service revenue is anumbrella category consisting of both service revenue and contract-based servicerevenue. The distinction between these two subcategories is that servicerevenue is generated from long-term identification and driver licenseproduction contracts, while contract-based service revenue is generated from otherlong-term, time-and-materials service contracts.

Service revenue increased primarily from increased productionfor several programs, including Florida, Alabama, Haiti and Latvia.

*Product and subscription**.*   Product and subscription revenue consists primarily of the sale ofequipment and consumables related to identification card production systems,software license sales, and subscriptions related to various software products.

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Product and subscriptionrevenue remained relatively flat. International revenue increased primarily dueto a new program with Yemen. Domestic revenue decreased due to lower productsales to  domestic customers in 2006.

*Cost of Revenue*

| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                                       |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | $                                | 17,099     |         | $          | 13,724         |       |   | $ | 3,375 |   |   |   | 25 | % |   |
| Product and subscription                               |       | 2,549                            |       | 2,353        |       |           | 196        |   |   |   | 8 | % |   |
| Total                                                  |       | $                                | 19,648     |         | $          | 16,077         |       |   | $ | 3,571 |   |   |   | 22 | % |   |
| Cost of revenue (as % of related revenue  components): |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | 77                               | %          | 70           | %          |           |       |   |   |   |   |   |   |
| Product and subscription                               |       | 52                               | %          | 49           | %          |           |       |   |   |   |   |   |   |

* *

*Service**.*   Cost of service revenue primarily includes costs of consumables used indelivering a service, compensation for software developers, quality assurancepersonnel, product managers, field operations personnel, business developmentpersonnel and outside contractors, depreciation charges for machinery,equipment and capitalized software, deployment costs used specifically forservice delivery, provisions for obsolete and excess inventories, travel costsdirectly attributable to service and development contracts, and charges forinfrastructure and centralized costs.

Cost of service revenue increased primarily as theresult of higher consumables cost of $0.4 million related to the higher revenueidentified above and increased support costs of $2.4 million  During the quarter ended March 31, 2006the Company allocated additional resources to fixing and improving existingprograms and experienced delays in initiation of certain capital projects. As aresult, fewer expenditures were capitalized to the balance sheet. Thisreduction in capitalized expenditures resulted in increased support costs.

*Product and subscription**.*   Cost of product and subscription revenue primarily includescompensation for operations personnel, costs of consumables sold to thirdparties, 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 increasedprimarily as the result of higher international material costs of $1.2 million,offset by lower domestic material costs of $0.9 million.

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*Gross Profit*

| ** **                                         | ** ** | **Three Months Ended**             | ** ** | **Dollar**                                   | ** ** | **Percent**    | ** ** |
|----------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| ** **                                         | ** ** | **March 31,**                           | ** ** | **Increase**                                 | ** ** | **Increase**   | ** ** |
| ** **                                         | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Gross profit                                       |       |                                         |       |                                         |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Service                                            |       |                                         | $          | 5,191                                        |       |           |       | $ | 5,872 |   |   |   | $ | (681 | ) |   |   | (12 | )% |   |
| Product and subscription                           |       |                                         | 2,354      |                                         |       |           | 2,430      |   |   |   | (76 | ) |   |   | (3 | )% |   |
| Total                                              |       |                                         | $          | 7,545                                        |       |           |       | $ | 8,302 |   |   |   | $ | (757 | ) |   |   | (9 | )% |   |
| Gross profit (as % of related revenue components): |       |                                         |       |                                         |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Service                                            |       |                                         | 23         | %                                            |       |           | 30         | % |   |   |   |   |   |   |   |   |   |
| Product and subscription                           |       |                                         | 48         | %                                            |       |           | 51         | % |   |   |   |   |   |   |   |   |   |
| Total                                              |       |                                         | 28         | %                                            |       |           | 34         | % |   |   |   |   |   |   |   |   |   |

 

Overall gross profit as a percentage of revenue forthe three-month period ended March 31, 2006 decreased to 28% compared tothe 34% for the three-month period ended March 31, 2005 largely for thereasons stated above due to increased costs described under the “Cost ofRevenue” section.

Thecosts included in our cost of revenue are comprised of three categories asdescribed below:

| ** **                                | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                          |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Variable                                  |       | $                                | 8,317      |         | $          | 7,281          |       |   | $ | 1,036 |   |   |   | 14 | % |   |
| Fixed field support and manufacturing     |       | 8,743                            |       | 6,013        |       |           | 2,730      |   |   |   | 45 | % |   |
| Program depreciation                      |       | 2,588                            |       | 2,783        |       |           | (195       | ) |   |   | (7 | )% |   |
| Total                                     |       | $                                | 19,648     |         | $          | 16,077         |       |   | $ | 3,571 |   |   |   | 22 | % |   |
| Cost of revenue (as % of  total revenue): |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Variable                                  |       | 31                               | %          | 30           | %          |           |       |   |   |   |   |   |   |
| Fixed field support and manufacturing     |       | 32                               | %          | 25           | %          |           |       |   |   |   |   |   |   |
| Program depreciation                      |       | 9                                | %          | 11           | %          |           |       |   |   |   |   |   |   |
| Total                                     |       | 72                               | %          | 66           | %          |           |       |   |   |   |   |   |   |

 

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 increase in variablecosts as a percentage was primarily due to a sales mix that included lowermargin sales of hardware and consumable products that occur from time to time.

