**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(MarkOne)**

**(MarkOne)**

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

**Forthe quarterly period ended JUNE 30, 2006**

**OR**

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

**Forthe transition period from               to                **

**CommissionFile Number: 000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     |   | **94-3342784**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **9405 SW Gemini Drive, Beaverton, Oregon**                      |   | **97008**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

 

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

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

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

Large accelerated filer o                         Acceleratedfiler x                            Non-accelerated filero

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

Asof July 31, 2006, there were 21,176,762 shares of the registrant’s commonstock, par value $0.001 per share, outstanding.

 

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**Table of Contents**
| **PART I FINANCIAL  INFORMATION** |   |                                                                                                                          |
|----------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           |   | Financial Statements:                                                                                                         |   |   |
|                                   |   | Condensed Consolidated  Balance Sheets as of June 30, 2006 and December 31,  2005 (Unaudited)                  |   | 3 |
|                                   |   | Condensed Consolidated  Statements of Operations for the three- and six-months ended June 30,  2006 and 2005 (Unaudited) |   | 4 |
|                                   |   | Condensed Consolidated  Statements of Cash Flows for the six-months ended  June 30, 2006 and 2005 (Unaudited)            |   | 5 |
|                                   |   | Notes to Condensed Consolidated Financial  Statements (Unaudited)                                                             |   | 6 |
| Item 2.                                |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                   |   | 20 |
| Item 3.                                |   | Quantitative and Qualitative  Disclosures About Market Risk                                                                   |   | 52 |
| Item 4.                                |   | Controls and Procedures                                                                                                       |   | 52 |
| **PART II  OTHER INFORMATION**    |   |                                                                                                                          |
| Item 1.                                |   | Legal Proceedings                                                                                                             |   | 53 |
| Item 4.                                |   | Submission of Matters to a  Vote of Security Holders                                                                          |   | 54 |
| Item 6.                                |   | Exhibits                                                                                                                      |   | 55 |
| **SIGNATURES**                         |   | 56                                                                                                                            |

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1.**                        FinancialStatements.

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

| ** **                                                                                                                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2006**          | ** ** | **2005(1)**           | ** ** |
| **ASSETS**                                                                                                                              |       |              |       |                  |       |   |   |
| Current assets:                                                                                                                         |       |              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                               |       | $                 | 17,698     |                  |       | $ | 23,964 |   |   |
| Short-term investments                                                                                                                  |       | 1,001             |       |                  | 739        |   |   |
| Trade accounts receivable, net                                                                                                          |       | 6,895             |       |                  | 9,469      |   |   |
| Unbilled trade receivables                                                                                                              |       | 7,201             |       |                  | 6,228      |   |   |
| Inventory, net                                                                                                                          |       | 6,349             |       |                  | 7,451      |   |   |
| Other current assets                                                                                                                    |       | 2,596             |       |                  | 2,828      |   |   |
| Total current assets                                                                                                                    |       | 41,740            |       |                  | 50,679     |   |   |
| Restricted cash                                                                                                                         |       | 11,483            |       |                  | 7,279      |   |   |
| Property and  equipment, net                                                                                                            |       | 61,568            |       |                  | 64,108     |   |   |
| Intangibles, net                                                                                                                        |       | 16,144            |       |                  | 17,164     |   |   |
| Other assets, net                                                                                                                       |       | 940               |       |                  | 1,009      |   |   |
| Total assets                                                                                                                            |       | $                 | 131,875    |                  |       | $ | 140,239 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                          |       |              |       |                  |       |   |   |
| Current liabilities:                                                                                                                    |       |              |       |                  |       |   |   |
| Accounts payable                                                                                                                        |       | $                 | 6,877      |                  |       | $ | 6,722 |   |   |
| Accrued payroll and related costs                                                                                                       |       | 3,481             |       |                  | 3,731      |   |   |
| Deferred revenue                                                                                                                        |       | 7,794             |       |                  | 6,809      |   |   |
| Other current liabilities                                                                                                               |       | 1,759             |       |                  | 2,032      |   |   |
| Total current liabilities                                                                                                               |       | 19,911            |       |                  | 19,294     |   |   |
| Other long-term  liabilities                                                                                                            |       | 1,189             |       |                  | 969        |   |   |
| Total liabilities                                                                                                                       |       | 21,100            |       |                  | 20,263     |   |   |
| Commitments and  contingencies (Note 5)                                                                                                 |       |              |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                              |       |              |       |                  |       |   |   |
| Common stock  (21,176,762 and 20,808,994 shares issued and outstanding at June 30, 2006  and December 31, 2005, respectively) |       | 22                |       |                  | 21         |   |   |
| Additional  paid-in capital                                                                                                             |       | 209,657           |       |                  | 209,337    |   |   |
| Deferred stock  compensation                                                                                                            |       | —            |       |                  | (1,519     | ) |   |
| Accumulated other  comprehensive income                                                                                                 |       | 137               |       |                  | 137        |   |   |
| Accumulated  deficit                                                                                                                    |       | (99,041           | )          |                  | (88,000    | ) |   |
| Total stockholders’ equity                                                                                                         |       | 110,775           |       |                  | 119,976    |   |   |
| Total liabilities  and stockholders’ equity                                                                                        |       | $                 | 131,875    |                  |       | $ | 140,239 |   |   |

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

See Notes to Unaudited Condensed Consolidated Financial Statements.

3

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

| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June30,**                      | ** ** | **June 30,**              | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                          |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | $                                | 20,519     |                           | $          | 21,616 |   | $ | 42,809 |   | $ | 41,212 |   |
| Product and subscription                          |       | 4,388                            |       | 3,137                          |       | 9,291 |   | 7,920 |   |
| Total revenue                                     |       | 24,907                           |       | 24,753                         |       | 52,100 |   | 49,132 |   |
| Cost of revenue:                                  |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | 15,002                           |       | 15,471                         |       | 32,101 |   | 29,195 |   |
| Product and subscription                          |       | 1,675                            |       | 1,089                          |       | 4,224 |   | 3,442 |   |
| Total cost of revenue                             |       | 16,677                           |       | 16,560                         |       | 36,325 |   | 32,637 |   |
| Gross profit                                      |       | 8,230                            |       | 8,193                          |       | 15,775 |   | 16,495 |   |
| Operating expenses:                               |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                               |       | 4,685                            |       | 3,889                          |       | 9,224 |   | 7,666 |   |
| Research, development and engineering             |       | 2,994                            |       | 3,428                          |       | 6,230 |   | 6,336 |   |
| General and administrative                        |       | 4,172                            |       | 5,521                          |       | 9,382 |   | 11,018 |   |
| Amortization of intangibles                       |       | 550                              |       | 1,339                          |       | 1,123 |   | 2,150 |   |
| Intellectual property                             |       | 481                              |       | 467                            |       | 912 |   | 1,003 |   |
| Restructuring charges, net                        |       | 547                              |       | —                         |       | 547 |   | — |   |
| Total operating expenses                          |       | 13,429                           |       | 14,644                         |       | 27,418 |   | 28,173 |   |
| Operating income (loss)                           |       | (5,199                           | )          | (6,451                         | )          | (11,643 | ) | (11,678 | ) |
| Other income (expense):                           |       |                             |       |                           |       |   |   |   |   |
| Interest income                                   |       | 341                              |       | 273                            |       | 666 |   | 537 |   |
| Interest expense                                  |       | (28                              | )          | (58                            | )          | (44 | ) | (120 | ) |
| Other                                             |       | (5                               | )          | 82                             |       | 43 |   | 64 |   |
| Total other income, net                           |       | 308                              |       | 297                            |       | 665 |   | 481 |   |
| Income (loss)  before provision for income taxes  |       | (4,891                           | )          | (6,154                         | )          | (10,978 | ) | (11,197 | ) |
| Provision for  income taxes                       |       | 22                               |       | (63                            | )          | (63 | ) | (140 | ) |
| Net income (loss)                                 |       | $                                | (4,869     | )                              | $          | (6,217 | ) | $ | (11,041 | ) | $ | (11,337 | ) |
| Net income (loss)  per share—basic           |       | $                                | (0.24      | )                              | $          | (0.30 | ) | $ | (0.54 | ) | $ | (0.55 | ) |
| Net income (loss)  per share—diluted         |       | $                                | (0.24      | )                              | $          | (0.30 | ) | $ | (0.54 | ) | $ | (0.55 | ) |
| Weighted average shares outstanding—basic    |       | 20,627                           |       | 20,468                         |       | 20,617 |   | 20,461 |   |
| Weighted average  shares outstanding—diluted |       | 20,627                           |       | 20,468                         |       | 20,617 |   | 20,461 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

4

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

| ** **                                                                                 | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005** | ** ** |
| Cash flows from  operating activities:                                                     |       |                           |       |   |   |
| Net loss                                                                                   |       | $                              | (11,041    | ) | $ | (11,337 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                              |       | 7,652                          |       | 8,554 |   |
| Stock-based compensation expense                                                           |       | 1,576                          |       | 202 |   |
| Increase (decrease) in allowance for doubtful  accounts                                    |       | (164                           | )          | 72 |   |
| Other non-cash charges                                                                     |       | (73                            | )          | (8 | ) |
| Changes in  operating assets and liabilities:                                              |       |                           |       |   |   |
| Restricted cash                                                                            |       | (4,204                         | )          | 992 |   |
| Trade and unbilled accounts receivable, net                                                |       | 1,765                          |       | (429 | ) |
| Inventory, net                                                                             |       | 1,102                          |       | 444 |   |
| Other current assets                                                                       |       | 232                            |       | (1,179 | ) |
| Other assets, net                                                                          |       | 69                             |       | 132 |   |
| Accounts payable                                                                           |       | 155                            |       | (3,981 | ) |
| Accrued payroll and related costs                                                          |       | (250                           | )          | 1,336 |   |
| Deferred revenue                                                                           |       | 985                            |       | (34 | ) |
| Other liabilities                                                                          |       | (321                           | )          | 324 |   |
| Net cash provided by (used in) operating activities                                        |       | (2,517                         | )          | (4,912 | ) |
| Cash flows from  investing activities:                                                     |       |                           |       |   |   |
| Purchase of property and equipment and capitalized  labor costs                            |       | (3,407                         | )          | (8,959 | ) |
| Purchase of Intangibles                                                                    |       | (30                            | )          | (20 | ) |
| Sale or maturity of short-term investments                                                 |       | 62,713                         |       | 91,538 |   |
| Purchase of short-term investments                                                         |       | (62,975                        | )          | (74,845 | ) |
| Net cash provided by (used in) investing activities                                        |       | (3,699                         | )          | 7,714 |   |
| Cash flows from  financing activities:                                                     |       |                           |       |   |   |
| Net proceeds from issuance of common stock                                                 |       | 264                            |       | 175 |   |
| Principal payments under capital lease obligations                                         |       | (314                           | )          | (234 | ) |
| Net cash provided by (used in) financing activities                                        |       | (50                            | )          | (59 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | (6,266                         | )          | 2,743 |   |
| Cash and cash equivalents at beginning of period                                           |       | 23,964                         |       | 18,489 |   |
| Cash and cash equivalents at end of period                                                 |       | $                              | 17,698     |   | $ | 21,232 |   |
| Supplemental disclosure  of cash flow information:                                         |       |                           |       |   |   |
| Cash paid for interest                                                                     |       | $                              | 44         |   | $ | 120 |   |
| Cash paid for income taxes                                                                 |       | $                              | 111        |   | $ | 104 |   |
| Summary of non-cash  investing and financing activities:                                   |       |                           |       |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       | $                              | 582        |   | $ | 51 |   |
| Grant of  restricted stock                                                                 |       | $                              | 1,202      |   | $ | 2,025 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

5

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

**1.**   TheCompany, Basis of Presentation

*Description ofBusiness*

Digimarc Corporation (“Digimarc,” “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 June 30, 2006, the Company held rights in271 issued U.S. patents and over 60 issued foreign patents on this technologyand related technologies, applications, systems, and processes and had morethan 500 U.S. and foreign applications pending.

