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TMCNet:  DIGIMARC CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[July 25, 2014]

DIGIMARC CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included in this Quarterly Report on Form 10-Q under the caption "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995." The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q. Readers are also urged to carefully review and consider the disclosures made in Part II, Item 1A (Risk Factors) of this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission ("SEC") on February 21, 2014 (the "2013 Annual Report") and in the audited consolidated financial statements and related notes included in our 2013 Annual Report, and other reports and filings made with the SEC.


Unless the context otherwise requires, references in this Quarterly Report on Form 10-Q to "Digimarc," "we," "our" and "us" refer to Digimarc Corporation.

All dollar amounts are in thousands except per share amounts or unless otherwise noted. Percentages within the following tables may not foot due to rounding.

Digimarc Discover and Digimarc Guardian (pending) are registered trademarks of Digimarc Corporation. This Quarterly Report on Form 10-Q also includes trademarks and trade names owned by other parties, and all other such trademarks and trade names mentioned in this Quarterly Report on Form 10-Q are the property of their respective owners.

Overview Digimarc Corporation enables governments and enterprises around the world to give digital identities to media and objects that computers can sense and recognize and to which they can react. Our technology provides the means to infuse persistent digital information, "Digimarc IDs," perceptible only to computers and digital devices, into all forms of media content. The unique digital identifier placed in media generally persists with it regardless of the distribution path and whether it is copied, manipulated or converted to a different format, and does not affect the quality of the content or the enjoyment or other traditional uses of it. Our technology permits computers and digital devices to quickly identify relevant data from vast amounts of media content.

Our technologies, and those of our licensees, span numerous applications across a wide range of media content, enabling our customers and those of our partners to: • Improve the speed of retail checkout; • Provide simple and intuitive mobile customer engagement experiences in stores; • Quickly and reliably identify and effectively manage music, movies, television programming, digital images, e-books, documents and other printed materials, especially in light of non-linear distribution over the Internet; • Deter counterfeiting of money, media and goods, and piracy of e-books, movies and music; • Support new digital media distribution models and methods to monetize media content; • Leverage the power of ubiquitous computing to instantly link consumers to a wealth of information and/or interactive experiences related to the media and objects they encounter each day; • Provide consumers with more choice and access to media content when, where and how they want it; • Enhance imagery and video by associating metadata or authenticating media content for government and commercial uses; and • Better secure identity documents to enhance national security and combat identity theft and fraud.

At the core of our intellectual property is a signal processing innovation known as "digital watermarking," which allows imperceptible digital information to be embedded in all forms of digitally designed, produced or distributed media content and some physical objects, including photographs, movies, music, television, personal identification documents, financial instruments, industrial parts and product packages. The digital information can be detected and read by a wide range of computers, mobile phones and other digital devices.

17-------------------------------------------------------------------------------- Table of Contents Our technology allows our customers to provide persistent digital identities for any media content that is digitally processed at some point during its lifecycle. The technology can be applied to printed materials, video, audio, and images. The inclusion of these digital signals enables a wide range of improvements in security and media management, and new business models for distribution and consumption of media content. Over the years our technology and intellectual property portfolios have grown to encompass many related technologies.

We provide solutions directly and through our licensees. Our proprietary technology has proven to be a powerful element of document security, giving rise to our long-term relationship with a consortium of central banks, which we refer to as the Central Banks, and many leading companies in the information technology industry. We and our licensees have successfully propagated the use of our technology in music, movies, television broadcasts, images and printed materials. Digimarc IDs have been used in these applications to improve media rights and asset management, reduce piracy and counterfeiting losses, improve marketing programs, permit more efficient and effective distribution of valuable media content and enhance consumer entertainment and commercial experiences.

Digimarc IDs are easily embedded into all forms of media and are imperceptible to human senses, but quickly detected by computers, networks or other digital devices like smartphones. Unlike traditional barcodes and tags, our solution does not require publishers to give up valuable space in magazines and newspapers; nor does it impact the overall layout or aesthetics of the publication. Our Digimarc Discover™ platform delivers a range of rich media experiences to its readers on their smartphones across multiple media including print, audio, video and packaging. Unique to the Digimarc Discover platform is its ability to use various content identification technologies as needed, including our patented technology.