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 quarter ended March 31, 2006, we focused on fixing and improvingcertain existing programs and as a result fewer expenditures were capitalizedto the balance sheet. The result of these actions was increased support costs.

Programdepreciation primarily consists of amortization and depreciation of costsincurred during the delivery process, where such costs are capitalized and thenamortized or depreciated over the life of the useful lives of the assets towhich the costs relate. Program depreciation decreased in relation to the othercomponents of cost of revenue primarily due to the change in estimating theuseful lives of program-related fixed assets. Through December 31, 2005,we depreciated program fixed assets that were 

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specifically used to provide services under long termcontracts over the shorter of the original contract term or estimated usefullife. Starting January 1, 2006, we changed our policy for depreciatingthese assets to the shorter of the original contract term plus 2.75 years orestimated useful life. This change in estimate was supported by analysis wecompleted during the first quarter of 2006 which showed that historically 95%of contracts were extended beyond the original contract term, that the averagecontract had at least two contract extensions during its life and that theseextensions added on average 2.75 years to the length of the contracts’ originalterms. Since contract-specific program assets are tracked on a contract basis,the findings that the contract life is routinely significantly longer than theoriginal contract term and that these extensions are not generally accompaniedby significant incremental capital investment indicates that thecontract-related asset’s useful life was longer than the original term of thecontract. Given the findings of the analysis, we concluded that it wasappropriate to change the estimated useful lives so that contract specificassets were being depreciated over our most accurate estimate. This change hadthe effect of reducing depreciation expense by $2,146 in the first quarter of2006. The following table shows the effect of this policy in the first quarterof 2006, as well as the expected 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 |   |

 

This change had the effect of reducing depreciationexpense by $2,146 in the first quarter of 2006. This reduction in depreciationincreased basic and diluted earnings by $0.10 per share before taxes. Giventhat the depreciation expense attributed to contract-specific assets is part ofcost 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 in the case of certain new programswhere we have provided a complete system replacement using advancedtechnologies. These programs have recently been completed and transitioned fromdeployment to revenue production, and thus are now affecting margins. Theseinstallations were particularly challenging for us, representing a stretch interms of scope from our historical system deliveries. We were successful indelivering these programs, but at higher costs than have been customary. Inanother case, we bid a program aggressively as part of a broader marketdevelopment strategy that we believe will yield good long-term performance. Thefixed costs for these systems, which include amortization and depreciation ofcosts capitalized during the delivery process, as well as field service andoperational costs to manage and maintain them, are higher than average and,thus, reduce reported margins. We anticipate that we will be able to improveprofit margins in these accounts over time and earn a better return oninvestment over the life of the account relationship.

We have observedseasonality in the production of driver license issuances and correspondingrevenue in the United States, with larger volumes in the second and thirdquarters, and generally lower volumes in the first and fourth quarters. Thefourth quarter is usually the seasonally lowest quarter each year. We use thestraight line method of depreciation and amortization for program-relatedassets. The combination of the seasonality of our revenues and straight linedepreciation and amortization can cause significant variations in quarterlygross margin trends, generally increasing margins as a percentage of revenue inthe second and third quarters when our revenues are higher and decreasingmargins as a percentage of revenue in the first and fourth quarters when ourissuance revenues are typically lower, while having a neutral effect on ayearly basis.

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*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Three Months Ended**                   | ** ** | **Dollar**                                         | ** ** | **Percent**    | ** ** |           |
|----------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|----------------|------------|----------------|
| ** **                                   | ** ** | **March 31,**                                 | ** ** | **Increase**                                       | ** ** | **Increase**   | ** ** |           |
| ** **                                   | ** ** | **    2006   ** | ** ** | **    2005   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |   |
| Sales and  marketing                         |       |                                               | $          | 4,539                                              |       |           |       | $              | 3,777 |   |   |   | $ | 762 |   |   |   | 20 | % |   |
| Sales and marketing (as %  of total revenue) |       |                                               | 17         | %                                                  |       |           | 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 increase for the three-month period resultedprimarily from increased employee compensation-related expenses of $0.7million, consisting of salaries, benefits, recruiting costs, and incentive plancompensation, due to increased personnel in marketing and governmentalactivities, and higher benefit program costs.

As of the date of thisreport, we are examining means to reduce fixed costs in order to facilitate oureffort to achieve profitability. Although we have not yet determined the natureand level of these reductions, we anticipate that some may be in the area ofsales and marketing. If such is the case, we would not anticipate lowerexpenses in this area until the third quarter of 2006 because of transitionneeds, as well as severance and other related costs that would be incurred inthe second quarter.

*Research, development and engineering*

| ** **                                                          | ** ** | **Three Months Ended**             | ** ** | **Dollar**                                   | ** ** | **Percent**    | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| ** **                                                          | ** ** | **March 31,**                           | ** ** | **Increase**                                 | ** ** | **Increase**   | ** ** |
| ** **                                                          | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Research,  development and engineering                              |       |                                         | $          | 3,236                                        |       |           |       | $ | 2,908 |   |   |   | $ | 328 |   |   |   | 11 | % |   |
| Research, development  and engineering (as % of total revenue) |       |                                         | 12         | %                                            |       |           | 12         | % |   |   |   |   |   |   |   |   |   |

 

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 increase for the three-month period resultedprimarily from increased infrastructure and centralized costs of $0.1 millionbeing allocated to research, development and engineering expenses.