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

The substantial majority of the Company’s revenue isgenerated pursuant to long-term contracts with government agencies—primarilyU.S. state government agencies responsible for driver license issuance (“Statedriver license issuers”), a consortium of leading Central Banks and nationalgovernments of a number of foreign countries. These systems rely on our systemsdesign, integration and materials science expertise, and proprietarytechnologies such as digital watermarking, to implement issuance systems andprocesses that improve the security of identity documents and banknotes.

The remainder of ourrevenue 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 theCompany and its business partners to identify, track, manage and protectcontent as it is distributed and consumed—either digitally or physically—and toenable new consumer applications to improve access to networks and informationfrom PCs and mobile devices.

*Interim Financial Statements*

The condensed consolidated financial statementsinclude the accounts of Digimarc and its wholly-owned subsidiaries. Allsignificant inter-company transactions and balances have been eliminated. 

6

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The condensed consolidatedfinancial statements have been prepared from the Company’s records withoutaudit and, in management’s opinion, include all adjustments (consisting of onlynormal recurring adjustments) necessary to fairly reflect the financialcondition and the results for the periods presented. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the U.S. have beencondensed or omitted under the rules and regulations of the Securities andExchange 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.This change had the effect of reducing depreciation expense by $2,095 and$4,241 for the three- and six-month periods ended June 30, 2006,respectively. This reduction in depreciation increased basic and dilutedearnings by $0.10 and $0.21 for the three- and six-month periods ended June 30,2006, respectively, per share before taxes. Given that the depreciation expenseattributed to contract-specific assets is part of cost of revenue, the decreasein depreciation expense will cause gross margins to increase by the amount ofthe reduction in depreciation expense.

*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.

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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 |   |
|                                                        |            |            |            |                  |            |              |            |                    |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                            | ** ** | ** ** | ** ** | **Intellectual** | ** ** | ** **   | ** ** | **Centralized**    | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------------|------------|--------------|------------|--------------------|------------|------------|------------|
| **Quarter ending June 30, 2005,** | ** ** | ** ** | ** ** | **Before**       | ** ** | **Property** | ** ** | **Infrastructure** | ** ** | **Cost**   | ** ** | **After** | ** ** |
| Cost of  revenue—service                         |       | $          | 14,878     |             |       | $            | —     |               |       |       | $          | 142 |   |   |   | $ | 451 |   |   | $ | 15,471 |   |
| Total cost of  revenue                                |       | 15,967     |       |             | —     |         |       |               | 142        |       |       |   | 451 |   |   | 16,560 |   |
| Gross profit                                          |       | 8,786      |       |             | —     |         |       |               | (142       | )          |       |   | (451 | ) |   | 8,193 |   |
| Sales and  marketing                                  |       | 3,898      |       |             | (287       | )            |       |               | 105        |       |       |   | 173 |   |   | 3,889 |   |
| Research,  development and engineering                |       | 3,001      |       |             | (220       | )            |       |               | 228        |       |       |   | 419 |   |   | 3,428 |   |
| General and  administrative                           |       | 6,999      |       |             | 40         |         |       |               | (475       | )          |       |   | (1,043 | ) |   | 5,521 |   |
| Amortization of  Intangibles                          |       | 1,339      |       |             | —     |         |       |               | —     |       |       |   | — |   |   | 1,339 |   |
| Intellectual  Property                                |       | —     |       |             | 467        |         |       |               | —     |       |       |   | — |   |   | 467 |   |
| Total operating expenses                              |       | 15,237     |       |             | —     |         |       |               | (142       | )          |       |   | (451 | ) |   | 14,644 |   |
|                                                       |            |            |            |                  |            |              |            |                    |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**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 5,632 and 5,324 were excluded from diluted net lossper share calculations for the three- and six-month periods ended June 30,2006, respectively, as their exercise price was higher than the average marketprice of the underlying common stock for the period and therefore their impactwould be anti-dilutive. In addition, common stock equivalents related to stockoptions and restricted stock of 759 and 821 for the three- and six-monthperiods ended June 30, 2006, respectively, were excluded from diluted netloss per share as the Company was in a loss position and their inclusion wouldbe anti-dilutive. The effect of 6,658 and 6,371 outstanding stock options forthe three- and 

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six-monthsperiods ended June 30, 2005, respectively, were excluded from thecalculation of diluted net loss per share because their exercise price washigher than the average market price of the underlying common stock for theperiod and therefore their inclusion would be anti-dilutive. In addition,common stock equivalents related to stock options of 407 and 351 for the three-and six-months periods ended June 30, 2005, respectively were excludedfrom diluted net loss per share as the Company was in a loss position and theirinclusion would 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 and recognition of compensation for all stock-based awards made toemployees and directors including stock options and employee stock purchasesunder a stock purchase plan based on estimated fair values. SFAS 123(R) supersedesprevious accounting under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*, for periodsbeginning in fiscal 2006. In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107 relating toapplication of SFAS 123(R). The Company has applied the provisions of SAB 107in 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 ofAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, *Accounting forCertain Transactions involving Stock Compensation, an Interpretation of APBOpinion No. 25*, as allowed by FASB Statement No. 123,  *Accountingfor Stock-Based Compensation*. FASB Statement No. 123 and FASBStatement No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure, an amendment of FASBStatement No. 123*, established accounting and disclosurerequirements 

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using afair-value-based method of accounting for stock-based employee compensationplans. Under APB Opinion No. 25, stock-based compensation expense isrecognized for stock awards granted with an exercise price below fair marketvalue on the date of grant.

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

*Valuation and Amortization Method.**  **The Company estimates the fair value ofstock-based awards granted using the Black-Scholes option valuation model. TheCompany amortizes the fair value of all awards on a straight-line basis overthe requisite service periods, which are generally the vesting periods.*

*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 post-vesting forfeitures. Stock optionsgranted during the three- and six-months ended June 30, 2006 and 2005generally vest over four years and have contractual terms of ten years. Stockpurchases under the Company’s stock purchase plan have an expected life of sixmonths 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 52,957 shares purchased under the Company’sstock purchase plan during the three- and six- month periods ended June 30,2006 and 32,491 shares purchased during the three- and six-month periods ended June 30,2005. A summary of the weighted average assumptions and results for optionsgranted during the periods presented is as follows:

| ** **               | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **               | ** ** | **2006**                                    | ** ** | **2005**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life (in years) |       | 6.0                                         |       | 4.0                                       |       | 6.0 |   | 4.0 |   |
| Expected volatility      |       | 53                                          | %          | 50                                        | %          | 53 | % | 50 | % |
| Risk-free interest rate  |       | 4.7                                         | %          | 4.5                                       | %          | 4.7 | % | 4.5 | % |
| Expected dividend yield  |       | 0                                           | %          | 0                                         | %          | 0 | % | 0 | % |
| Expected forfeiture rate |       | 14                                          | %          | 20                                        | %          | 14 | % | 20 | % |
| Fair value               |       | $                                           | 3.89       |                                      | $          | 2.85 |   | $ | 3.89 |   | $ | 2.85 |   |
|                          |            |                                             |            |                                           |            |  |  |  |  |  |  |  |  |

 

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***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- and six-months ended June 30, 2006 whichwas incurred as follows (in thousands):

| ** **                             | ** ** | **Three Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2006** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Stock-based compensation:              |       |                                                  |       |                                                |       |   |   |   |   |
| Cost of revenue                        |       |                                                  | $          | 84                                                  |       |   |   | $ | 138 |   |   |
| Sales and marketing                    |       |                                                  | 134        |                                                |       |   | 256 |   |   |
| Research, development and  engineering |       |                                                  | 76         |                                                |       |   | 190 |   |   |
| General and administrative             |       |                                                  | 488        |                                                |       |   | 992 |   |   |
| Total stock-based compensation         |       |                                                  | $          | 782                                                 |       |   |   | $ | 1,576 |   |   |

 

At June 30, 2006 the Company had 1.6 million non-vested stockoptions that had a weighted average grant date price of $6.32. As of June 30,2006, the Company had $6.1 million of total unrecognized compensation costrelated to non-vested stock-based awards granted under all equity compensationplans, including options, restricted stock, and employee stock purchase plan.Total unrecognized compensation cost will be adjusted for any future changes inestimated forfeitures. The Company expects to recognize this cost over aweighted average period of 1.72 years.

The following table presents the impact of the Company’s adoption ofSFAS 123(R) on selected line items from its condensed consolidatedfinancial statements for the three- and six-month periods ended June 30,2006 (in thousands, except per share amounts):

| ** **                                       | ** ** | **Three Months Ended June 30, 2006** | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                       | ** ** | **As Reported**Following FAS 123 (R       | ** ** | **If Reported**Following APB 25              | ** ** | **As Reported**Following FAS 123 (R) | ** ** | **If Reported**Following APB 25 | ** ** |
| Condensed consolidated statement of operations:  |       |                                                          |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating income (loss)                          |       |                                                          | $          | (5,199                                                      | )          |   |   | $ | (4,636 | ) |   |   | $ | (11,643 | ) |   |   | $ | (10,474 | ) |   |
| Income (loss) before  provision for income taxes |       |                                                          | (4,891     | )                                                           |       |   | (4,328 | ) |   |   | (10,978 | ) |   |   | (9,809 | ) |   |
| Net income (loss)                                |       |                                                          | (4,869     | )                                                           |       |   | (4,306 | ) |   |   | (11,041 | ) |   |   | (9,872 | ) |   |
| Net income (loss) per  share                     |       |                                                          |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                            |       |                                                          | (0.24      | )                                                           |       |   | (0.21 | ) |   |   | (0.54 | ) |   |   | (0.48 | ) |   |
| Diluted                                          |       |                                                          | (0.24      | )                                                           |       |   | (0.21 | ) |   |   | (0.54 | ) |   |   | (0.48 | ) |   |
|                                                  |            |                                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Stock Option Activity***

As of June 30, 2006, under all of the Company’s stock-basedcompensation plans, options to purchase an aggregate of 7.3 million shareswere outstanding, and options to purchase an additional 3.6 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** | ** ** | **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 |   |

 

| ** **                         | ** ** | **Options** | ** ** | **Weighted**AverageExercisePrice | ** ** | **Weighted**AverageRemaining  ContractualLife | ** ** |
|------------------------------------|------------|-------------|------------|----------------------------------|------------|-----------------------------------------------|------------|
| Outstanding at March 31, 2006 |       | 7,236,501   |       |                             | $          | 14.00                                         |       |   |   |   |
| Options granted                    |       | 277,825     |       |                             | 6.83       |                                          |       |   |   |
| Options exercised                  |       | (3,857      | )          |                             | 2.81       |                                          |       |   |   |
| Options canceled                   |       | (212,919    | )          |                             | 11.07      |                                          |       |   |   |
| Options expired                    |       | —      |       |                             | —     |                                          |       |   |   |
| Outstanding at June 30, 2006  |       | 7,297,550   |       |                             | $          | 13.82                                         |       |   | 6.80 years |   |
| Exercisable at June 30, 2006  |       | 5,706,024   |       |                             | $          | 15.91                                         |       |   | 6.09 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 June 30, 2006:

| ** **                                      | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices**     | ** ** | ** **                   | ** ** | **Number**Outstanding        | ** ** | **Remaining**Contractual Life  (Years) | ** ** | **Weighted**AveragePrice | ** ** | **Number**Exercisable | ** ** | **Weighted**AveragePrice | ** ** |
| $  0.50 - $  6.15 |       |                         | 1,414,558  |                         |       |   | 8.46 |   |   |   | $ | 5.40 |   |   | 452,302 |   |   | $ | 4.24 |   |   |
| $  6.19 - $  9.85 |       |                         | 1,066,836  |                         |       |   | 8.81 |   |   |   | $ | 7.58 |   |   | 437,566 |   |   | $ | 8.58 |   |   |
| $10.29 - $12.25                       |       |                         | 760,612    |                         |       |   | 7.48 |   |   |   | $ | 11.60 |   |   | 760,612 |   |   | $ | 11.60 |   |   |
| $12.40 - $12.25                       |       |                         | 653,043    |                         |       |   | 6.59 |   |   |   | $ | 12.83 |   |   | 653,043 |   |   | $ | 12.83 |   |   |
| $13.38 - $14.13                       |       |                         | 797,200    |                         |       |   | 4.67 |   |   |   | $ | 14.06 |   |   | 797,200 |   |   | $ | 14.06 |   |   |
| $14.40 - $15.24                       |       |                         | 629,210    |                         |       |   | 6.47 |   |   |   | $ | 15.10 |   |   | 629,210 |   |   | $ | 15.10 |   |   |
| $15.25 - $17.00                       |       |                         | 830,297    |                         |       |   | 6.38 |   |   |   | $ | 16.26 |   |   | 830,297 |   |   | $ | 16.26 |   |   |
| $17.60 - $26.25                       |       |                         | 769,744    |                         |       |   | 4.92 |   |   |   | $ | 20.99 |   |   | 769,744 |   |   | $ | 20.99 |   |   |
| $27.50 - $35.13                       |       |                         | 121,050    |                         |       |   | 3.86 |   |   |   | $ | 31.40 |   |   | 121,050 |   |   | $ | 31.40 |   |   |
| $53.94 - $53.94                       |       |                         | 255,000    |                         |       |   | 3.59 |   |   |   | $ | 53.94 |   |   | 255,000 |   |   | $ | 53.94 |   |   |
| $  0.50 - $53.94            |       |                         | 7,297,550  |                         |       |   | 6.80 |   |   |   | $ | 13.82 |   |   | 5,706,024 |   |   | $ | 15.91 |   |   |
|                                                 |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

Prior to the fiscal year ending December 31,2006, the Company accounted for stock-based compensation plans using theintrinsic value method prescribed in APB 25 and related interpretations. Nostock-based compensation related to option grants or the employee stockpurchase plan was reflected in net loss in the three- and six-months ended June 30,2005, as all stock options granted under those plans had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant. Had compensation cost for the plans been determined based on thefair value at the grant dates for awards under those plans consistent with themethod of SFAS 123, the Company’s net loss and basic and diluted net loss pershare for the three- and six-month periods ended June 30, 2005 would havebeen changed to the pro forma amounts indicated below (in thousands, except forper share data):

| ** **                                                                                                        | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net loss, as  reported                                                                                            |       |                                                  | $          | (6,217                                              | )          |   |   | $ | (11,337 | ) |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       |                                                  | 151        |                                                |       |   | 202 |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards |       |                                                  | (1,834     | )                                                   |       |   | (3,510 | ) |   |
| Pro forma net  loss                                                                                               |       |                                                  | $          | (7,900                                              | )          |   |   | $ | (14,645 | ) |   |
| *Earnings per share:*                                                                                             | * *   |                                                  |       |                                                |       |   |   |   |   |
| Basic—as reported                                                                                            |       |                                                  | $          | (0.30                                               | )          |   |   | $ | (0.55 | ) |   |
| Diluted—as  reported                                                                                         |       |                                                  | $          | (0.30                                               | )          |   |   | $ | (0.55 | ) |   |
| Basic—pro forma                                                                                              |       |                                                  | $          | (0.39                                               | )          |   |   | $ | (0.72 | ) |   |
| Diluted—pro forma                                                                                            |       |                                                  | $          | (0.39                                               | )          |   |   | $ | (0.72 | ) |   |

 

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, 2005under the Company’s Restated 1999 Stock Incentive Plan and 2000 Non-OfficerEmployee Stock Incentive Plan, except for options held by members of theCompany’s Board of Directors. Options to purchase 422,248 shares of the Company’scommon stock, or 6% of the Company’s total outstanding options, with a weightedaverage exercise price of $11.51 and varying remaining vesting schedules, weresubject to this acceleration and became immediately vested and exercisable asof December 31, 2005. Of these 422,248 options, 120,972 options are heldby 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. 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 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 single reportingsegment, secure identity and media management. Revenue is generated in thisreporting segment through licensing and subscription of its various productsand the delivery of contracted and consulting services related to theseproducts. The Company markets its products in the U.S. and in other countriesthrough its sales personnel and its subsidiaries.

Revenueby geography is as follows:

| ** **    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Domestic      |       | $                                               | 21,112     |                                          | $          | 20,108 |   | $ | 41,307 |   | $ | 40,069 |   |
| International |       | 3,795                                           |       | 4,645                                         |       | 10,793 |   | 9,063 |   |
| Total         |       | $                                               | 24,907     |                                          | $          | 24,753 |   | $ | 52,100 |   | $ | 49,132 |   |

 

One customer accounted forapproximately 11% of total revenue in the three-month period endedJune 30, 2006 and approximately 10% of total revenue in the six-monthperiod ended June 30, 2006. There was no single customer in the three- andsix-month periods ended June 30, 2005 that accounted for more than 10% oftotal revenue. There was one customer that accounted for more than 10% of tradeand unbilled accounts receivable, net at June 30, 2006. There was onecustomer who accounted for 11% of trade and unbilled accounts receivable, netat December 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’s announcementthat it had discovered errors in its accounting for software development costsand project 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. On August 4, 2006,the Court granted this motion and dismissed the lawsuit with prejudice.Plaintiffs have thirty days to appeal this decision to the U.S. Court ofAppeals for the Ninth Circuit. Due to the inherent uncertainties of litigation,the Company cannot accurately predict the ultimate outcome of the matter.

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On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company. TheBoard of Directors appointed an independent committee to investigate the claimsasserted in this derivative lawsuit, as well as the second derivative actiondescribed in the immediately following paragraph. 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. In May of 2006, the Board committee, after completing itsinvestigation, concluded that pursuit of the allegations would not be in thebest interests of Digimarc or its shareholders.

A separate derivative action, involving substantiallythe same claims, was filed on or about April 6, 2005 in the Circuit Courtof the State of Oregon for the County of Washington. On March 31, 2006 theindividual defendants filed a motion to dismiss the lawsuit based on therecommendation of the Board committee. Plaintiffs subsequently stipulated to adismissal of the lawsuit and, on May 5, 2006, Judge Gardner signed astipulated motion and order of dismissal, dismissing the lawsuit withprejudice.

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 the partial settlement, including agreeing to assign away, not assert, orrelease certain potential claims the Company may have against its underwriters.Any direct financial impact of the proposed settlement (other than defensecosts incurred and expensed prior to May 31, 2003) is expected to be borneby the Company’s insurers. The court granted the preliminary approval motion onFebruary 15, 2005, subject to certain modifications. On August 31,2005, the court issued a preliminary order further approving the 

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modifications to thesettlement and certifying the settlement classes. The court also appointed theNotice Administrator for the settlement and ordered that notice of thesettlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearingwas held on April 26, 2006, but the court has not yet rendered itsdecision. If the court determines that the settlement is fair to the classmembers, the settlement will be approved. There can be no assurance that thisproposed settlement will be approved and implemented in its current form, or atall. Due to the inherent uncertainties of litigation and because the settlementapproval process is at a preliminary stage, the Company cannot accuratelypredict the ultimate outcome of the matter.

The Company from time to time experiences delays inidentification system implementation, timely acceptance for identificationsystems programs, concerns regarding identification system program performance,and other contractual disputes. Customers have asserted, and may in the future assert, compensatory orliquidated damages, breach of contract, or other claims alleging that theCompany has failed to meet timing or other delivery requirements and milestonespursuant to the terms of such contracts. From time to time, customershave given notice of their intention to assert claims for liquidated damages.Management believes that these assertions are often part of the resolutionprocess involving commercial disagreements over the terms of these contracts.Such disputes are not uncommon and tend to be resolved over time. However, the Company’s failure to meetcontractual milestones or other performance requirements as promised, or tosuccessfully resolve customer disputes, could result in the Company incurringliability for damages, as well as increased costs, lower margins, orcompensatory obligations in addition to other losses, such as harm to itsreputation. Such circumstances could have a material adverse effect on theCompany’s business and financial results. The Company anticipates that futurecontracts will continue to have such provisions unless and until industrypractices 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,  *Accountingfor Contingencies*. To date, there have been no claims made undersuch indemnification provisions.

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

**6.**   Recent Accounting Pronouncements

In March 2006, the FASB 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.

In July 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes*, which defines the threshold for recognizing thebenefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. Interpretation No. 48 applies toall tax positions accounted for under SFAS No. 109, *Accountingfor Income Taxes*. Interpretation No. 48 is effective as of thebeginning of the first fiscal year beginning after December 15, 2006. Uponadoption, we will adjust our financial statements to reflect only those taxpositions that are more-likely-than-not to be sustained as of the adoptiondate. Any adjustment will be recorded directly to our beginning retained 

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earningsbalance in the period of adoption and reported as a change in accountingprinciple. We are currently analyzing the effects of adopting Interpretation No. 48.

**7.**   Revenue Recognition

Revenue from the Company’s government-issuedcredential systems is generally billed and recognized on a per card producedbasis. The Company recognizes revenue on these contracts based on the actualmonthly production, if available, and in limited situations on estimated volumeinformation. When actual production information becomes available, typicallywithin one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Differences to date have not been significant. Revenue earned which has notbeen invoiced is classified as unbilled trade receivables in the consolidatedbalance sheets. Revenue related to an enhancement of or upgrade to an existingsystem is deferred and recognized over the remaining life of the contract.

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

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. Progress towards completion is measured using costs incurredcompared to the budgeted amounts contained in the contract. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the consolidatedbalance sheets.

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

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

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

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorizedduplication or alteration of high-value documents, for use in communicatingcopyright, asset management and business-to-business image commerce solutions,and for use in connecting analog media to a digital environment. Softwarerevenue is recognized in accordance with AICPA SOP No. 97-2, asamended by AICPA SOP No. 98-9, *Modificationof SOP 97-2*, *With Respectto Certain Transactions*. Revenue for licenses of the Company’ssoftware products is recognized upon the Company meeting the followingcriteria: persuasive evidence of an arrangement exists; delivery has occurred;the vendor’s fee is fixed or determinable; and collectibility is probable.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence exists only for undelivered elements. Under the residualmethod, revenue is recognized as follows: (1) the total fair value ofundelivered elements, as indicated by vendor specific objective evidence, isdeferred and subsequently recognized in accordance with the relevant sectionsof AICPA SOP No. 97-2, and (2) the difference between the totalarrangement fee and the amount deferred for the undelivered elements is recognizedas revenue related to the delivered elements.

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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.

**8.**   Inventory

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

| ** **                             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Equipment and  deferred contract costs |       |                    | $          | 778                         |       |   |   | $ | 899 |   |   |
| Consumable  materials                  |       |                    | 5,571      |                        |       |   | 6,552 |   |   |
| Inventory, net                         |       |                    | $          | 6,349                       |       |   |   | $ | 7,451 |   |   |

 

The reserve for slowmoving and obsolete items was $220 and $240 at June 30, 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.

**9.**   Software Development Costs

Under Statement of Financial Accounting Standards (“SFAS”)No. 86,  *Accounting for the Cost of Computer Software to Be Sold, Leased, orOtherwise Marketed,*software development costs are to be capitalizedbeginning when a product’s technological feasibility has been established andending when a product is made available for general release to customers. Todate, the establishment of technological feasibility of the Company’s productshas occurred shortly before general release and, therefore, software developmentcosts qualifying for capitalization have been immaterial. Accordingly, theCompany has not capitalized any software development costs and has charged allsuch costs to research and development expense.

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

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stageare expensed as incurred. Internal use software development projects that havebeen capitalized to date relate to card manufacturing and control systemssoftware.

**10.**   Related Party Transactions

During the three- and six-month periods ended June 30,2006, the Company recognized revenue of $100 and $225, respectively, from aholder of common stock. In addition the Company recognized revenue of $113 and$255 for the three- and six-month periods ended June 30, 2005,respectively, from this stockholder. Net accounts receivable from thisstockholder was $20 at June 30, 2006 and $231 at December 31, 2005.

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

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

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readersare also urged to carefully review and consider the various disclosures made byus which attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made under the caption “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.

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

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

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revenueis generated through commercial applications of our digital watermarking andrelated technologies, primarily from patent and technology license fees paid bybusiness partners. Our licensing business is built upon our extensive patentportfolio, which contains 267 issued U.S. patents as of June 30, 2006. Weexpect that patent licensing will continue to contribute most of our revenuesfrom non-government customers for the foreseeable future.

**Markets**

*Government*

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

We believe that many aspects of our driver license issuancesolutions have value in other forms of credentials and secure personalidentification systems. As the global market for secure personal identificationsolutions develops, we believe that our position as the 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. Each media objectenabled by our technology creates the potential for several applications, suchas counterfeiting and piracy deterrence, media identification and management,authentication, monitoring, or linking to networks and enhanced services insupport of mobile commerce. We believe the market for digital watermarkingapplications is in the early stages of development and that existing solutionsrepresent only a small portion of the potential market for our products,services, and technologies. However, we cannot, as of the date of this report, providereliable estimates of the size of these markets or predict the extent to whichthese markets will provide opportunities for revenue growth.

**Products andServices**

***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.

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***Secure ID Solutions***

As the leading provider of government-issued secureIDs in North America, our systems produce more than 60 million driver licensesand other secure personal IDs per year. Two-thirds of the U.S. States andmany foreign governments, including Russia, Latvia, Mexico, and Canada, useDigimarc secure ID solutions to issue credentials to citizens.**In North America, we are generally a prime contractor,providing full issuance systems to Federal, State, and Provincial departmentsof motor vehicles or other government issuing authorities. Our North American driverlicense issuance systems vary from jurisdiction to jurisdiction. These systemsare typically provided pursuant to long-term (normally five or more years)contracts. The systems provided include 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 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 orother ID 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 on broadening our security offerings toprovide more integrated identity verification and fraud detection capabilitieswithin the issuance workflow of our customers. Many aspects of our solutionsanticipate both the mandate of the REAL ID Act and the emerging consensus onbest practices consistent with our product and service strategy. In 2005, we introduced the Digimarc IdentityValidation Suite (“IDVS”) to validate identity documents and verify thebiometric and demographic data presented to establish an applicant’s identity.As identity credentials become more secure and difficult to counterfeit,counterfeiters turn to producing false breeder documents to fuel attempts tofraudulently obtain valid secure credentials. Thus, the process of validatingidentity is becoming central to secure ID issuance as document qualityimproves, ensuring that only valid applicants receive genuine IDs. This marketdevelopment is underscored by the focus of the REAL ID Act on identityvalidation. IDVS is our most strategic product offering in 2006, serving agrowing demand by our customers for effective multi-factor identification ofapplicants.

Inthe second quarter of 2006, we introduced the next generation of three Digimarcsecure enrollment products—the Digimarc Camera Tower, Digimarc CaptureSoftware, and Digimarc Image Server—to digitally capture and manage theindustry’s highest quality portraits, clear signatures, and reliable fingerprints.Together, these products securely capture, store and serve up the biometricimages needed by driver license and other government ID issuers for cardproduction, renewals, fraud investigation, and more. Additionally, knowledgetesting, validation of documents and verification of applicant identity arekeys to the secure intake and enrollment process, and a critical step towardensuring that driver licenses are only issued to legitimate applicants.

***Mediaand Entertainment***

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

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

·       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

·       enable fair and legitimateuse of content by consumers.

Our business partners include Activated ContentCorporation, AquaMobile, 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,Verimatrix, Inc. and VCP (an affiliate of VEIL Interactive Technologies).

***Additional Information***

A more detailed discussionof our business is contained in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2005 and in our Quarterly Report on Form 10-Qfor the quarter ended March 31, 2006.

**Recent Developments**

In our report on Form 10-Qfor the quarter ending March 31, 2006, we disclosed certain developmentsconcerning our protest of a notice of intent to award a contract issued by theCommonwealth of Virginia Department of Motor Vehicles (“DMV”) for the issuanceof driver licenses. On April 5, 2006, DMV issued a notice of intent toaward a contract to Canadian Bank Note Secure Technologies, Inc. (“CBN”)for a new driver license issuance system pursuant to RFP 154:5-060. On April 17,2006, Digimarc filed a protest of this award, based in part on certain allegedirregularities in the evaluation process and the assertion that the CBNproposal did not represent the best value for the Commonwealth and itscitizens. On April 27, 2006, DMV issued a response, in which it rescindedthe Notice of Intent to Award. The DMV response stated that “Digimarc’s protestraises issues that DMV believes warrant further consideration and evaluation”and that, “[i]n addition, DMV has determined that certain details pertaining tothe agreement with the proposed contractor were still being addressed when theearlier notice was posted.” On June 1, 2006, DMV cancelled the RFP andinformed bidders that DMV is working to issue a new RFP in the near future.

**Critical AccountingPolicies and Estimates**

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the United Statesof America requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to bad debts, inventories, intangibleassets, income taxes, restructuring, long-term service contracts, warranties,investments, contingencies and litigation, and inputs related to stock-basedcompensation calculations. We base our estimates on historical experience andon various other assumptions we believe to be reasonable under thecircumstances. Actual results may differ from these estimates under differentassumptions or conditions.

Certain of our accounting policies require higher degreesof judgment than others in their application. These include revenue recognitionon long-term service contracts, impairments and estimation of useful lives oflong-lived assets, inventory valuation, reserves for uncollectible accountsreceivable, contingencies 

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and litigation, and inputsrelated to stock-based compensation calculations. We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our consolidated financial statements:

**Revenue recognition on long-term service contracts:****  **We recognize revenue on long-term identificationand driver license production contracts using primarily a price-per-cardmethod. We use actual monthly volume amounts, if available, or we estimate thecard production volume on a monthly basis for certain of these contracts inorder to recognize revenue earned during the period. In the case of estimates,when the actual production information becomes available, which is typicallywithin four weeks, we bill the customer accordingly and any differences fromthe estimates are recognized in the month the billing occurs. These amountsrepresent our best estimates of cards produced and are based on historicaltrends, known events during the period, and discussions with contractrepresentatives. Prior to publicly reporting results, our practice is tocompare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Any estimated amounts are included inunbilled receivables on the balance sheet until the actual productioninformation is available and the billing occurs. Any estimation processinvolves inherent risk. We reduce the inherent risk relating to productionestimation through our approval and monitoring processes related to accountingestimates. We also evaluate contracts for multiple elements and account forthese items under the appropriate accounting literature.

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. Losses on contracts, if any, are provided for in the period in whichthe loss becomes determinable. Billing for services rendered generally occurswithin one month following when the services are provided. Revenue earned whichhas not been invoiced is classified as unbilled trade receivables in theconsolidated balance sheets.

**Impairments and estimation of useful lives oflong-lived assets:****  **Weperiodically assess long-lived assets for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable, in accordance with the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 144,* Accounting for the Impairment or Disposal ofLong-Lived Assets.* This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values,depending on the nature of the asset. If our estimates of projected future cashflows were too high by 10% or less, we believe there would be no materialimpact on the reported value of intangible assets on our Consolidated BalanceSheet. Also, we periodically review the useful lives of long-lived assetswhenever events or changes in circumstances indicate that the useful life mayhave changed. If the estimated useful lives of such assets do change, we adjustthe depreciation or amortization period to a shorter or longer period, based onthe circumstances identified.

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

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**Reserves for uncollectible accounts receivable:****  **We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. We determine the allowance based on historical write-off experienceand current information. We review, and adjust when appropriate, our allowancefor doubtful accounts on at least a quarterly basis. If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required. If ourestimate of uncollectible accounts were too low by 10% or less, we believethere would be no material impact on the reported value of accounts receivableon our consolidated balance sheets.

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

**Stock-BasedCompensation:**   On January 1, 2006, we adoptedSFAS 123(R), which requires the measurement and recognition ofcompensation for all stock-based awards made to employees and directorsincluding stock options and employee stock purchases under a stock purchaseplan based on estimated fair values. Under SFAS 123(R), we use theBlack-Scholes option pricing model as our method of valuation for stock-basedawards. Our determination of the fair value of stock-based awards on thedate of grant using an option pricing model is affected by our stock price aswell as assumptions regarding a number of highly complex and subjectivevariables. These variables include, but are not limited to the expected 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   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                         |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                  | 82         | %                                                   |       |   | 87 | % |   |   | 82 | % |   |   | 84 | % |   |
| Product and subscription                         |       |                                                  | 18         |                                                |       |   | 13 |   |   |   | 18 |   |   |   | 16 |   |   |
| Total revenue                                    |       |                                                  | 100        |                                                |       |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                  | 60         |                                                |       |   | 63 |   |   |   | 62 |   |   |   | 59 |   |   |
| Product and subscription                         |       |                                                  | 7          |                                                |       |   | 4 |   |   |   | 8 |   |   |   | 7 |   |   |
| Total cost of revenue                            |       |                                                  | 67         |                                                |       |   | 67 |   |   |   | 70 |   |   |   | 66 |   |   |
| Gross profit                                     |       |                                                  | 33         |                                                |       |   | 33 |   |   |   | 30 |   |   |   | 34 |   |   |
| Operating expenses:                              |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                                                  | 19         |                                                |       |   | 16 |   |   |   | 17 |   |   |   | 16 |   |   |
| Research, development and engineering            |       |                                                  | 12         |                                                |       |   | 14 |   |   |   | 12 |   |   |   | 13 |   |   |
| General and administrative                       |       |                                                  | 17         |                                                |       |   | 22 |   |   |   | 18 |   |   |   | 23 |   |   |
| Amortization of intangibles                      |       |                                                  | 2          |                                                |       |   | 5 |   |   |   | 2 |   |   |   | 4 |   |   |
| Intellectual property                            |       |                                                  | 2          |                                                |       |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |
| Restructuring charges, net                       |       |                                                  | 2          |                                                |       |   | 0 |   |   |   | 1 |   |   |   | 0 |   |   |
| Total operating expenses                         |       |                                                  | 54         |                                                |       |   | 59 |   |   |   | 52 |   |   |   | 58 |   |   |
| Operating income (loss)                          |       |                                                  | (21        | )                                                   |       |   | (26 | ) |   |   | (22 | ) |   |   | (24 | ) |   |
| Other income (expense):                          |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                  |       |                                                  | 1          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                 |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Other                                            |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Total other income, net                          |       |                                                  | 1          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                                                  | (20        | )                                                   |       |   | (25 | ) |   |   | (21 | ) |   |   | (23 | ) |   |
| Provision for  income taxes                      |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                                                  | (20        | )%                                                  |       |   | (25 | )% |   |   | (21 | )% |   |   | (23 | )% |   |

 

*Revenue*

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|--------------------------------|------------|--------------|------------|--------------|------------|
| ** **                        | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**                 | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue:                          |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | $                                | 20,519     |         | $          | 21,616         |       |                           | $          | (1,097       | )          |         |       | (5 | )% |   | $ | 42,809 |   | $ | 41,212 |   |   | $ | 1,597 |   |   |   | 4 | % |   |
| Product and subscription          |       | 4,388                            |       | 3,137        |       |           | 1,251      |                           |       |         | 40         | %            |       | 9,291 |   | 7,920 |   |   | 1,371 |   |   |   | 17 | % |   |
| Total                             |       | $                                | 24,907     |         | $          | 24,753         |       |                           | $          | 154          |       |         |       | 1 | % |   | $ | 52,100 |   | $ | 49,132 |   |   | $ | 2,968 |   |   |   | 6 | % |   |
| Revenue (as % of  total revenue): |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | 82                               | %          | 87           | %          |           |       |                           |       |         |       |         |       | 82 | % | 84 | % |   |   |   |   |   |   |   |   |
| Product and subscription          |       | 18                               | %          | 13           | %          |           |       |                           |       |         |       |         |       | 18 | % | 16 | % |   |   |   |   |   |   |   |   |
| Total                             |       | 100                              | %          | 100          | %          |           |       |                           |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

26

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

Service revenue decreased for the three-month periodended June 30, 2006 compared to the corresponding three-month period endedJune 30, 2005 primarily due to decreased card issuance revenue from theMexico program that resulted from a several month hiatus related to nationalelections. The increase in revenue for the six-month period ended June 30,2006 compared to the corresponding six-month period ended June 30, 2005resulted primarily from increased production for certain programs includingFlorida, Alabama, Haiti and Latvia, offset by decreased revenue from the Mexicoprogram.