As part of the Digimarc Discover platform, we recently introduced Digimarc Barcodes, which contain the same type of information found in traditional product UPC codes, but is invisibly repeated multiple times over the entire packaging. We have partnered with Datalogic, a global leader in Automatic Data Capture and Industrial Automation markets and producer of barcode readers, who has enabled its new MagellanTM 9800i multi-plane imaging scanner to detect and process Digimarc Barcodes. Digimarc Barcodes can also connect mobile-enabled consumers directly from packaging to engaging mobile experiences such as additional product information, special offers, recommendations, reviews, social networks and more.

Our patent portfolio contains a number of innovations in digital watermarking, pattern recognition (sometimes referred to as "fingerprinting"), digital rights management and related fields. To protect our significant efforts in creating our technology, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, we believe we have one of the world's most extensive patent portfolios in digital watermarking and related fields, with more than 1,250 U.S. and foreign patents and pending patent applications as of June 30, 2014. We continue to develop and broaden our portfolio of patented technology in the fields of media identification and management technology and related applications and systems. We devote significant resources to developing and protecting our inventions and continuously seek to identify and evaluate potential licensees for our patents. The patents in our portfolio have a life of approximately 20 years from invention date, and up to 17 years after the patent has been granted.

As part of our intellectual property marketing and patent monetization efforts, our key objectives in building relationships with potential customers and partners are to: • make progress toward the realization of our vision to enrich everyday living via pervasive, intuitive computing; • expand the scope of our license program; • more effectively monetize our patent assets; • encourage large scale adoption of our technologies by industry leaders; • improve our financial performance; • increase the scale and rate of growth of our products and services business; and • lay a foundation for continuing innovation.

For a discussion of activities and costs related to our research and development, read the section titled "Research, development and engineering." Critical Accounting Policies and Estimates Detailed information on our critical accounting policies and estimates are set forth in our 2013 Annual Report in Part II, Item 7 thereof ("Management's Discussion and Analysis of Financial Condition and Results of Operations"), under the caption "Critical Accounting Policies and Estimates," which is incorporated by reference into this Quarterly Report on Form 10-Q.

18-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table presents statements of operations data for the periods indicated as a percentage of total revenue. Unless otherwise indicated, all references in this Management's Discussion and Analysis of Financial Condition and Results of Operations to the three- and six-month periods relate to the three- and six-month periods ended June 30, 2014 and all changes discussed with respect to such period reflect changes compared to the three- and six-month periods ended June 30, 2013.

Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 Revenue: Service 48 % 29 % 44 % 29 % Subscription 26 14 23 14 License 26 57 33 58 Total revenue 100 100 100 100 Cost of revenue: Service 21 14 20 14 Subscription 12 6 10 6 License 1 1 1 1 Total cost of revenue 34 20 32 21 Gross profit 66 80 68 79 Operating expenses: Sales and marketing 36 15 31 14 Research, development and engineering 60 27 54 27 General and administrative 41 22 37 22 Intellectual property 7 2 7 3 Total operating expenses 144 67 129 65 Operating income (loss) (79 ) 13 (60 ) 14 Other income, net - - - - Income (loss) before income taxes (79 ) 13 (60 ) 15 (Provision) benefit for income taxes 31 (7 ) 24 (7 ) Net income (loss) (47 )% 6 % (36 )% 8 % Summary During 2013, we increased the level of investment in our product development and sales growth initiatives, primarily through hiring additional engineering and sales personnel. These initiatives include developing and marketing Digimarc Discover, the Digimarc Barcode and other aspects of our Intuitive Computing Platform as well as further developing our retained patent assets and exploring strategic opportunities in the mobile payments market. We expect to maintain a similar level of investment for these initiatives in the second half of 2014 as made during the first half of 2014.