 As of the date of this report, we areexamining means to reduce fixed costs in order to facilitate our effort toachieve profitability. Although we have not yet determined the nature and levelof these reductions, we anticipate that some may be in the area of research anddevelopment. If such is the case, we would not anticipate lower expenses inthis area until the third quarter of 2006 because of transition needs, as wellas severance and other related costs that would be incurred in the secondquarter.

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*General and administrative*

| ** **                                          | ** ** | **Three Months Ended**                         | ** ** | **Dollar**                                               | ** ** | **Percent**    | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------|------------|
| ** **                                          | ** ** | **March 31,**                                       | ** ** | **Increase**                                             | ** ** | **Increase**   | ** ** |
| ** **                                          | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| General and  administrative                         |       |                                                     | $          | 5,210                                                    |       |           |       | $ | 5,497 |   |   |   | $ | (287 | ) |   |   | (5 | )% |   |
| General and  administrative (as % of total revenue) |       |                                                     | 19         | %                                                        |       |           | 23         | % |   |   |   |   |   |   |   |   |   |

 

General and administrative expenses consist primarilyof compensation, benefits and related costs of executive, finance andadministrative personnel, human resources and other professional fees, andcharges for infrastructure and centralized costs.

The decrease forthe three-month period resulted primarily from the following:

·       decreasedinfrastructure and centralized costs of $0.3 million allocated to general andadministrative expenses; and

·       partiallyoffset by increased other general and administrative expenditures of $0.1million.

 As of the date of this report, we areexamining means to reduce fixed costs in order to facilitate our effort toachieve profitability. Although we have not yet determined the nature and levelof these reductions, we anticipate that some may be in the area of general andadministrative. If such is the case, we would not anticipate lower expenses inthis area until the third quarter of 2006 because of transition needs, as wellas severance and other related costs that would be incurred in the secondquarter. We will continue to examine means to gain efficiencies to reducegeneral and administrative spending as a percentage of revenue in the longerterm.

*Amortization of intangible assets*

| ** **                                             | ** ** | **Three Months Ended**                         | ** ** | **Dollar**                                               | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------|------------|
| ** **                                             | ** ** | **March 31,**                                       | ** ** | **Increase**                                             | ** ** | **Increase**   | ** ** |
| ** **                                             | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Amortization of  intangibles                           |       |                                                     | $          | 573                                                      |       |           |       | $ | 811 |   |   |   | $ | (238 | ) |   |   | (29 | )% |   |
| Amortization of  intangibles (as % of total   revenue) |       |                                                     | 2          | %                                                        |       |           | 3          | % |   |   |   |   |   |   |   |   |   |

 

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 for thethree-month period ended March 31, 2006, as compared to the correspondingthree-month period of 2005, resulted primarily from the increased amortization in2005 related to a domestic customer who awarded their contract to a competitor.The intangible asset related to this customer was fully amortized by the fourthquarter of 2005.

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*Intellectual property*

| ** **                                     | ** ** | **Three Months Ended**             | ** ** | **Dollar**                                   | ** ** | **Percent**    | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------|------------|
| ** **                                     | ** ** | **March 31,**                           | ** ** | **Increase**                                 | ** ** | **Increase**   | ** ** |
| ** **                                     | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Intellectual  Property                         |       |                                         | $          | 431                                          |       |           |       | $ | 536 |   |   |   | $ | (105 | ) |   |   | (20 | )% |   |
| Intellectual Property  (as % of total revenue) |       |                                         | 2          | %                                            |       |           | 2          | % |   |   |   |   |   |   |   |   |   |

 

Intellectual property costs primarily consist of employee-relatedexpenses, such as salaries, benefits, recruiting costs, and incentive plans, aswell as costs associated with documenting, applying for, and maintainingpatents. The decrease of $0.1 million was primarily due to higher consultingfees paid to third-party attorneys related to patent work in 2005.

*Stock-basedcompensation.**  *Stock-basedcompensation includes expense charges for all stock-based awards to employeesand directors. Such awards include option grants, restricted stock awards, andshares expected to be 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 and recognition of compensation for allstock-based awards made to employees and directors including stock options andemployee stock purchases under a stock purchase plan based on estimated fairvalues. SFAS 123(R) supersedes previous accounting under AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued 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) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s condensed consolidated financial statements for periods prior to thefirst quarter of fiscal 2006 have not been restated to reflect this change.Stock-based compensation recognized during the period is based on the value ofthe portion of the stock-based award that will vest during the period, adjustedfor expected forfeitures. Stock-based compensation recognized in the Company’scondensed consolidated financial statements for the first quarter of fiscal2006 includes compensation cost for stock-based awards granted prior to, butnot fully 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 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 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, 

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*Accountingfor Certain 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.

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

| ** **                             | ** ** | **Three Months Ended**                         | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **March 31,**                                       | ** ** |
| ** **                             | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Cost of revenue                        |       |                                                     | $          | 54 |   |   |   | $ | — |   |   |
| Sales and  marketing                   |       |                                                     | 122        |   |   |   | — |   |   |
| Research,  development and engineering |       |                                                     | 114        |   |   |   | — |   |   |
| General and  administrative            |       |                                                     | 504        |   |   |   | 51 |   |   |
| Total                                  |       |                                                     | $          | 794 |   |   |   | $ | 51 |   |   |

 

We anticipate an additional $6.6 million instock-based compensation through fiscal 2010 for awards outstanding as of March 31,2006. Additional impact resulting from adoption of this statement on ourfinancial position and results of operations will be determined by stock-basedawards granted in future periods and the assumptions on which the value ofthose stock-based awards is based. Our tax accounting may also be impacted byactual exercise behavior and the relative market prices at exercise.

 On December 15,2005, the Board of Directors of the Company approved the acceleration ofvesting of the Company’s outstanding stock options with option exercise pricesequal to or greater than $9.00. The acceleration applied to all optionsoutstanding as of December 31, 2005 under the Company’s Restated 1999Stock Incentive Plan and 2000 Non-Officer Employee Stock Incentive Plan, exceptfor options held by members of the Company’s Board of Directors. Options topurchase 422,248 shares of the Company’s common stock, or 6% of the Company’stotal outstanding options, with a weighted average exercise price of $11.51 andvarying remaining vesting schedules, were subject to this acceleration andbecame immediately vested and exercisable as of December 31, 2005. Of these422,248 options, 120,972 options 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 have otherwisevested in full by June 30, 2005 in accordance with their terms. Theeffective date of the vesting acceleration was December 31, 2004. Optionsto purchase 310,057 shares of the Company’s common stock, or 5% of the totalnumber of options of the Company outstanding as of December 31, 2004 withremaining vesting schedules, were accelerated. Of these 310,057 options,approximately 50,000 options were held by the Company’s executive officers. Noadditional compensation expense was recorded in the statement of operations asthe options that were accelerated had an exercise price greater than the fairmarket value of the shares underlying the options on the date of themodification.

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 $0.4 million for the three-month period ended March 31,2006, compared to 

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$0.2 million for thethree-month period ended March 31, 2005. The increase resulted fromhigher interest earned on lower cash and investment balances, which waspartially offset by higher interest expense related to capitalized leases.

*Provision for IncomeTaxes.*   The provision for income taxes reflectsexpected tax expense from profitability in foreign jurisdictions. Due to theuncertainty of realization of deferred tax assets, including those generated inthe current period, we have recorded a full valuation allowance against our netdeferred tax assets at March 31, 2006. We will continue to evaluate therealizability of our net deferred tax assets in future periods and mayrecognize income tax benefits in future earnings if we determine that therealization of these assets is more likely than not.

**Liquidity andCapital Resources**

As of March 31, 2006, we had cash and cashequivalents, restricted cash, and short-term investments of $31.0 million,representing a decrease of approximately $1.0 million from $32.0 million at December 31,2005. The decrease primarily resulted from investments in new programimplementations and the purchase of fixed assets. As of March 31, 2006,$6.8 million of cash and cash equivalents is restricted as a result of therequirements of performance bonds that we are obligated to maintain inconnection with some of our long-term contracts in our personal identificationsystems business. Working capital at March 31, 2006 was $29.4 million,compared to working capital of $31.4 million at December 31, 2005. Thedecrease in working capital resulted primarily from investments made in newprograms and infrastructure assets.

The $0.4 million of cash provided by operations forthe three-months ended March 31, 2006 resulted from a net loss of $6.2million, partially offset by non cash items related to depreciation andamortization of $3.8 million and a decrease in trade and unbilled accountsreceivable, net of $2.6 million and inventory of $1.6 million. Negativelyaffecting cash provided by operations was a decrease in accounts payable of$1.4 million. The $4.3 million of cash used in operations for the three-monthsended March 31, 2005 resulted from a net loss of $5.1 million, offset bynon cash items related to depreciation and amortization of $3.4 million and anincrease in accrued payroll and related costs of $1.3 million. Items negativelyaffecting cash used in operations were a decrease in accounts payable of $2.2million and an increase in trade and unbilled accounts receivable, net of $1.5million.

The $1.0 million of cash used in investing activitiesfor the three-month period ended March 31, 2006 primarily related to $0.3million in net purchase of short-term investments and $0.8 million for thepurchase of property and equipment, including capitalization of labor costs of$0.3 million. The $5.1 million of cash provided by investing activitiesfor the three-months ended March 31, 2005 was related primarily to $10.3million in net sale or maturity of short-term investments partially offset by$5.2 million for the purchase of property and equipment, includingcapitalization of labor costs of $3.0 million.

The $0.1 million of cash used in financing activitiesfor the three-month period ended March 31, 2006 resulted primarily fromthe principal payments on capital leases, partially offset by the proceeds fromthe issuance of stock. The $0.1 million of cash used in financing activitiesfor the three-month period ended March 31, 2005 resulted primarily fromthe principal payments on capital leases.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $8.4 million as of March 31,2006, and are payable in monthly installments through August 2011. Ourobligations under non-cancelable capital leases, which totaled $0.9 million asof March 31, 2006, are payable in monthly installments through March 2009.

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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. This means that,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 for which we have estimated the amounts tocomplete. In order to complete these contracts, we estimate we will incurapproximately $11 million of expenditures. The estimates are derived frominformation 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.

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.

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, theFASB issued SFAS No. 156, *Accounting for Servicingof Financial Assets, an amendment of SFAS No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.*The statement changes the way entities account for servicing assets andobligations associated with financial assets acquired or disposed of. SFAS No. 156is effective 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.

**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 

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arenot historical facts are hereby identified as “forward-looking statements” forthe purposes of the safe harbor provided by Section 21E of the SecuritiesExchange Act of 1934 and Section 27A of the Securities Act of 1933. Suchforward-looking statements include but are not limited to statements relatingto:

·       trendsand expectations in revenue growth, including, but not limited to, statementsregarding anticipated growth in U.S. driver license revenues due to broadeninguse of the driver license as a secure credential, statements regardingopportunities to facilitate efforts of state government agencies to comply withthe REAL ID Act;

·       thesuccess of new products, such as IDVS;

·       ourability to support customer requirements for Smart Card technologies;

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

·       ourability to improve margins;

·       theexpected deployment of programs in 2006;

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

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

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

·       ourprofitability in future periods;

·       thedevelopment and growth of the market for digital watermarking technology;

·       momentumin the recognition of the benefits offered by digital watermarking and in theadoption of digital watermarking;

·       businessopportunities that could require that we seek additional financing;

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

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

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

·       thecontinuance of operational pressures on our identification systems business infuture quarters;

·       thesource of a majority of our future revenue;

·       thecontribution of new sales channels in domestic and foreign markets to ourfuture results;

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

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

·       ouruse of cash in upcoming quarters;

·       anticipatedlevels of backlog in future periods;

·       anticipatedextensions of the term of our contract with the central banks;

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

·  the anticipated effects of the Company’sadoption of SFAS 123(R).

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

**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 March 31, 2006 was $94.2 million. In order to attain sustainedprofitability, we will need to generate higher revenue than we have in prioryears while controlling expenditures. Achieving profitability will depend upona variety of factors, including the impact of new financial accounting mandatesrequiring us to expense stock options, as well as expenses related tolitigation and other proceedings that have arisen as a result of our prior yearrestatement. In addition, we evaluate our strategy and market opportunities onan ongoing basis and will adjust our approach to market conditions that prevailfrom time to time. Accordingly, in the short term we may focus more on growingour revenue and taking advantage of market opportunities than an immediatereturn to profitability. Finally, various adverse developments including theloss of large contracts or cost overruns on our existing contracts could have anegative impact on our revenue or our margins. Accordingly, increases in ourexpenses may not be offset by revenue increases and as a result we may not beable to regain and/or sustain profitability.

*Theloss of any large contract may result in loss of revenue and potentialacceleration of amortization expense or impairment of intangible assets.*

Contracts betweengovernment agencies and Digimarc have varying duration, generally five or moreyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. 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.

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*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 in which we compete for business areintensely competitive and rapidly evolving. We expect competition to continuefrom both existing competitors and new market entrants. We face competitionfrom other companies and from alternative technologies. The potential for aninflux of federal funds into our core U.S. driver license market has drawn newcompetition and is likely to continue to do so. As we expand the applicationsfor our technologies, we will experience more competition from products andservices that are substitutes for our applications. Because our digitalwatermarking business is new and emerging, we also may face competition fromunexpected sources. Alternative technologies that may directly or indirectlycompete with particular applications of our watermarking technologies include:

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

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

·       DataGlyphs®—a slightly visiblemodification of the characteristics of an image or document that ismachine-readable;

·       ScrambledIndicia®—an opticalrefraction-based data-hiding technique that is inserted into an image and canbe read with a lens;

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

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

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

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

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

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

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

New developments areexpected to continue, and we 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 necessitate

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us torequire 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. Despite testing,defects or errors in our products and services may occur, which could result indelays in the development and implementation of products and systems, inabilityto meet customer requirements or expectations in a timely manner, loss of revenueor market share, increased implementation and support costs, failure to achievemarket acceptance, diversion of development resources, injury to ourreputation, increased insurance costs, increased service and warranty costs andwarranty or breach of contract claims. Although we attempt to reduce the riskof losses resulting from warranty or breach of contract claims through warrantydisclaimers and liability limitation clauses in our sales agreements when wecan, these contractual provisions are sometimes not included and may not beenforceable in every instance. If a court refuses to enforce theliability-limiting provisions of our contracts for any reason, or ifliabilities arose that were not contractually limited or adequately covered byinsurance, 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 technologies effectivelyand address the increasingly sophisticated technological needs of our customersin a timely and cost-effective manner. Our ability to remain competitive willdepend in part on our ability to:

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

·       continueto develop our technical expertise; and

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

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

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

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

·       delaysin project implementation;

·       failureto achieve add-on sales to existing customers;

·       governmentalregulation of credentials and issuance policies;

·       privatesector usage trends for driver licenses and other credentials;

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

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

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

·       variationsin costs of materials and manufacturing;

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

·       seasonalityof issuance volumes;

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

·       salesmix related to domestic sales compared to international sales;

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

·       strategicdecisions on new business; and

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

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

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*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 by third-partysoftware developers and original equipment manufacturers. For example, one formof our digital watermark reader is commonly deployed in image editingapplications (offered by vendors including Adobe, Corel and Ulead) to permitusers of these products to read watermarks embedded in imagery, and therebydiscern the identities of image owners. Another form of our digital watermarkreader is used in our anti-counterfeiting product offerings. We anticipateentering into additional agreements with third-party vendors to create, promoteand service products that incorporate, embed, integrate or bundle ourtechnologies. If third parties who include such technologies in their productscease to do so, or we fail to obtain other partners that will incorporate,embed, integrate or bundle such technologies, or these partners areunsuccessful in their efforts, our efforts to expand deployment of ourtechnologies would be adversely affected and, consequently, our ability toincrease revenues would be adversely affected and we may suffer other adverseeffects to our business. In addition, if our technologies do not performaccording to market expectations, our future sales would suffer as customersseek other providers.

*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 services are not yetwell-established in the marketplace, and because some such products and serviceswill not directly displace existing solutions, we cannot be certain that thepricing structure for these products and services will gain market acceptanceor be sustainable over time or that the marketing for such products andservices will be effective.

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*Thesecurity systems used in our product and service offerings may be circumventedor sabotaged by third parties, which could result in the disclosure ofsensitive government information or private personal information or cause otherbusiness interruptions that could damage our reputation and disrupt ourbusiness.*

Our business relies oncomputers and other information technologies, both in-house and at customer andvendor locations. In addition, many of the systems we sell manage privatepersonal information and protect information involved in sensitive governmentfunctions. The protective measures that we use in these systems may not preventsecurity breaches, and failure to prevent security breaches may disrupt ourbusiness, damage our reputation, and expose us to litigation and liability. Aparty who is able to circumvent security measures used in these systems couldmisappropriate sensitive or proprietary information or materials or causeinterruptions or otherwise damage our products, services and reputation, andthe property of our customers. If unintended parties obtain sensitive data andinformation, or create bugs or viruses or otherwise sabotage the functionalityof our systems, we may receive negative publicity, incur liability to ourcustomers or lose the confidence of our customers, any of which may cause thetermination or modification of our contracts. Further, our insurance coveragemay be insufficient to cover losses and liabilities that may result from suchevents.

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.

*Asinternational customers have accounted for approximately 26% of our totalrevenue during the quarter ended March 31, 2006, the loss of thesecustomers or the failure to find new customers may result in a decline in ourinternational revenue, which could lower our profitability and slow our growth.*

Weexpect revenue from sales of products and services to governments and othercustomers outside the U.S. to represent a growing percentage of our total revenuein the future. International sales and services are subject to a number ofrisks, including the following:

·       changesin foreign government regulations and security requirements;

·       exportlicense requirements, tariffs and taxes;

·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       longerpayment cycles than those for customers in the United States;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

If we are affected bythese risks, our sales of products and services to customers outside the U.S.could be reduced significantly. In addition, if foreign customers, inparticular foreign government authorities, terminate or delay the implementationof our products and services, we may have limited recourse against them torecover 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.

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*Asignificant portion of our business depends on contracts that are subject to avariety of terms and conditions, including damage payment obligations, as wellas a variety of other provisions that may cause our quarterly results tofluctuate and our anticipated revenue to potentially decrease significantly.*

Our contracts for driverlicense and other identification issuance systems and related productstypically include terms relating to, time-based performance, development anddelivery schedules customer acceptance and testing, and other performancemilestones. Such provisions are common in large scale government contracts atthe state and federal levels. Because procedures often require compliance overextended periods of time, they give rise to an increased risk that we may failto meet timing or other delivery requirements and milestones pursuant to theterms of such contracts. If we failed to meet such requirements or milestones,customers may assert against us compensatory or liquidated damages, breach ofcontract, or other claims. Consequently, our failure to meet contractualmilestones or other performance requirements as promised could result in ourhaving to incur increased costs, lower margins, or compensatory obligations, inaddition to other losses, such as harm to our reputation. Such unexpectedincreases in costs to meet our contractual obligations or any otherrequirements necessary to address claims and damages with regard to ourcustomer contracts could have a material adverse effect on our business andfinancial results. We anticipate that future contracts will continue to havesuch provisions unless and until industry practices change.

A significant portion ofour business depends on a limited number of large, public-sector contracts,which are generally subject to termination for convenience, as determined bythe subject agency, or for lack of budgetary appropriation provided for thesubject agency. Some government contracts also may be one-time events, such asin the case of some personal identification systems in non-U.S. marketsinvolving voter registration programs. In such cases, we may generatesubstantial revenue that may not be subject to future renewal. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain largerestricted cash reserves as a guarantee, reducing our ability to use thesefunds for our other business purposes. Even with the availability of such cashreserve guarantees, we may not be able to obtain such performance bondunderwriting at a favorable rate or at all. Our failure to be able to providesuch performance bonds may preclude our ability to bid on new governmentcontracts or maintain our existing contracts for their full terms. The size,nature and purpose of, and the risks and uncertainties associated with, publicsector contracts can potentially cause our quarterly results to fluctuate andanticipated revenue to decrease significantly.

*Asignificant portion of our business depends on contracts with fixed priceterms. In the event of cost overruns in connection with such contracts, ourmargins 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 cost overruns.Under these contracts, we provide specific tasks for a specific price and aretypically paid on a milestone basis. We have experienced low margins or losseson some of these contracts in the recent past. Such contracts involve greaterfinancial risks because we bear the risk if actual project costs exceed theamounts we are paid under the contracts.

*We may decline to pursuenew, or renew existing, business opportunities in secure ID systems markets dueto objectionable terms required by the contracting agencies, or we may agree toobjectionable contract terms for competitive reasons.*

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure ID issuance systems. For example, it is customary for state agencies torequire that a vendor fund 

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thecapital-intensive initial deployment of a driver license issuance system (thecosts of which the vendor normally recoups over the life of the contract inper-card fees), while reserving the right to terminate the contract forconvenience. Similarly, in connection with intellectual property rights, acontract may require that our pre-existing issuance system software be writtenin a different language and a state may then argue that it falls within theclass of works for which it owns the copyright, enabling the state to turn theDigimarc-authored software over to one of our competitors, dedicate it to thepublic domain, or otherwise use the software in a manner detrimental to ourbusiness. Objectionable contract terms may lead us to decline to bid onidentification issuance systems to new customers, or to decline to retainbusiness with customers we have historically served, which could reduce ourmarket share and lower our revenues or profits. In addition, if we decline toretain business with customers we have historically served, it could result inthe accelerated depreciation of intangible assets. Alternatively, we may decideto accept at least some level of objectionable terms rather than cede animportant contract to a competitor, which could also lower our revenues orprofits.

*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:

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

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

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

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

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*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 our competitorswill not independently develop similar technologies, duplicate our services ordesign around any of our patents or other intellectual property rights we hold.

We are the exclusive licensee under some third-partypatents, and may need the assistance of these parties if we choose to enforceany of these patent rights. The cooperation of these third parties cannot beassured even though we rely on some of these technologies for our products.

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

Some of our contracts include provisions by which we assurenon-infringement of third-party intellectual property rights. As deployment ofour technology increases, and more companies enter our markets, the likelihoodof a third party lawsuit resulting from such indemnification increases. If aninfringement arose in a context governed by such a contract, we may have torefund to our customer amounts already paid to us or pay significant damages,or we may be sued by the party allegedly infringed 

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upon. Similarly, as weseek to broaden the number of companies licensed under our patent portfolio,some may seek contractual assurances that we will pursue—by litigation ifnecessary—their competitors who use our patented technology but are notlicensed to do so. Compliance with any such contract provisions may requirethat 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 invested significant time and resources inproduct development activities for new secure identification markets, includingdesigning and developing numerous enhancements to our driver license systemsand improving our cards’ ability to withstand intrusions or alterations withoutdetection. At present, our new products include Digimarc ID Validation Suite (IDVS)and Digimarc IDMarc. If we do not experience a timely, positive reaction fromissuing authorities to our new offerings, our projected revenues, margins andearnings may be negatively impacted.

In addition, we aredeveloping new sales channels in domestic and foreign markets for certaincomponents and subsystems of our domestic driver license solutions. We believethese new sales channels may contribute significantly to our future results, asour products get placed into other programs and start generating recurringrevenue streams. However, given that this is an emerging area of our business,involving significant time and effort in connection with the development of newproducts and distribution relationships, there are ongoing risks that thesemarket areas will not develop in the manner or along the timeline that we areprojecting, or at all, resulting in significant costs and expenses withoutcorresponding increases in any revenues and profits.

*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 work on Sarbanes-Oxley compliance. In 2005, we made certain organizationalchanges designed to better consolidate the secure ID systems and digitalwatermarking groups into a single business unit and thereby improve ourbusiness execution and operational efficiencies. In addition, we appointed anew President of Government Programs and made considerable changes to themanagement team that reports to him. While we anticipate that these changes inleadership and staffing will improve operations, there is a risk that thesechanges may disrupt the operations of our business and, consequently, mayresult in some short-term inefficiencies as personnel complete theirtransitions and new leaders implement their new plans and procedures. We alsoexpect that these changes may require further modifications of our finance and 

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businessprocesses and will likely cause additional costs to our business in the shortterm before any benefits from such changes, if any, may be realized.

*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 shareholder litigation and financial performance. In addition, thesecircumstances may have a negative impact on the market price of our commonstock, and employees and prospective employees may factor in the uncertaintiesrelating to our stability and the value of any equity-based incentives intheir decisions regarding employment opportunities and decide to leave ouremploy. In addition, our business is based in part on patented technology,which is unique and not generally known. New employees require substantialtraining, involving significant resources and management attention. Competitionfor experienced personnel in our business can be intense. If we do not succeedin attracting new, qualified personnel or in integrating, retaining andmotivating our current personnel, our growth and ability to deliver productsand services that our customers require may be hampered. Although our employeesgenerally have executed agreements containing non-competition clauses, there isno assurance that a court would enforce all of the terms of these clauses orthe clauses generally. If these clauses were not fully enforced, our employeescould be able to freely join our competitors. Although we generally attempt tocontrol access to and distribution of our proprietary information by ouremployees, there can be no assurances that the confidential nature of ourproprietary information will be maintained in the course of such futureemployment. Any of these events could have a material adverse effect on ourfinancial and business prospects.

*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, and expect that we willcontinue to do so. Due to the inherent uncertainties of such litigation, theultimate cost and outcome cannot be predicted.

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*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 andofficer liability 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.

**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 March 31, 2006, which includedan evaluation of disclosure controls and procedures applicable to the periodcovered by the filing of this periodic report. Based on the evaluation of theeffectiveness of our disclosure controls and procedures by our management as ofMarch 31, 2006, our principal executive officer and principal financialofficer have concluded that our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in thereports that we file or submit under the Securities Exchange Act of 1934 isaccumulated and communicated to our management, including our principalexecutive and principal financial officers, or persons performing similarfunctions, as appropriate to allow timely decisions regarding requireddisclosure.