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

*Productand subscription.  *Product and subscriptionrevenue consists primarily of the sale of equipment and consumables related toidentification card production systems, software licenses, and subscriptionsrelated to various software products.

Product and subscription revenue increased for thethree-month period ended June 30, 2006 compared to the correspondingthree-month period ended June 30, 2005 primarily due to several programs,including Ghana, Russia and Florida. The increase in revenue between thesix-month period ended June 30, 2006 and the corresponding six monthperiod ended June 30, 2005 resulted primarily from a new internationalprogram with Yemen, which was offset by decreased domestic revenue due to lowerproduct sales to certain domestic customers in 2006.

*Backlog.**  *Based on projected driver license production volumesand other commitments we have for the periods under contract with ourrespective customers, we anticipate our current contracts as of June 30,2006 will generate more than $220 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectapproximately $40 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

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

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period. For example,the three-month period ended June 30, 2006 had a low level of bid awards,and as a result we have consumed backlog during the quarter without largereplenishments from competitive bid wins. Over the next year or so, we anticipateseveral States to request bids on their driver license issuance systemprograms. This period of expected high bid activity could lead to additionalbacklog if we are successful with our bids. Another example is the variablerevenue model. Two of our recent domestic driver license issuance system saleswere not our characteristic price-per-card model, but instead included hardwareand consumable sales. Although these types of revenue models are positivegrowth indicators for our business, they can lead to lower reported backlog.

Therecan be no assurance that our backlog will result in actual revenue in anyparticular period, because the orders, awards and contracts included in ourbacklog may be subject to modification, cancellation or suspension. We may notrealize revenue on certain contracts, orders or awards included in our backlogor the timing of such recognition may change.

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|--------------------------------|------------|--------------|------------|--------------|------------|
| ** **                        | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**                 | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Revenue by geography:             |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                          |       | $                                | 21,112     |         | $          | 20,108         |       |                           | $          | 1,004        |       |         |       | 5 | % |   | $ | 41,307 |   | $ | 40,069 |   |   | $ | 1,238 |   |   |   | 3 | % |   |
| International                     |       | 3,795                            |       | 4,645        |       |           | (850       | )                              |       |         | (18        | )%           |       | 10,793 |   | 9,063 |   |   | 1,730 |   |   |   | 19 | % |   |
| Total                             |       | $                                | 24,907     |         | $          | 24,753         |       |                           | $          | 154          |       |         |       | 1 | % |   | $ | 52,100 |   | $ | 49,132 |   |   | $ | 2,968 |   |   |   | 6 | % |   |
| Revenue (as % of  total revenue): |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                          |       | 85                               | %          | 81           | %          |           |       |                           |       |         |       |         |       | 79 | % | 82 | % |   |   |   |   |   |   |   |   |
| International                     |       | 15                               | %          | 19           | %          |           |       |                           |       |         |       |         |       | 21 | % | 18 | % |   |   |   |   |   |   |   |   |
| Total                             |       | 100                              | %          | 100          | %          |           |       |                           |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

The increase in domestic revenue for the three-monthperiod ended June 30, 2006 as compared to the corresponding three-monthperiod ended June 30, 2005 resulted primarily from increased revenue fromcertain programs such as Florida and Alabama that were either delivered orachieved full production in early 2006. The increase in revenue for thesix-month period ended June 30, 2006 as compared to the correspondingsix-month period ended June 30, 2005 was due primarily to increasedrevenue from the Florida and Alabama programs offset by lower productionrevenues in certain States that occur from time to time. The decrease in internationalrevenue for the three-month period ended June 30, 2006 compared to thecorresponding three-month period ended June 30, 2005 was due primarily todecreased revenue from the second quarter hiatus in our Mexico plant due tonational elections. The increase in international revenue for the six-monthperiod ended June 30, 2006 as compared to the corresponding six-monthperiod ended June 30, 2005 was due primarily to increased revenue fromYemen, Haiti, and Latvia programs that were either delivered or achieved fullproduction in early 2006, offset by the Mexico program.

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

28

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

*Cost of Revenue*

| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|--------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                             | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**                 | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of Revenue:                                       |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                |       | $                                | 15,002     |         | $          | 15,471         |       |                           | $          | (469         | )          |         |       | (3 | )% |   | $ | 32,101 |   | $ | 29,195 |   |   | $ | 2,906 |   |   |   | 10 | % |   |
| Product and subscription                               |       | 1,675                            |       | 1,089        |       |           | 586        |                           |       |         | 54         | %            |       | 4,224 |   | 3,442 |   |   | 782 |   |   |   | 23 | % |   |
| Total                                                  |       | $                                | 16,677     |         | $          | 16,560         |       |                           | $          | 117          |       |         |       | 1 | % |   | $ | 36,325 |   | $ | 32,637 |   |   | $ | 3,688 |   |   |   | 11 | % |   |
| Cost of Revenue  (as % of related revenue components): |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                |       | 73                               | %          | 72           | %          |           |       |                           |       |         |       |         |       | 75 | % | 71 | % |   |   |   |   |   |   |   |   |
| Product and  subscription                              |       | 38                               | %          | 35           | %          |           |       |                           |       |         |       |         |       | 45 | % | 43 | % |   |   |   |   |   |   |   |   |

 

*Service.*   Cost of service revenue primarilyincludes costs of consumables used in delivering a service, compensation forsoftware developers, quality assurance personnel, product managers, fieldoperations personnel, business development personnel and outside contractors,depreciation charges for machinery, equipment and capitalized software,deployment costs used specifically for service delivery, provisions forobsolete and excess inventories, travel costs directly attributable to serviceand development contracts, and charges for infrastructure and centralizedcosts.

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

·       decreasedprogram costs related to cost reduction initiatives of $0.6 million,

·       decreasedemployee compensation-related expenses of $0.2 million as part of arestructuring initiative, offset by

·       increasedallocated infrastructure and centralized costs of $0.3 million primarily due tosystem upgrades and enhancements in our information technology department.

Cost of service revenue increased for the six-monthperiod ended June 30, 2006 compared to the corresponding six-month periodended June 30, 2005 primarily due to the increased support cost of $3.2million. During the first two quarters of the fiscal year the Company allocatedadditional resources to fixing and improving existing programs and experienceddelays in initiation of certain capital projects. As a result, support costs increasedand fewer expenditures were capitalized to the balance sheet

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

Cost of product and subscription revenue increased forthe three-month period ended June 30, 2006 compared to the correspondingthree-month period ended June 30, 2005 primarily due to increased domesticand international material costs of $0.6 million related to hardware and consumablesales.

Cost of product and subscription revenue increased forthe six-month period ended June 30, 2006 compared to the correspondingsix-month period ended June 30, 2005 primarily due to increasedinternational material costs of $1.6 million, offset by lower domestic materialcosts of $0.6 million related to hardware and consumable sales.

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

| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|--------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                     | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**                 | ** ** | **2006**     | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                               |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                       |       | $                                | 6,454      |         | $          | 6,850          |       |                           | $          | (396         | )          |         |       | (6 | )% |   | $ | 14,771 |   | $ | 14,131 |   |   | $ | 640 |   |   |   | 5 | % |   |
| Fixed field support and manufacturing     |       | 7,595                            |       | 6,524        |       |           | 1,071      |                           |       |         | 16         | %            |       | 16,338 |   | 12,537 |   |   | 3,801 |   |   |   | 30 | % |   |
| Program depreciation                           |       | 2,628                            |       | 3,186        |       |           | (558       | )                              |       |         | (18        | )%           |       | 5,216 |   | 5,969 |   |   | (753 | ) |   |   | (13 | )% |   |
| Total                                          |       | $                                | 16,677     |         | $          | 16,560         |       |                           | $          | 117          |       |         |       | 1 | % |   | $ | 36,325 |   | $ | 32,637 |   |   | $ | 3,688 |   |   |   | 11 | % |   |
| Cost of revenue  (as % of total revenue): |       |                             |       |         |       |           |       |                           |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                       |       | 26                               | %          | 28           | %          |           |       |                           |       |         |       |         |       | 28 | % | 29 | % |   |   |   |   |   |   |   |   |
| Fixed field support and manufacturing     |       | 30                               | %          | 26           | %          |           |       |                           |       |         |       |         |       | 32 | % | 25 | % |   |   |   |   |   |   |   |   |
| Program depreciation                           |       | 11                               | %          | 13           | %          |           |       |                           |       |         |       |         |       | 10 | % | 12 | % |   |   |   |   |   |   |   |   |
| Total                                          |       | 67                               | %          | 67           | %          |           |       |                           |       |         |       |         |       | 70 | % | 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 changes in variablecosts as a percentage are primarily due to a sales mix that included lowermargin sales of hardware and consumable products that occur from time to time,as well as continued pricing improvement with vendors and improved yieldsduring the manufacturing process.

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

30

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Programdepreciation primarily consists of amortization and depreciation of costsincurred during the delivery process, where such costs are capitalized and thenamortized or depreciated over the useful lives of the assets to which the costsrelate. Program depreciation decreased in relation to the other components ofcost of revenue primarily due to the change in the estimated useful lives ofprogram-related fixed assets. Through December 31, 2005, we depreciatedprogram fixed assets that were specifically used to provide services under longterm contracts over the shorter of the original contract term or estimateduseful life. Starting January 1, 2006, we changed our policy fordepreciating these assets to the shorter of the original contract term plus 2.75years or estimated useful life. This change in estimate was supported byanalysis we completed during the first quarter of 2006 which showed thathistorically 95% of contracts were extended beyond the original contract term,that the average contract had at least two contract extensions during its lifeand that these extensions added on average 2.75 years to the length of thecontracts’ original terms. Since contract-specific program assets are trackedon a contract basis, the findings that the contract life is routinelysignificantly longer than the original contract term and that these extensionsare not generally accompanied by significant incremental capital investmentindicates that the contract-related assets’ useful life was longer than theoriginal term of the contract. Given the findings of the analysis, we concludedthat it was appropriate to change the estimated useful lives so that contractspecific assets were being depreciated over our most accurate estimate. Thefollowing table shows the effect of this policy of reducing depreciationexpense in the first two quarters of 2006, as well as the expected effect inthe future periods specified:

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

 

The change in estimating the useful lives ofprogram-related fixed assets had the effect of reducing depreciation expense by$2,095 and $4,241 for the three- and six-month periods ended June 30,2006, respectively. This reduction in depreciation increased basic and dilutedearnings per share by $0.10 and $0.21 for the three- and six-month periodsended June 30, 2006, respectively. Given that the depreciation expenseattributed to contract-specific assets is included in cost of revenue, the decreasein depreciation expense will cause gross margins to increase by the amount ofthe reduction in depreciation expense.

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

We use the straight linemethod of depreciation and amortization for program-related assets. Thecombination of the seasonality of our revenues and straight line depreciationand amortization can cause significant variations in quarterly gross margintrends, generally increasing margins as a percentage of revenue in the secondand third quarters when our revenues are higher and decreasing margins as apercentage of revenue in the first and fourth quarters when our issuancerevenues are typically lower, while having a neutral effect on a yearly basis.

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*Gross Profit*

| ** **                                          | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Gross Profit:  Service                              |       |                                                                 | $          | 5,517                                                                |       |                  |       | $                                             | 6,145      |                                                                 |       |                                                                 | $          | (628 | ) |   |   | (10 | )% |   |   | $ | 10,708 |   |   |   | $ | 12,017 |   |   |   | $ | (1,309 | ) |   |   | (11 | )% |   |
| Product and subscription                            |       |                                                                 | 2,713      |                                                                 |       |                  | 2,048      |                                          |       |                                                                 | 665        |                                                                 |       |   | 32 | % |   |   | 5,067 |   |   |   | 4,478 |   |   |   | 589 |   |   |   | 13 | % |   |
| Total                                               |       |                                                                 | $          | 8,230                                                                |       |                  |       | $                                             | 8,193      |                                                                 |       |                                                                 | $          | 37 |   |   |   | <1 | % |   |   | $ | 15,775 |   |   |   | $ | 16,495 |   |   |   | $ | (720 | ) |   |   | (4 | )% |   |
| Gross Profit (as % of  related revenue components): |       |                                                                 |       |                                                                 |       |                  |       |                                          |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                             |       |                                                                 | 27         | %                                                                    |       |                  | 28         | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 25 | % |   |   | 29 | % |   |   |   |   |   |   |   |   |   |
| Product and subscription                            |       |                                                                 | 62         | %                                                                    |       |                  | 65         | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 55 | % |   |   | 57 | % |   |   |   |   |   |   |   |   |   |
| Total                                               |       |                                                                 | 33         | %                                                                    |       |                  | 33         | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 30 | % |   |   | 34 | % |   |   |   |   |   |   |   |   |   |

 

Overall gross profit as apercentage of revenue was 33% and 30%, respectively, for the three- andsix-month periods ended June 30, 2006, compared to 33% and 34% for thethree- and six-month periods ended June 30, 2005. The decrease in thesix-month period ended June 30, 2006 as compared to the six-month periodended June 30, 2005 was primarily due to the increased costs describedunder the “Cost of Revenue” section.

*Operating Expenses*

*Sales and marketing*

| ** **                        | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |           |
|-----------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------|
| ** **                        | ** ** | **     2006**      | ** ** | **     2005**      | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006**      | ** ** | **     2005**      | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |   |
| Sales and marketing               |       |                                                                 | $          | 4,685                                                                |       |                  |       | $                                             | 3,889      |                                                                 |       |                                                                 | $          | 796            |   |   |   | 21 | % |   |   | $ | 9,224 |   |   |   | $ | 7,666 |   |   |   | $ | 1,558 |   |   |   | 20 | % |   |
| Variable (as % of  total revenue) |       |                                                                 | 19         | %                                                                    |       |                  | 16         | %                                             |       |                                                                 |       |                                                                 |       |           |   |   |   |   | 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 insales and marketing expense for the three-month period ended June 30,2006, as compared to the corresponding three-month period ended June 30,2005, resulted primarily from:

·       increasedcosts related to tradeshows, advertising, consulting fees and event sponsorhipof $0.4 million, and

·       increasedemployee compensation-related expenses of $0.2 million, consisting of salaries,benefits, recruiting costs, and incentive plan compensation, due to increasedpersonnel in marketing and governmental activities, and higher benefit programcosts.

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

·       increasedcosts related to tradeshows, advertising, consulting fees and event sponsorhipof $0.4 million,

·       increasedemployee compensation-related expenses of $0.3 million, consisting of salaries,benefits, recruiting costs, and incentive plan compensation, due to increasedpersonnel in marketing and governmental activities, and higher benefit programcosts, and

·       increasedstock option expense of $0.3 million.

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*Research, development and engineering*

| ** **                                                     | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Research, development and engineering                          |       |                                                                 | $          | 2,994                                                                |       |                  |       | $                                             | 3,428      |                                                                 |       |                                                                 | $          | (434 | ) |   |   | (13 | )% |   |   | $ | 6,230 |   |   |   | $ | 6,336 |   |   |   | $ | (106 | ) |   |   | (2 | )% |   |
| Research,  development and engineering (as % of total revenue) |       |                                                                 | 12         | %                                                                    |       |                  | 14         | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 12 | % |   |   | 13 | % |   |   |   |   |   |   |   |   |   |

 

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

The decrease forthe three-month period ended June 30, 2006, as compared to thecorresponding three-month period ended June 30, 2005, resulted primarilyfrom:

·       decreasedemployee compensation-related expenses of $0.3 million as part of arestructuring initiative.

The decrease forthe six-month period ended June 30, 2006, as compared to the correspondingsix-month period ended June 30, 2005, resulted primarily from:

·       decreasedemployee compensation-related expenses of $0.3 million as part of arestructuring initiative, offset by

·       increased stock optionexpense of $0.2 million.

*General and administrative*

| ** **                                               | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| General and administrative                               |       |                                                                 | $          | 4,172                                                                |       |                  |       | $                                             | 5,521      |                                                                 |       |                                                                 | $          | (1,349 | ) |   |   | (24 | )% |   |   | $ | 9,382 |   |   |   | $ | 11,018 |   |   |   | $ | (1,636 | ) |   |   | (15 | )% |   |
| General and  administrative (as % of total revenue) |       |                                                                 | 17         | %                                                                    |       |                  | 22         | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 18 | % |   |   | 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 ended June 30, 2006, as compared to thecorresponding three-month period ended June 30, 2005, resulted primarilyfrom:

·       decreasedprofessional and audit fees of $1.1 million related to our audit and review,Sarbanes-Oxley audit, compliance and remediation efforts in 2005,

·       decreasedother administration costs of $0.3 million related to cost cuttinginitiatives, offset by

·       increasedstock option expense of $0.3 million.

The decrease forthe six-month period ended June 30, 2006, as compared to the correspondingsix-month period ended June 30, 2005, resulted primarily from:

·       decreasedprofessional and audit fees of $1.6 million related to our audit and review,Sarbanes-Oxley audit, compliance and remediation efforts in 2005,

·       decreasedother administration costs of $0.5 million related to cost cuttinginitiatives, offset by

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·       increased stock optionexpense of $0.8 million.

*Amortization of intangible assets*

| ** **                                                | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Amortization of intangibles                               |       |                                                                 | $          | 550                                                                  |       |                  |       | $                                             | 1,339      |                                                                 |       |                                                                 | $          | (789 | ) |   |   | (59 | )% |   |   | $ | 1,123 |   |   |   | $ | 2,150 |   |   |   | $ | (1,027 | ) |   |   | (48 | )% |   |
| Amortization of  intangibles (as % of total revenue) |       |                                                                 | 2          | %                                                                    |       |                  | 5          | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 2 | % |   |   | 4 | % |   |   |   |   |   |   |   |   |   |

 

We account for intangible assets resulting fromacquisitions in accordance with FASB Statement Nos. 141, *Business Combinations*and 142, *Goodwill and Other Intangible Assets*.These statements require the recording of intangible assets under purchaseaccounting rules, and require the amortization of such intangible assets overtheir expected useful life. As a result, in December 2001, we recorded$29.5 million of intangible assets related to the acquisition of certain assetsand certain liabilities from Polaroid and affiliates. These intangible assetswere set up to amortize over a 12-year period, representing the expected usefullife. Changes in contract status and customer relationships may lengthen orshorten 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- and six-month periods ended June 30, 2006 compared to thecorresponding three- and six-month periods ended June 30, 2005 resultedprimarily from extended amortization periods from contract extensions onseveral domestic customers and the increased amortization in 2005 related to adomestic customer who awarded their contract to a competitor. The intangibleasset related to this customer was fully amortized by the fourth quarter of2005.

*Intellectual property*

| ** **                                          | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Dollar  Increase**                                                 | ** ** | **Percent  Increase**                                                | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                                | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Intellectual property                               |       |                                                                 | $          | 481                                                                  |       |                  |       | $                                             | 467        |                                                                 |       |                                                                 | $          | 14 |   |   |   | 3 | % |   |   | $ | 912 |   |   |   | $ | 1,003 |   |   |   | $ | (91 | ) |   |   | (9 | )% |   |
| Intellectual  property (as % of total revenue) |       |                                                                 | 2          | %                                                                    |       |                  | 2          | %                                             |       |                                                                 |       |                                                                 |       |   |   |   |   |   | 2 | % |   |   | 2 | % |   |   |   |   |   |   |   |   |   |

 

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

The slight increase for the three-month period ended June 30,2006, as compared to the corresponding three-month period ended June 30,2005, resulted primarily from a decrease of $0.1 million related to a reductionin headcount, which was offset by an increase of $0.1 million in consultingfees paid to third-party agents and government fees related to patent and otherintellectual property work

The decrease for thesix-month period ended June 30, 2006, as compared to the correspondingsix-month period ended June 30, 2005, resulted primarily from a decreaseof $0.1 million related to a reduction in headcount.

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*Restructuring charges, net.*

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

*Duringthe second quarter, we initiated productivity improvement initiatives andsignificantly reduced fixed costs in order to facilitate our effort to achieveprofitability. The reduction in fixed costs included reduction of our workforceby nearly 20% since the beginning of 2006. The restructuring charge for thethree-month period ended June 30, 2006 totaled $547, primarily due toemployee severance and related costs. These restructuring charges wereallocated out of the departments as noted above.*

*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 and recognition of compensation for all stock-based awards made toemployees and directors including stock options and employee stock purchasesunder a stock purchase plan based on estimated fair values. SFAS 123(R) supersedesprevious accounting under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*, for periodsbeginning in fiscal 2006. In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107 relating toapplication of SFAS 123(R). The Company has applied the provisions of SAB 107in our adoption of SFAS 123(R).

The Company adopted SFAS 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s condensed consolidated financial statements for periods prior 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.

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

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

| ** **                             | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Six Months Ended  June 30,**                        | ** ** |
|----------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                             | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| Cost of revenue                        |       |                                                                 | $          | 84                                                                   |       |   |   | $ | — |   |   |   | $ | 138 |   |   |   | $ | — |   |   |
| Sales and  marketing                   |       |                                                                 | 134        |                                                                 |       |   | — |   |   |   | 256 |   |   |   | — |   |   |
| Research,  development and engineering |       |                                                                 | 76         |                                                                 |       |   | — |   |   |   | 190 |   |   |   | — |   |   |
| General and  administrative            |       |                                                                 | 488        |                                                                 |       |   | 152 |   |   |   | 992 |   |   |   | 203 |   |   |
| Total                                  |       |                                                                 | $          | 782                                                                  |       |   |   | $ | 152 |   |   |   | $ | 1,576 |   |   |   | $ | 203 |   |   |

 

We anticipate anadditional $6.1 million in stock-based compensation through fiscal 2010 forawards outstanding as of June 30, 2006. Additional impact resulting fromadoption of this statement on our financial position and results of operationswill be determined by stock-based awards granted in future periods and theassumptions on which the value of those stock-based awards is based. Our taxaccounting may also be impacted by actual exercise behavior and the relativemarket prices at exercise.