Total revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, decreased 46% to $5.7 million and 38% to $12.9 million, respectively, primarily due to the end of the quarterly license fee payments from Intellectual Ventures ("IV") in the second quarter of 2013 and the end of the quarterly license fee payments from The Nielsen Company ("Nielsen") in the first quarter of 2014.

Total operating expenses for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, increased 17% to $8.2 million and 23% to $16.5 million, respectively, reflecting the increased level of investment in our ongoing product development and sales growth initiatives.

19-------------------------------------------------------------------------------- Table of Contents Revenue Three Three Six Six Months Months Months Months Ended Ended Dollar Percent Ended Ended Dollar Percent June 30, June 30, Increase Increase June 30, June 30, Increase Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) Revenue: Service $ 2,716 $ 3,022 $ (306 ) (10 )% $ 5,704 $ 5,951 $ (247 ) (4 )% Subscription 1,496 1,433 63 4 % 2,908 2,817 91 3 % License 1,451 6,015 (4,564 ) (76 )% 4,256 11,945 (7,689 ) (64 )% Total $ 5,663 $ 10,470 $ (4,807 ) (46 )% $ 12,868 $ 20,713 $ (7,845 ) (38 )% Revenue (as % of total revenue): Service 48 % 29 % 44 % 29 % Subscription 26 % 14 % 23 % 14 % License 26 % 57 % 33 % 58 % Total 100 % 100 % 100 % 100 % Service. Service revenue consists primarily of software development and consulting services. The majority of service revenue arrangements are structured as time and materials consulting agreements, or fixed price consulting agreements. Most of our service revenue is derived from contracts with the Central Banks, IV and government agency contractors. The agreements range from several months to several years in length, and our longer term contracts are subject to work plans that are reviewed and agreed upon at least annually. These contracts generally provide for billing hours worked at predetermined rates and, to a lesser extent, reimbursement for third party costs and services. Increases or decreases in the services provided under these contracts are generally subject to both volume and price changes. The volume of work is generally negotiated at least annually and can be modified as the customer's needs change.

We also have provisions in our longer term contracts that allow for specific hourly rate price increases on an annual basis to account for cost of living variables. Contracts with government agency contractors are generally shorter term in nature, less linear in billings and less predictable than our longer term contracts because the contracts with government agency contractors are subject to government budgets and funding.

The decrease in service revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was primarily due to the timing of program work with the Central Banks and less program work with government agency contractors.

Subscription. Subscription revenue includes subscriptions for products and services, is generally recurring in nature, paid in advance and recognized over the term of the subscription.

Subscription revenue was essentially flat for both our Digimarc Discover and Digimarc Guardian products for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013.

License. License revenue originates primarily from licensing our technology and patents where we receive fixed license fees and/or royalties as our income stream. The majority of our current license revenue is derived from contracts with Verance and Civolution. Revenue from our licensed products have minimal associated direct costs, and thus are highly profitable.

The decrease in license revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three-six-month periods ended June 30, 2013, was primarily due to the end of the quarterly license fee payments from IV in the second quarter of 2013 and from Nielsen in the first quarter of 2014.

20 -------------------------------------------------------------------------------- Table of Contents Revenue by Geography Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) Revenue by geography: Domestic $ 1,782 $ 6,241 $ (4,459 ) (71 )% $ 4,899 $ 12,366 $ (7,467 ) (60 )% International 3,881 4,229 (348 ) (8 )% 7,969 8,347 (378 ) (5 )% Total $ 5,663 $ 10,470 $ (4,807 ) (46 )% $ 12,868 $ 20,713 $ (7,845 ) (38 )% Revenue (as % of total revenue): Domestic 31 % 60 % 38 % 60 % International 69 % 40 % 62 % 40 % Total 100 % 100 % 100 % 100 % The decrease in domestic revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was primarily the result of the end of the quarterly license fee payments from IV and Nielsen.

The decrease in international revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was primarily due to the timing of program work with the Central Banks.