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**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 commenced against us and certain of our current andformer directors and officers by or on behalf of persons claiming to have purchasedor otherwise acquired our securities during the period from April 17, 2002to July 28, 2004. These lawsuits were filed in the United States DistrictCourt for the District of Oregon and were consolidated into one action for allpurposes on December 16, 2004. On May 16, 2005, plaintiffs filed anamended complaint. The complaint asserted claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934, relating to our announcement that we had discoverederrors in our accounting for software development costs and projectcapitalization and other project cost capitalization accounting practices, andthat we likely would be required to restate our previously reported financialstatements for full fiscal year 2003 and the first two quarters of 2004.Specifically, the complaint alleged that we issued false and misleadingfinancial statements and created a misperception regarding the profitability ofthe company in order to inflate the value of Digimarc stock, which permittedinsider sales of personal holdings at inflated values, and that we maintainedinsufficient accounting controls, which created an environment where improperaccounting could be used to manipulate financial results. The complaint soughtunspecified damages. On November 30, 2005, the Court granted our motion todismiss the amended complaint on the grounds that plaintiffs had failed toallege facts sufficient to support their allegation that the defendantsknowingly or recklessly acted in violation of the securities laws. Plaintiffsfiled a second amended complaint on January 17, 2006. On February 14,2006, we filed a motion to dismiss the second amended complaint on the groundsthat plaintiffs still fail to allege facts sufficient to support theirallegation that the defendants knowingly or recklessly acted in violation ofthe securities laws. This motion is pending. Due to the inherent uncertaintiesof litigation and because the lawsuits are still at a preliminary stage, wecannot accurately predict the ultimate outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of our officers anddirectors, naming us as a nominal defendant, in the Superior Court of the Stateof California for the County of San Luis Obispo. These lawsuits wereconsolidated into one action for all purposes on March 14, 2005. On July 19,2005, the court granted our motion to stay these consolidated actions in favorof a shareholder derivative action to be filed by plaintiffs in the CircuitCourt of the State of Oregon for the County of Washington. On August 25,2005, the California plaintiffs filed two new derivative lawsuits in the UnitedStates District Court for the District of Oregon. On October 17, 2005,defendants filed a motion to dismiss these complaints for lack of subjectmatter jurisdiction and failure to state a claim. This motion currently ispending. Separately, on November 8, 2004, a letter was mailed to thechairman of our Board of Directors by a law firm purporting to represent one ofour shareholders, demanding that the Board commence a civil action against eachof the directors and officers on behalf of Digimarc to recover for damagesalleged to have been incurred as a result of alleged breaches of fiduciaryduties. On or about April 6, 2005, this shareholder filed a purportedshareholder derivative suit against certain of our officers and directors,naming us as a nominal defendant, in the Circuit Court of the State of Oregonfor the County of Washington. On August 25, 2005, the individualdefendants filed a motion to stay this state court derivative lawsuit, and on September 26,2005, the court entered a stipulated order granting the motion and staying thecase pending the outcome of an investigation by a committee appointed by ourBoard of Directors of the claims asserted in the demand letter and in thederivative lawsuits. That stay expired on February 28, 2006, and on March 31,2006 the individual defendants filed a motion to dismiss the lawsuit based onthe recommendation of the Board committee. Plaintiffs subsequently stipulatedto a dismissal of the lawsuit and, on May 5, 2006, Judge Gardner signed astipulated motion and order of dismissal, dismissing the lawsuit with prejudice.The derivative lawsuit filed 

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in the United StatesDistrict Court for the District of Oregon remains on file, pending a decisionon the individual defendats’ motion to dismiss.

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 ofour officers and directors, and certain underwriters of our initial publicoffering as defendants. The complaints have since been consolidated into asingle action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of ourinitial public offering violated securities laws by failing to disclose certainalleged compensation arrangements (such as undisclosed commissions or stockstabilization practices) in our initial public offering registration statementand by engaging in manipulative practices to artificially inflate the price ofour stock in the after-market subsequent to our initial public offering.Certain of our officers and directors and we are named in the amended complaintpursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. The individualofficer and director defendants entered into tolling agreements and, pursuantto a court order dated October 9, 2002, were dismissed from the litigationwithout prejudice. Furthermore, in July 2002, the other defendants in theconsolidated cases and we 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 us. The claims against us under Section 10(b), however, weredismissed. In June 2003, a committee of our 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 us and of the individual defendants for the conductalleged in the amended complaint to be wrongful. We would agree to undertakeother responsibilities under the partial settlement, including agreeing toassign away, not assert, or release certain potential claims we may haveagainst its underwriters. Any direct financial impact of the proposedsettlement (other than defense costs incurred and expensed prior to May 31,2003) is expected to be borne by our 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 allsettlement class 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, we cannot accurately predict the ultimate outcome of the matter.

We are subject, from timeto time, to other legal proceedings and claims arising in the ordinary courseof business. Although the ultimate outcome of these other matters cannot bedetermined, management believes that, as of March 31, 2006, the final dispositionof these proceedings will not have a material adverse effect on ourconsolidated financial position, results of operations, or liquidity.

**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: May 10, 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)                                            |
| 10.1            |       | Form of  Performance Vesting Share Agreement (incorporated by reference to  Exhibit 10.21 of Exhibits to Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 13, 2006)                                          |
| 10.2            |       | Summary of  Executive Compensation Arrangements (incorporated by reference to  Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on January 9, 2006)                                                                             |
| 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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