On December 15, 2005,the Board of Directors of the Company approved the acceleration of vesting ofthe Company’s outstanding stock options with option exercise prices equal to orgreater than $9.00. The acceleration applied to all options outstanding asof December 31, 2005 under the Company’s Restated 1999 Stock IncentivePlan and 2000 Non-Officer Employee Stock Incentive Plan, except for optionsheld by members of the Company’s Board of Directors. Options to purchase422,248 shares of the Company’s common stock, or 6% of the Company’s totaloutstanding 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. Ofthese 422,248 options, 120,972 options are held by the Company’s executiveofficers.

On December 21, 2004,the Audit, Compensation and Corporate Governance Committees of the Board ofDirectors of the Company approved the acceleration of vesting of the Company’soutstanding stock options with option exercise prices greater than $15.00. Theacceleration applied to all options outstanding under the Company’s Restated1999 Stock Incentive Plan and 2000 Non-Officer Employee Stock Incentive Planthat would not have otherwise vested in full by June 30, 2005 in accordancewith their terms. The effective date of the vesting acceleration was December 31,2004. Options to purchase 310,057 shares of the Company’s common stock, or5% of the total number of options of the Company outstanding as of December 31,2004 with remaining 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 theseaccelerations, the Company reduced its exposure to the effects of SFAS 123(R).

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*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.3 and $0.7 million for the three- and six-month periodsended June 30, 2006, respectively, compared to $0.3 and $0.5 million forthe three- and six-month periods ended June 30, 2005. The increaseresulted from higher interest earned on lower cash and investmentbalances, which was partially offset by higher interest expense related tocapitalized leases.

*Provisionfor Income Taxes.*   The provision for income taxesreflects expected tax expense from profitability in foreign jurisdictions. Thetax expense for the three-month period ended June 30, 2006 reflects anegative adjustment of $135,000 related to a reduction in taxes ultimatelyincurred in foreign jurisdictions for the year ended December 31, 2005, aswell as expected to be incurred for the quarter ended March 31, 2006. Theseadjustments are due in part to a study undertaken by the Company to betterdefine and document the functions performed and risks undertaken in certainforeign jurisdictions and apply proper economic analyses to compensate each ofour foreign subsidiaries accordingly. Due to the uncertainty of realization ofthe Company’s NOL and other deferred tax assets, including those generated inthe current period, we have recorded a full valuation allowance against our netdeferred tax assets at June 30, 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 therealization of these assets is more likely than not.

**Liquidity and Capital Resources**

As of June 30, 2006,we had cash and cash equivalents, restricted cash, and short-term investmentsof $30.2 million, representing a decrease of approximately $1.8 million from$32.0 million at December 31, 2005. The decrease primarily resulted fromthe increase in restricted cash due to a large number of performance bondrenewals on various government contracts and investments in new programimplementations and the purchase of fixed assets. As of June 30, 2006,$11.5 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 June 30, 2006 was $21.8 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 $2.5 million of cashused in operations for the six-months ended June 30, 2006 resulted from anet loss of $11.0 million, partially offset by non cash items related todepreciation and amortization of $7.7 million and stock-based compensationexpense of $1.6 million, and a decrease in trade and unbilled accountsreceivable, net of $1.8 million and inventory of $1.1 million. Negativelyaffecting cash provided by operations was an increase in restricted cash of$4.2 million. The $4.9 million of cash used in operations for the six monthsended June 30, 2005 resulted from a net loss of $11.3 million, offset bynon cash items related to depreciation and amortization of $8.6 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 $4.0million and an increase in other current assets of $1.2 million.

The $3.7 million of cashused in investing activities for the six-month period ended June 30, 2006primarily related to $0.3 million in net purchase of short-term investments and$3.4 million for the purchase of property and equipment, includingcapitalization of labor costs of $1.1 million. The $7.7 million of cashprovided by investing activities for the six-months ended June 30, 2005primarily related to $16.7 million in net sale or maturity of short-terminvestments partially offset by $9.0 million for the purchase of property andequipment, including capitalization of labor costs.

The $0.1 million of cashused in financing activities for the six-month periods ended June 30, 2006resulted primarily from the principal payments on capital leases, partiallyoffset by the proceeds from the issuance of stock. The $0.1 million of cashused in financing activities for the six-month period ended 

37

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June 30,2005 resulted primarily from the principal payments on capital leases,partially offset by the proceeds from the issuance of stock.

Our significantcommitments consist of obligations under non-cancelable operating leases, whichtotaled $7.9 million as of June 30, 2006, and are payable in monthlyinstallments through August 2011. Our obligations under non-cancelablecapital leases, which totaled $0.9 million as of June 30, 2006, arepayable in monthly installments through June 2011.

Many of our secureidentity management contracts have significant capital requirements. Thegeneral industry model for supplying driver license issuance systems to Statedriver license issuers is for the system supplier to develop and install theissuance system using the supplier’s capital and to charge the customer on aper-card issued basis. This means that, during times of substantial competitivewins and/or substantial system upgrades, the Company may experience significantworking capital needs that may exceed cash flow from operations. To date, theCompany has relied upon cash reserves to fund such expenditures.

We have driver licensecontracts with various states that are not yet fully deployed for which we haveestimated the amounts to complete. In order to complete these contracts, weestimate we will incur approximately $18 million of expenditures. Theestimates are derived from information known to us as of quarter end, the timethe estimates were prepared. Actual expenditures may vary from our estimates.We anticipate that these expenditures will be recouped through receipts fromthe related long-term price-per-card agreements.

Our planned operatingexpenses and capital expenditures may constitute a material use of our cashresources. In addition, we expect that we will continue to utilize cash in theupcoming few quarters as we complete program implementations. We may utilizecash resources to fund acquisitions or investments in complementary businesses,technologies or product lines.

We believe that ourcurrent cash, cash equivalents, and short-term investment balances will satisfyour projected working capital and capital expenditure requirements for at leastthe next 12 months. Thereafter, we anticipate continuing to use cash, cashequivalents, and short-term investment balances to satisfy our projectedworking capital and capital expenditure requirements. However, in the eventthat we were to win contracts requiring significant capital investment, we mayneed to seek additional 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 Sheet Arrangements**

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

**Recent Accounting Pronouncements**

In March 2006, theFASB issued SFAS No. 156,  *Accounting for Servicing of Financial Assets, an amendment of SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities*. The statement changes the way entities account forservicing assets and obligations associated with financial assets acquired ordisposed of. SFAS No. 156 is effective for the first fiscal year beginningafter September 15, 2006. The Company does not expect the adoption of thisstandard to have a material effect on the Company’s financial statements.

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In July 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes*, which defines the threshold for recognizing thebenefits of tax return positions in the financial statements as “more-likely-than-not”to be sustained by the taxing authority. Interpretation No. 48 applies toall tax positions accounted for under SFAS No. 109, *Accountingfor Income Taxes*. Interpretation No. 48 is effective as of thebeginning of the first fiscal year beginning after December 15, 2006. Uponadoption, we will adjust our financial statements to reflect only those taxpositions that are more-likely-than-not to be sustained as of the adoptiondate. Any adjustment will be recorded directly to our beginning retainedearnings balance in the period of adoption and reported as a change inaccounting principle. We are currently analyzing the effects of adoptingInterpretation No. 48.

**Safe Harbor Statement under the Private SecuritiesLitigation Reform Act of 1995**

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

·       trendsand expectations in revenue growth, including, but not limited to, statementsregarding the temporary nature of the decrease in ID systems bid activity andthe expected increase of such activity in the future, statements regardinganticipated growth in U.S. driver license revenues due to broadening use of thedriver license as a secure credential, statements regarding opportunities tofacilitate efforts of state government agencies to comply with the REAL ID Act;

·       thesuccess of new products, such as IDVS;

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

·       ourability to improve margins;

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

·       anticipatedrevenue to be generated from current contracts, 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;

·  the source of a majority of our futurerevenue;

·  our expected short-term and long-termliquidity positions;

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·       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; and

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

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 Affecting Forward Looking Statements**

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

*Givenour history of losses, we cannot guarantee sustained 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 June 30, 2006 was $99.0 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. 

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We havenot experienced the early termination of any driver license issuance contractsand are not aware of any early terminations of such contracts of ourcompetitors.

*Themarket for our products is highly competitive, and as a result, alternativetechnologies or larger companies may undermine, limit or eliminate the marketfor our products’ technologies, which would decrease our revenue and profits.*

Themarkets in which we compete for business are intensely competitive and rapidlyevolving. We expect competition to continue from both existing competitors andnew market entrants. We face competition from other companies and fromalternative technologies. The potential for an influx of federal funds into ourcore U.S. driver license market has drawn new competition and is likely tocontinue to do so. As we expand the applications for our technologies, we willexperience more competition from products and services that are substitutes forour applications. Because our digital watermarking business is new andemerging, we also may face competition from unexpected sources. Alternativetechnologies that may directly or indirectly compete with particularapplications of our watermarking technologies include:

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

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

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

·       ScrambledIndicia®—an optical refraction-based data-hidingtechnique that is inserted into an image and can be read with a lens;

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

·       Radiofrequency tags—embedding a chip that emits a signal when in close proximitywith a receiver, which is being used in photo identification 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 morebroadly apply our digital watermarking technologies to the Internet through newcommercial solutions applications, we may begin to compete with a wide range ofother types of companies beyond those companies using digital watermarking technologiesand alternative technologies. We cannot assure you that digital watermarkingtechnologies, and our products and services using these technologies, will gainwidespread market acceptance.

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

*Ourproducts could have unknown defects or errors, which may give rise to claimsagainst us, divert application of our resources from other purposes or increaseour 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 ofrevenue or market share, increased implementation and support costs, failure toachieve market acceptance, diversion of development resources, injury to ourreputation, increased insurance costs, increased service and warranty costs andwarranty or breach of contract claims. Although we attempt to reduce the riskof losses resulting from warranty or breach of contract claims through warrantydisclaimers and liability limitation clauses in our sales agreements when wecan, these contractual provisions are sometimes not included and may not beenforceable in every instance. If a court refuses to enforce the liability-limitingprovisions of our contracts for any reason, or if liabilities arose that werenot contractually limited or adequately covered by insurance, the expenseassociated with defending such actions or paying the resultant claims could besignificant.

*Ifleading companies in our industry or standard-setting bodies or institutionsdownplay, minimize, or reject the use of digital watermarking, its deploymentmay be slowed and we may be unable to achieve revenue growth—particularly inthe 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.

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*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.

Our market is characterized by new and evolvingtechnologies. The success of our business will depend on our ability to developand integrate new technologies effectively and address the increasinglysophisticated technological needs of our customers in a timely andcost-effective manner. Our ability to remain competitive will depend in part onour 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 may need to retain additional employees or contractlabor in the future in order to take advantage of new business opportunitiesarising from increased demand, which could impede our ability to achieve orsustain profitability.*

In the fourth quarter of 2005 and the first half of2006, we made significant reductions in our workforce as part of our efforts toreach quarterly profitability in the second half of 2006 or early in 2007. Thesereductions did not impede our ability to meet demand because they wereaccompanied by improvements in our internal business processes and coincidedwith a period of relatively low bid activity with respect to development anddeployment of new systems. We believe that this decrease in bid activity istemporary and that the U.S. driver license market will demonstrate increaseddemand in future periods.  Our currentreduced staffing levels could affect our ability to respond to increased demandfor our services. In addition, to meet any increased demand and take advantageof new business opportunities in the future, we may need to increase ourworkforce through additional employees or contract labor, which would increaseour costs.  If we experience such anincrease in costs, we may not succeed in achieving or sustaining profitability.