We anticipate a decrease in revenue for 2014 compared to 2013 primarily as a result of the end of quarterly license fee payments from IV and Nielsen. These declines are expected to be partially offset by increased revenue from our other existing customers and new customers as we continue to expand the marketing and monetization of our intellectual property portfolio and related products and services.

Cost of Revenue Service. Cost of service revenue primarily includes costs that are allocated from research, development and engineering, sales and marketing and intellectual property that relate directly to performing services under our customer contracts and direct costs of program delivery for both personnel and operating expenses. Costs include: • compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of our software developers, quality assurance personnel, product managers, business development managers and other personnel where we bill our customers for time and materials costs; • payments to outside contractors that are billed to customers; • charges for equipment directly used by customers; • depreciation and other charges for machinery, equipment and software directly used by customers; • travel costs directly attributable to service and development contracts; and • charges for infrastructure and centralized costs of facilities and information technology.

Subscription. Cost of subscription revenue primarily includes: • compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of operations personnel and the cost of contractors to support our Digimarc Guardian subscription service; • Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers; and • charges for infrastructure and centralized costs of facilities and information technology.

License. Cost of license revenue primarily includes: • amortization of capitalized patent costs and patent maintenance fees; • patent or software license costs for any patents licensed from third parties where the party receives a portion of royalties or license revenue received by Digimarc; and • charges for infrastructure and centralized costs of facilities and information technology.

21 -------------------------------------------------------------------------------- Table of Contents Gross Profit Three Three Six Six Months Months Months Months Ended Ended Ended Ended Dollar Percent June 30, June 30, Dollar Percent June 30, June 30, Increase Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) Gross Profit: Service $ 1,547 $ 1,590 $ (43 ) (3 )% $ 3,121 $ 3,116 $ 5 0 % Subscription 797 845 (48 ) (6 )% 1,560 1,594 (34 ) (2 )% License 1,367 5,915 (4,548 ) (77 )% 4,089 11,749 (7,660 ) (65 )% Total $ 3,711 $ 8,350 $ (4,639 ) (56 )% $ 8,770 $ 16,459 $ (7,689 ) (47 )% Gross Profit (as % of related revenue components): Service 57 % 53 % 55 % 52 % Subscription 53 % 59 % 54 % 57 % License 94 % 98 % 96 % 98 % Total 66 % 80 % 68 % 79 % The increase in service gross profit as a percentage of revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was due primarily to higher billable rates under our agreement with the Central Banks.

The decrease in subscription gross profit as a percentage of revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was due primarily to higher contractor costs to support our Digimarc Guardian subscription service.

The decrease in license gross profit and license gross profit as a percentage of revenue for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was due primarily to the end of the quarterly license fee payments from IV in the second quarter of 2013 and from Nielsen in the first quarter of 2014.

Operating Expenses We allocate certain costs of research, development and engineering, sales and marketing, and intellectual property to cost of service revenue when they relate directly to our customer contracts. We record all remaining, or "residual," costs as sales and marketing, research, development and engineering, general and administrative, and intellectual property expenses.

We anticipate operating expenses will be higher in 2014 than 2013, reflecting the increased investment in our product development and sales growth initiatives, partially offset by lower legal costs due to the settlement of the arbitration with IV.

Sales and marketing Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 Increase Increase 2014 2013 Increase Increase Sales and marketing $ 2,052 $ 1,563 $ 489 31 % $ 3,931 $ 2,840 $ 1,091 38 % Sales and marketing (as % of total revenue) 36 % 15 % 31 % 14 % Sales and marketing expenses consist primarily of: • compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of sales and marketing employees and product managers; 22 -------------------------------------------------------------------------------- Table of Contents • travel and market research costs, and costs associated with marketing programs, such as trade shows, public relations and new product launches; • professional services and outside contractors for product and marketing initiatives; and • charges for infrastructure and centralized costs of facilities and information technology.

The increase in sales and marketing expenses for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, reflects the increased level of investment in our ongoing sales growth initiatives.

We anticipate sales and marketing expenses will be higher in 2014 than 2013, reflecting the full-year effect of the increased investment in our sales and marketing growth initiatives.

Research, development and engineering Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 Increase Increase 2014 2013 Increase Increase Research, development and engineering $ 3,404 $ 2,822 $ 582 21 % $ 6,950 $ 5,547 $ 1,403 25 % Research, development and engineering (as % of total revenue) 60 % 27 % 54 % 27 % Research, development and engineering expenses arise primarily from three areas that support our business model: • Fundamental Research: • investigation of new watermarking algorithms to increase robustness and/or computational efficiency; • mobile device usage models and imaging sub-systems in camera-phones; • industry conference participation and authorship of papers for industry journals; • survey and study of human and computer interaction models with a focus on mobile devices and modeling of intent; • development of new intellectual property, including documentation of claims and production of supporting diagrams and materials; • research in fingerprinting and other content identification technologies; • metadata ranking algorithms for matching Internet file content against reference database; and • investigation of substrates, printing techniques, and printing technology relating to consumer packaged goods.

• Platform Development: • tuning and optimization of implementation models to improve resistance to non-malicious attacks and routine transformations, such as JPEG, cropping and printing; • mobile platform creation to leverage device-specific capabilities (e.g., instruction sets and Graphics Processing Units); • tuning big data analytics transformation and metrics aggregation engine; • tuning data-driven Internet crawling infrastructure with policy-driven feedback loop; and • assembly of master book publishing catalog based on aggregation and reconciliation of multiple public data sources.

• Product Development: • deliver the Digimarc Barcode; • maintaining the Digimarc Discover ID Manager to provide campaign management and routing services for the Digimarc Discover platform; • maintaining the web-hosted image watermark embedder in support of Digimarc Discover platform; • iterative development and release of the Digimarc Discover application for the iOS and Android platforms; 23 -------------------------------------------------------------------------------- Table of Contents • real-time analytics portal to support anti-piracy services for the book industry; and • consumer book discovery application based on social network connections and shared interests.

Research, development and engineering expenses consist primarily of: • compensation, benefits, incentive compensation in the form of stock-based compensation expense, recruiting and related costs of software and hardware developers and quality assurance personnel; • payments to outside contractors; • the purchase of materials and services for product development; and • charges for infrastructure and centralized costs of facilities and information technology.

The increase in research, development and engineering expenses for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, reflects the increased level of investment in our ongoing product development initiatives.

We anticipate research, development and engineering expenses will be higher in 2014 than 2013, reflecting the full-year effect of the increased investment in our research and product development initiatives.

General and administrative Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 (Decrease) (Decrease) 2014 2013 Increase Increase General and administrative $ 2,326 $ 2,348 $ (22 ) (1 )% $ 4,747 $ 4,534 $ 213 5 % General and administrative (as % of total revenue) 41 % 22 % 37 % 22 % We incur general and administrative costs in the functional areas of finance, legal, human resources, executive and board of directors. Costs for facilities and information technology are also managed as part of the general and administrative processes and are allocated to this area as well as each of the areas in costs of services, sales and marketing, research, development and engineering and intellectual property.

General and administrative expenses consist primarily of: • compensation, benefits and incentive compensation in the form of stock-based compensation expense and related costs of general and administrative personnel; • third party and professional fees associated with legal, accounting and human resources; • costs associated with being a public company; and • charges for infrastructure and centralized costs of facilities and information technology.

General and administrative expenses were flat for the three-month period ended June 30, 2014, compared to the corresponding three-month period ended June 30, 2013.

The increase in general and administrative expenses for the six-month period ended June 30, 2014, compared to the corresponding six-month period ended June 30, 2013, resulted primarily from: • an increase of $0.2 million due to the reversal of the liability for contingent merger consideration related to the acquisition of Attributor in the first quarter of 2013; • increased legal fees of $0.1 million related to the settlement of the arbitration with IV; partially offset by • decreased accounting and tax fees of $0.2 million due to costs incurred in the first quarter of 2013 related to the Attributor acquisition.

24 -------------------------------------------------------------------------------- Table of Contents We anticipate general and administrative expenses will be lower in 2014 than 2013 reflecting lower legal costs due to the settlement of the arbitration with IV. We will continue to examine means to reduce general and administrative expenses in the longer term.

Intellectual property Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 Increase Increase 2014 2013 Increase Increase Intellectual property $ 387 $ 261 $ 126 48 % $ 921 $ 538 $ 383 71 % Intellectual property (as % of total revenue) 7 % 2 % 7 % 3 % We incur intellectual property expenses that arise primarily from costs associated with documenting, applying for, and maintaining domestic and international patents and trademarks.

Gross expenditures for intellectual property costs, before reflecting the effect of capitalized patent costs, primarily consist of: • compensation, benefits and incentive compensation in the form of stock-based compensation expense and related costs of attorneys and legal assistants; • third party costs, including filing and governmental regulatory fees and fees for outside legal counsel and translation costs, each incurred in the patent process; • consulting costs related to marketing our intellectual property portfolio; and • charges for infrastructure and centralized costs of facilities and information technology.

Intellectual property expenses can vary from period to period based on: • the level of capitalized patent activity, and • prosecution costs and direct labor hours (compensation, benefits and incentive compensation) related to the patents that were exclusively licensed to IV that are allocated to cost of revenue.

The increase in intellectual property expense for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, reflects the increased level of investment in our ongoing intellectual property development and marketing efforts, including a third party intellectual property valuation and marketing study.

We anticipate intellectual property expenses will be higher in 2014 than 2013, reflecting the full-year effect of the increased investment in our intellectual property development and marketing efforts.

Stock-based compensation expense Three Three Six Six Months Months Months Months Ended Ended Dollar Percent Ended Ended Dollar Percent June 30, June 30, Increase Increase June 30, June 30, Increase Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) Cost of revenue $ 129 $ 139 $ (10 ) (8 )% $ 270 $ 296 $ (26 ) (9 )% Sales and marketing 175 83 92 111 % 318 195 123 63 % Research, development and engineering 364 232 132 57 % 720 488 232 48 % General and administrative 607 560 47 8 % 1,156 1,066 90 8 % Intellectual property 97 63 34 54 % 167 124 43 35 % Total $ 1,372 $ 1,077 $ 295 27 % $ 2,631 $ 2,169 $ 462 21 % 25 -------------------------------------------------------------------------------- Table of Contents The increase in total stock-based compensation expense for the three- and six-month periods ended June 30, 2014, compared to the corresponding three- and six-month periods ended June 30, 2013, was primarily due to higher headcount in support of our product development and sales growth initiatives. We anticipate incurring an additional $9,416 in stock-based compensation expense through June 2018 for awards outstanding as of June 30, 2014.

Other income, net Three Three Six Six Months Months Months Months Ended Ended Ended Ended June 30, June 30, Dollar Percent June 30, June 30, Dollar Percent 2014 2013 Increase Increase 2014 2013 Increase Increase Other income, net $ 21 $ 19 2 11 % $ 48 $ 48 0 0 % Other income, net (as % of total revenue) * * * * * Less than 1% The increase in other income, net for the three-month period ended June 30, 2014, compared to the corresponding three-month period ended June 30, 2013, was primarily due to gains on foreign currency partially offset by lower interest income, due to a combination of lower cash balances and interest rates on cash and investments.

Provision for Income Taxes The provision (benefit) for income taxes for the three- and six-month periods ended June 30, 2014 and 2013 reflects current taxes, deferred taxes, and withholding taxes in certain foreign jurisdictions. The effective tax rate for the six-months ended June 30, 2014 and 2013 was 40% and 48%, respectively. The valuation allowance against net deferred tax assets as of June 30, 2014 was $472, an increase of $101 from $371 as of December 31, 2013.

We continually assess the applicability of a valuation allowance. Based upon the positive and negative evidence available as of June 30, 2014, and due to Attributor's history of losses and the inability to utilize Attributor losses to offset Digimarc income for state tax purposes, we concluded that it is not more likely than not that the Attributor state deferred tax assets will be realized, and a full valuation allowance has been recorded on the state deferred tax assets of Attributor.

Liquidity and Capital Resources June 30, December 31, 2014 2013 Working capital $ 27,032 $ 31,380 Current (liquidity) ratio (1) 8.0:1 6.4:1 Cash, cash equivalents and short-term marketable securities $ 24,115 $ 29,662 Long-term marketable securities $ 3,744 $ 5,302 Total cash, cash equivalents and all marketable securities $ 27,859 $ 34,964 (1) The current (liquidity) ratio is calculated by dividing total current assets by total current liabilities.

The $7.1 million decrease in cash, cash equivalents and marketable securities resulted primarily from: • cash used in operations; • purchases of common stock related to the exercise of stock options and vesting of restricted stock; • payment of dividends; and • investments in both equipment and patent assets; partially offset by • cash flows provided by the net maturity of marketable securities; and • proceeds from stock option exercises.

26 -------------------------------------------------------------------------------- Table of Contents Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, marketable securities, and trade accounts receivable. We place our cash and cash equivalents with major banks and financial institutions and at times deposits may exceed insured limits. Marketable securities include pre-refunded municipal bonds, corporate notes, certificates of deposit, commercial paper and U.S. federal agency notes.

Our investment policy requires the portfolio to be invested to ensure that the greater of $3 million or 7% of the invested funds will be available within 30 days notice.

Other than cash used for operating needs, which may include short-term marketable securities, our investment policy limits our credit exposure to any one financial institution or type of financial instrument by limiting the maximum of 5% of our cash and cash equivalents and marketable securities or $1 million, whichever is greater, to be invested in any one issuer except for the U.S. government, U.S. federal agencies and U.S. backed securities, which have no limits, at the time of purchase. Our investment policy also limits our credit exposure by limiting to a maximum of 40% of our cash and cash equivalents and marketable securities, or $15 million, whichever is greater, to be invested in any one industry category, (e.g., financial or energy industries), at the time of purchase. As a result, we believe our credit risk associated with cash and investments to be minimal. A decline in the market value of any security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. To determine whether an impairment is other-than-temporary, we consider whether we have the ability and intent to hold the investment until a market price recovery and evidence indicating that the cost of the investment is recoverable outweighs evidence to the contrary. There have been no other-than-temporary impairments identified or recorded by us.

Operating Cash Flow The components of operating cash flows were: Six Six Months Months Ended Ended June 30, June 30, Dollar Percent 2014 2013 (Decrease) (Decrease) Net income (loss) $ (4,666 ) $ 1,573 $ (6,239 ) (397 )% Non-cash items 2,058 4,307 (2,249 ) (52 )% Changes in operating assets and liabilities (1,439 ) 269 (1,708 ) (635 )% Net cash provided by (used in) operating activities $ (4,047 ) $ 6,149 $ (10,196 ) (166 )% Cash flows from operating activities for the six-month period ended June 30, 2014, compared to the six-month period ended June 30, 2013, decreased by $10.2 million, reflecting a net loss versus net income, lower non-cash items and changes in operating assets and liabilities. The change in operating assets and liabilities was primarily from the generation of income taxes receivable due to net operating losses generated in the six-month period ended June 30, 2014 that can be carried back to the 2012 tax return.

Cash flows provided by investing activities for the six-month period ended June 30, 2014, compared to the six-month period ended June 30, 2013, increased by $7.8 million from $(2.4) million to $5.4 million, reflecting higher net maturities of marketable securities.

Cash flows used in financing activities for the six-month period ended June 30, 2014, compared to the six-month period ended June 30, 2013, decreased $0.4 million from $2.3 million to $1.9 million, primarily as a result of cash proceeds from stock option exercises, partially offset by higher stock repurchases to cover employee tax withholding obligations.

Future Cash Expectations In connection with our license agreement with IV, the quarterly license fee ended in the second quarter of 2013. We are not able to estimate the future cash flow impact of any profit sharing we may earn from IV. No profit sharing was earned from 2013 licensing activities.

In connection with our license agreement with Nielsen, the quarterly license fee ended in the first quarter of 2014.

Our Board of Directors previously approved a stock repurchase program under which we have $3,998 available to purchase shares of our common stock as of June 30, 2014. Shares of our common stock may be purchased in the open market or through privately negotiated transactions, subject to market conditions. This repurchase program does not obligate us to acquire any specific number of shares or to acquire shares over any specified period of time. This repurchase program expires in December 2014.

27 -------------------------------------------------------------------------------- Table of Contents We believe that our current cash, cash equivalents, and short-term marketable securities balances will satisfy our projected working capital and capital expenditure requirements for at least the next 12 months. Thereafter, we anticipate continuing to use cash, cash equivalents and marketable securities balances to satisfy our projected working capital and capital expenditure requirements.

We may use cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines. In order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities. We do not believe at this time, however, that our long-term working capital and capital expenditures would require us to take steps to remedy any such potential deficiencies. If it becomes necessary to obtain additional financing or credit facilities, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms.

Off-Balance Sheet Arrangements Other than the contractual obligations disclosed in our 2013 Annual Report, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 This Quarterly Report on Form 10-Q includes "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Words such as "may," "plan," "should," "could," "expect," "anticipate," "intend," "believe," "project," "forecast," "estimate," "continue," variations of such terms or similar expressions are intended to identify such forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements, or other statements made by us, are made based on our expectations and beliefs concerning future events impacting us, and are subject to uncertainties and factors (including those specified below), which are difficult to predict and, in many instances, are beyond our control. As a result, our actual results could differ materially from those expressed in or implied by any such forward-looking statements, and investors are cautioned not to place undue reliance on such statements. Forward-looking statements include but are not limited to statements relating to: • concentration of revenue with few customers comprising a large majority of the revenue; • revenue trends and expectations; • our future level of investment in our business, including investment in research, development and engineering of products and technology, development of our intellectual property, sales growth initiatives and development of new market opportunities; • our ability to improve margins; • anticipated expenses, costs, margins, provision for income taxes and investment activities in the foreseeable future; • anticipated revenue to be generated from current contracts and as a result of new programs; • variability of contracted arrangements; • our profitability in future periods; • business opportunities that could require that we seek additional financing; • the size and growth of our markets; • the existence of international growth opportunities and our future investment in such opportunities; • the sources of our future revenue; • our expected short-term and long-term liquidity positions; • our capital expenditure and working capital requirements and our ability to fund our capital expenditure and working capital needs through cash flow from operations; • capital market conditions, including the recent economic crisis, interest rate volatility and other limitations on the availability of capital, which could have an impact on our cost of capital and our ability to access the capital markets; • our use of cash, cash equivalents and marketable securities in upcoming quarters; 28 -------------------------------------------------------------------------------- Table of Contents • anticipated levels of backlog in future periods; • the success of our arrangements with Intellectual Ventures; • the success of our acquisition of Attributor Corporation; • protection, development and monetization of our intellectual property portfolio; and • other risks detailed in our filings with the Securities and Exchange Commission, including the risk factors set forth in Part I, Item 1A of our 2013 Annual Report.

We believe that the risk factors specified above and the risk factors identified in Part I, Item 1A of our 2013 Annual Report, among others, could affect our future performance and the liquidity and value of our securities and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us or on our behalf. Investors should understand that it is not possible to predict or identify all risk factors and that there may be other factors that may cause our actual results to differ materially from the forward-looking statements. All forward-looking statements made by us or by persons acting on our behalf apply only as of the date of this Quarterly Report on Form 10-Q. We do not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report on Form 10-Q.

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