Value Investors Club / Digimarc (DMRC)

Description

How would you like to own one of the most valuable patent portfolios in the world and a profitable intellectual licensing business for an enterprise value of little more than cash and one times sales? Digimarc is a spin-off from an acquisition and has $43 million in cash and no debt and a patent portfolio the Wall Street Journal and the Patent Scoreboard ranks as one of the strongest patent portfolios in the information technology sector in the world.

The buyout and spin-off

Before the spin-off, Digimarc operated two businesses: secure identification solutions and digital watermarking. L-1 Identity Solutions, Inc. (NYSE: ID) acquired the secure ID business for $12.25 cash per share or $310 million while the digital watermarking business was spun-off into a separate business. Shareholders in the spin-off received one share for every 3.5 shares they held of the old business.

What the new Digimarc is made of

The watermarking spin-off kept the same name, Digimarc, and now trades on NASDAQ under the ticker DMRC. The spin-off kept all of the intellectual property relating to the watermarking business, about $43 million in cash or $5.79 per share on a fully diluted basis, and a $60 million backlog. The management team and Board will remain the same. This is the exact same team that just sold out for a big profit. Revenues for fiscal 2008 are expected to be around $19 million with profitability expected in the first full year of operations as a separate entity, and this is up from $13 million in fiscal 2007.

Revenues are split in half between licensing fees and service revenue. Revenues from licensing produce 98% gross margins and revenues from services produce 47% gross margins. The net result is a company with a 72% gross margin.

Digimarc holds 360 US patents and currently has 500 pending patent applications in digital watermarking and related technologies.

What is digital watermarking?

There are literally billions of digitally watermarked objects in circulation around the world.

Digital (meaning made by a computer) watermarks are embedded in various types of media to provide security, tracking, and authenticity.

Pull out a $20 bill from your wallet. There are watermarks near the border of the portraits on the face of the bill. If you hold the bill up to light, a visible watermark in the form of a portrait is shown. These watermarks serve to protect the currency from being counterfeited. Digimarc has several central banks that are customers.

Digital watermarks can be placed on tangible and intangible media, including music, television, film, photographic images, documents (especially financial documents—like currency and checks), advertisements, identification cards, and Internet broadcasts. The identifying content on the watermark is determined by the customer’s needs and can be unlocked by authorized users with digital watermark readers.

For an example of intangible media that has been digitally watermarking think of David Letterman’s “Stupid Pet Tricks”. During the television airing, let’s say one million people watch. Then let’s say someone puts the footage up on YouTube where eventually three million people watch it. Because the footage has been watermarked, CBS can now track when, and where the footage is being viewed and by who (in addition to the original broadcast). CBS can now block the person from putting the footage up on YouTube, or they can place advertisements in the video stream to generate more revenues for CBS.

In the future, it will be ideal to place advertisements for dog food, cat litter, and pet insurance in the YouTube video. Without watermarking, CBS would misjudge their audience for “Stupid Pet Tricks” by three million. Not to mention, CBS would lose the potential to generate extra revenues from advertisements on YouTube.

Furthermore, there are two categories of digital watermarks: invisible and visible. Invisible digital watermarks do not degrade the quality of the media and cannot be seen or heard by humans, like the watermark on “Stupid Pet Tricks”. Visible watermarks perform the same functions as invisible watermarks, but they are visible like the watermarks on the $20 bill. Additionally, digital watermarks can be robust or fragile. Robust watermarks cannot be altered by any means (pure or not pure in nature) like copying, stretching, recording, editing, compression and decompression, encryption, decryption, broadcast and conversion (digital to analog and back). On the other hand, fragile watermarks are made to distort easily. This is especially useful in preventing counterfeiting of currency, other financial documents, and identification cards.

A study by MultiMedia Intelligence places the market for digital watermarking at “$131 million in 2007 to $171 million this year and $588 million in 2012”. Currently Digimarc owns 10% of the market. There is no reason to think believe that Digimarc won’t be able to at least maintain its market share if not grow it.

Patent Scoreboard

The Patent Board publishes the Patent Scoreboard in the Wall Street Journal. The Patent Board is an independent research firm that ranks a company’s patent strength based on the number of patents granted, science strength, innovation cycle time, industry impact, technology strength, and research intensity.