*We expect our secure ID systems business to experiencevariability in gross margins.*

We arelikely to experience variability in gross margins on our government contractsdue to numerous 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;

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·       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;

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

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

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. Weare continually refining our predictive tools and increasing our understandingof what drives these various factors. For reasons such as those listed above,we expect 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.

*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 substantial portions of our revenue fromgovernment contracts which are subject to periodic open, competitive bids. Thetiming of such bids is solely within the discretion of the governmentalauthority. Consequently, large components of new revenue are tied toprocurement schedules, which could shift as the needs of the related governmentprocurement agencies change. Many of these governmental customers are facing continuedbudget pressures introducing added uncertainty. In addition, the Department ofHomeland Security’s initiatives in passports and border crossing cards, as wellas delays in disbursement of funding for REAL ID Act projects, could createconfusion within the U.S. driver license market that may delay purchasedecisions by government customers. Any shift in the government procurementprocess, which is outside our control and may not be predictable, could resultin delays in bookings forecasted for any particular financial period, couldimpact the predictability of our quarterly results, and might limit our actualrevenue in any given quarter, resulting in reduced and less predictable revenueand lower profitability.

*Ourfuture growth will depend to some extent on our successful implementation ofour intellectual property in solutions provided by third parties, includingpartners and suppliers.*

Our business and strategyrely, in part, on deployment of our digital watermark reader technology bythird-party software developers and original equipment manufacturers. Forexample, one form of our digital watermark reader is commonly deployed in imageediting applications (offered by vendors including Adobe, Corel and Ulead) topermit users of these products to read watermarks embedded in imagery, and 

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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 we anticipate,that the majority of our revenue will be from government and private-sectorcustomers for providing security-related applications relating to securepersonal identification, copyright protection, and counterfeit deterrence tosuch customers. We have not fully developed revenue models for certain of ourfuture digital watermarking applications and licensing endeavors. Because someof our products and services are not yet well-established in the marketplace,and because some such products and services will not directly displace existingsolutions, we cannot be certain that the pricing structure for these productsand services will gain market acceptance or be sustainable over time or thatthe marketing for such products and services will be effective.

*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.

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*As international customers have accounted forapproximately 15% of our total revenue during the quarter ended June 30,2006, the loss of these customers or the failure to find new customers mayresult in a decline in our international revenue, which could lower ourprofitability and slow our growth.*

We expect revenue fromsales of products and services to governments and other customers outside theU.S. to represent a growing percentage of our total revenue in the future.International sales and services are subject to a number of risks, includingthe following:

·       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.

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

Our contracts for 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.

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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 the subjectagency. Some government contracts also may be one-time events, such as in thecase of some personal identification systems in non-U.S. markets involvingvoter registration programs. In such cases, we may generate substantial revenuethat may not be subject to future renewal. Moreover, government contractsresult from purchasing decisions made by public sector agencies that may besubject to political influence, unusual procurement procedures, strict legalrequirements, budget changes and cutbacks during economic downturns, variationsin appropriations cycles, and protests of contract awards. Additionally, somegovernmental authorities require performance bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bondsrequire that we maintain large restricted cash reserves as a guarantee,reducing our ability to use these funds for our other business purposes. Evenwith the availability of such cash reserve guarantees, we may not be able toobtain such performance bond underwriting at a favorable rate or at all. Ourfailure to be able to provide such performance bonds may preclude our abilityto bid on new government contracts or maintain our existing contracts for theirfull terms. The size, nature and purpose of, and the risks and uncertaintiesassociated with, public sector contracts can potentially cause our quarterlyresults to fluctuate and anticipated revenue to decrease significantly.

*A significant portion of our business depends oncontracts with fixed price terms. In the event of cost overruns in connectionwith such contracts, our margins may be adversely affected.*

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

*We may decline to pursue new, or renew existing,business opportunities in secure ID systems markets due to objectionable termsrequired by the contracting agencies, or we may agree to objectionable contractterms for competitive reasons.*

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure ID issuance systems. For example, it is customary for state agencies torequire that a vendor fund the capital-intensive initial deployment of a driverlicense issuance system (the costs of which the vendor normally recoups overthe life of the contract in per-card fees), while reserving the right toterminate the contract for convenience. Similarly, in connection withintellectual property rights, a contract may require that our pre-existingissuance system software be written in a different language and a state maythen argue that it falls within the class of works for which it owns thecopyright, enabling the state to turn the Digimarc-authored software over toone of our competitors, dedicate it to the public domain, or otherwise use thesoftware in a manner detrimental to our business. Objectionable contract termsmay lead us to decline to bid on identification issuance systems to newcustomers, or to decline to retain business with customers we have historicallyserved, which could reduce our market share and lower our revenues or profits.In addition, if we decline to retain business with customers we havehistorically served, it could result in the accelerated depreciation ofintangible assets. Alternatively, we may decide to accept at least some levelof objectionable terms rather than cede an important contract to a competitor,which could also lower our revenues or profits.

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*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.

*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 

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difficult. If we fail toprotect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to ourinterests, or if we become involved in litigation relating to our intellectualproperty rights and proprietary technologies or relating to the intellectualproperty rights of others, our business could be seriously harmed because thevalue ascribed to our intellectual property could diminish and result in alower stock price or we may incur significant costs in bringing legalproceedings against third parties who are infringing our patents.

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

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

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

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

As part of ourconfidentiality procedures, we generally enter into non-disclosure agreementswith our employees, directors, consultants and corporate partners, and attemptto control access to and distribution of our technologies, solutions,documentation and other proprietary information. Despite these procedures,third parties could copy or otherwise obtain and make unauthorized use of ourtechnologies, solutions or other proprietary information or independentlydevelop similar technologies, solutions or information. The steps that we havetaken to prevent misappropriation of our solutions, technologies or otherproprietary information may not prevent their misappropriation, particularlyoutside the United States where laws or law enforcement practices may notprotect our proprietary rights as fully as in the United States.

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*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 Camera Tower, DigimarcCapture Software, Digimarc Image Server, 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.

*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 andbusiness processes and will likely cause additional costs to our business inthe short term 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 the performanceand continued service of our senior management. Except for our Chief ExecutiveOfficer, our senior management does not have employment agreements. The loss ofthe services of any of our senior management could delay projects or underminecustomer 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 

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opportunitiesand decide to leave our employ. In addition, our business is based in part onpatented technology, which is unique and not generally known. New employeesrequire substantial training, involving significant resources and managementattention. Competition for experienced personnel in our business can beintense. If we do not succeed in attracting new, qualified personnel or inintegrating, retaining and motivating our current personnel, our growth andability to deliver products and services that our customers require may behampered. Although our employees generally have executed agreements containingnon-competition clauses, there is no assurance that a court would enforce allof the terms of these clauses or the clauses generally. If these clauses werenot fully enforced, our employees could be able to freely join our competitors.Although we generally attempt to control access to and distribution of ourproprietary information by our employees, there can be no assurances that theconfidential nature of our proprietary information will be maintained in thecourse of such future employment. Any of these events could have a materialadverse effect on our financial 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.

*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. In addition,if this insurance coverage becomes unavailable to us or premiums increasesignificantly in the future, it could make it more difficult for us to retainand 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.

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**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk.

The market riskdisclosures as set forth in Item 7A of our Annual Report on Form 10-Kfor the year ended December 31, 2005 have not changed materially.

**Item 4.**                        Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

The SEC defines the term “disclosurecontrols and procedures” to mean a company’s controls and other procedures thatare designed to ensure that information required to be disclosed in the reportsthat it files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported, within the time periods specified in theCommissions’ rules and forms. While our disclosure controls and proceduresare designed to provide reasonable assurance of achieving their objectives, thedesign of any system of controls is based in part upon certain assumptionsabout the likelihood of future events, and there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions, regardless of how remote. Our management, with the participation ofour principal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) ofthe Securities Exchange Act of 1934) as of June 30, 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 ofJune 30, 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.

**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 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’s announcementthat it had discovered errors in its accounting for software development costsand project 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. On August 4, 2006,the Court granted this motion and dismissed the lawsuit with prejudice.Plaintiffs have thirty days to appeal this decision to the U.S. Court ofAppeals for the Ninth Circuit. Due to the inherent uncertainties of litigation,the Company cannot accurately predict the ultimate outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in the SuperiorCourt of the State of California for the County of San Luis Obispo. Theselawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company. TheBoard of Directors appointed an independent committee to investigate the claimsasserted in this derivative lawsuit, as well as the second derivative actiondescribed in the immediately following paragraph. 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. In May of 2006, the Board committee, after completing itsinvestigation, concluded that pursuit of the allegations would not be in thebest interests of Digimarc or its shareholders.

A separate derivative action, involving substantiallythe same claims, was filed on or about April 6, 2005 in the Circuit Courtof the State of Oregon for the County of Washington. On March 31, 2006 theindividual defendants filed a motion to dismiss the lawsuit based on therecommendation of the Board committee. Plaintiffs subsequently stipulated to adismissal of the lawsuit and, on May 5, 2006, Judge Gardner signed astipulated motion and order of dismissal, dismissing the lawsuit withprejudice.

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Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including 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 compensation arrangements(such as undisclosed commissions or stock stabilization practices) in theCompany’s initial public offering registration statement and by engaging inmanipulative practices to artificially inflate the price of the Company’s stockin the after-market subsequent to the Company’s initial public offering. TheCompany 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 the partial settlement, including agreeing to assign away, not assert, orrelease certain potential claims the Company may have against its underwriters.Any direct financial impact of the proposed settlement (other than defensecosts incurred and expensed prior to May 31, 2003) is expected to be borneby the Company’s insurers. The court granted the preliminary approval motion onFebruary 15, 2005, subject to certain modifications. On August 31,2005, the court issued a preliminary order further approving the modificationsto the settlement and certifying the settlement classes. The court alsoappointed the Notice Administrator for the settlement and ordered that noticeof the settlement 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.

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

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

We held our annual meeting of stockholders on May 2,2006. Two proposals were voted on by our stockholders.

**Proposal 1:**Election of Three Class I Directors

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WilliamJ. Miller, Jim Roth and Lloyd “Buzz” Waterhouse were elected as Class Idirectors for a term of 3 years. The voting for each director was as follows:

| ** **                        | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-----------------------------------|------------|------------|------------|--------------|------------|
| William J. Miller                 |       | 18,876,882 |       | 628,561      |       |
| Jim Roth                          |       | 18,769,273 |       | 736,170      |       |
| Lloyd “Buzz” Waterhouse |       | 19,045,908 |       | 459,535      |       |

 

The Company’s Class II and III directors did notstand for reelection at the annual meeting. The terms of the Company’s Class IIdirectors, Philip J. Monego, Sr., Peter W. Smith and Bernard Whitney, willcontinue until the 2007 annual meeting of stockholders. The terms of theCompany’s Class III directors, Bruce Davis, Brian J. Grossi and James T.Richardson will continue until the 2008 annual meeting of stockholders.

**Proposal 2:** Ratification of the Appointment of Grant ThrontonLLP as the Company’s Independent Certified Public Accountants

Grant Thornton wasratified as our independent certified public accountants for the fiscal yearending December 31, 2006 with 19,277,114 votes in favor, 217,860 votesagainst and 10,469 abstentions.

**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: August 9,  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            |       | Summary of  Non-employee Director compensation Arrangements (incorporated by reference to  Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on May 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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