Digimarc consistently ranks in the Top 50 of IT industry patent portfolios. Digimarc ranked 21st on March 18, 2008 ahead of Google, McAfee, Western Digital, Siemens ADS, NEC, Dell, Eastman Kodak, Apple, Seagate Technology, Network Appliance, Accenture, TDK ADS, Konica Minolta Holdings, and others.

Digimarc ranked 29th on July 15, 2008 ahead of NEC, Yahoo, Google, Western Digital, Eastman Kodak, Siemens ADS, and others.

The Patent Board keeps track of how many times a company’s patents block another company’s patents and how many times a patent is cited in another patent’s application. And it is for this reason that Digimarc ranks so highly.

Licensees

Digimarc’s patent licensees are quite a formidable list. Licensees include Nielsen, Central Banks, Adobe, AquaMobile, Signum, MarkAny, MSI, Philips, Verance, Cinea (a Dolby Company), Thomson, Veil, Verimatrix, and GCS Research.

Valuation and comps

    Digimarc    Qualcomm    DivX    Dolby
Price    9.80    40.29    5.86    32.05
Cash/Share    5.79    1.80    0.87    3.25
Price-Cash    4.01    38.49    4.99    28.80
S/O: diluted    7,428,571    1,654,000,000    32,907,000    113,696,000
M Cap    72,800,000    66,639,660,000    192,835,020    3,643,956,800
Cash    43,000,000    2,970,000,000    28,785,000    369,907,000
Debt    -     2,771,000,000    20,860,000    241,431,000
Preferred Shares    -     -     -     -
EV    29,800,000    66,440,660,000    184,910,020    3,515,480,800

Assumed Growth    25%    25%    10%    25%

Sales 08     19,000,000     10,114,000,000     85,280,000     610,000,000
EV/Sales 08     1.57     6.57     2.17     5.76
Sales 09     23,750,000     12,642,500,000     93,808,000     762,500,000
EV/Sales 09     1.25     5.26     1.97     4.61

Net Income 08     NA    3,031,000,000     9,900,000     190,000,000
EPS 08     NA    1.83     0.30     1.67
P/E 08     NA    21.99     19.48     19.18
P/E 08 - Cash     NA     21.01     16.57     17.23

Net Income 09     3,000,000     3,788,750,000     10,890,000     237,500,000
EPS 09     0.40     2.29     0.33     2.09
P/E 09     24.5     17.59     17.71     15.34
P/E 09 - cash     10.0     16.80     15.06     13.79

Digimarc has no debt and $43 million in cash as cited above. They have 7.4 million shares outstanding, meaning that at current quotational value, the stock trades at an enterprise value of $26 million outside of cash for a profitable company with one of the world’s most valuable patent portfolios around.

Digimarc compares very favorably to other intellectual property licensing companies. On average intellectual property companies trade at 4 times revenue and over 15 times earnings, even in this terrible market. Digimarc by comparison trades for 1.25 times sales and 10 times my estimate for next year.

Financial Assumptions

According to management, fiscal 08 revenues will increase to $19 million from $13 million in fiscal 07. I assume that revenue will grow a very conservative 25% in fiscal 2009, which based upon market research, past performance and its backlog should be pretty easy to attain.

The pro-forma financials on the Form 10 state Digimarc’s net income for the first half of 08 to be $1.588 million. I decided to assume that Digimarc earns no income in the second half due to one-time items resulting from the spin-off (consulting fees, costs from downsizing, attorney fees etc.). I assume that with the additional revenue and lack of one-time expenses that the company earns $3 million in fiscal 2009. At current prices, Digimarc is trading at 10 times my estimate for fiscal 2009 earnings.

Summary

With almost $6 a share in cash, an intellectual patent portfolio treasure chest, a growing profitable licensing business in a fast growing and important field, Digimarc is well positioned even in this terrible economy. When the market recovers and stabilizes, this is the type of company that will do well, a growth company with excess cash with exciting technologies. Get it while its still a value stock.

Catalyst

-analyst coverage
-new licensees
-earnings reports
-Regular outperformance of spin-offs

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			2008	2009
Price:	9.80	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	73	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT