UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x                              Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2006

OR

o                                 Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                 to                

Commission File Number 000-28317

DIGIMARC CORPORATION

(Exact name of registrant as specified in its charter)

(503) 469-4800

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o   No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o   No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer o          Accelerated filer x          Non-accelerated filer o

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

The aggregate market value of common stock, par value $0.001 per share, held by non-affiliates of the registrant, based on the closing price for the common stock on The Nasdaq National Market on the last business day of the registrant’s most recently completed fiscal second quarter (June 30, 2006), was approximately $127 million. Shares of common stock beneficially held by each officer and director have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for any other purposes.

As of January 31, 2007, there were 21,342,330 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement pursuant to Regulation 14A (the “Proxy Statement”) for its 2006 annual meeting of stockholders are incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K. The registrant intends to file the Proxy Statement not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.

Table of Contents

PART I

The following discussion of Digimarc’s business contains forward-looking statements relating to future events or the future financial performance of Digimarc. Digimarc’s actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included in this Annual Report on Form 10-K in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

Although Digimarc believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and Digimarc does not intend to update or revise any forward-looking statements as a result of new information, future events or otherwise. Readers are urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Factors Affecting Forward Looking Statements” in this Annual Report on Form 10-K, the audited consolidated financial statements and related notes included in this Annual Report on Form 10-K, and other reports and filings made with the SEC.

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 Annual Report on Form 10-K.

This Annual Report on Form 10-K includes trademarks and registered trademarks of Digimarc Corporation. Products or service names of other companies mentioned in this Annual Report on Form 10-K may be trademarks or registered trademarks of their respective owners.

ITEM 1:               BUSINESS

Overview

Digimarc Corporation (“Digimarc,” “the Company,” “our” or “we”) is a leading supplier of secure identity solutions and digital watermarking technology for use in media management. Our solutions enable governments and businesses around the world to enhance traffic safety and national security, combat identity theft and fraud, facilitate the effectiveness of voter identification programs, improve the management of media content, deter counterfeiting and piracy and support new digital media distribution models that provide consumers with more choice and access to media content. Our mission is two-fold:

·       Foster large-scale adoption of digital watermarking solutions licensed under the Company’s intellectual property; and

·       Be the most desired profitable supplier of driver license issuance systems.

We issue more than 60 million identification documents (“IDs”) annually and are the leading supplier of government-issued citizen IDs in North America, including supplying systems that produce more than two-thirds of all driver licenses issued in the United States (the “U.S.”). We are also a pioneer and leading owner of intellectual property in a signal processing technology innovation known as “digital watermarking” which allows imperceptible digital information to be embedded in all forms of digitally designed, produced or distributed media content, including personal identification documents, financial instruments, photographs, movies, music, television, and product packages. The embedded data within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital devices.

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Digital watermarking is a strategic component of nearly all of our product offerings. We provide solutions based on this technology directly and through our licensees. Digital watermarking has already proven to be a powerful differentiator in banknote security, giving rise to our long-term relationship with a consortium of leading Central Banks and many leading companies in the information technology industry. We are working to achieve a similar success in secure identity management systems. We anticipate that by the end of 2007 more than one out of  two driver licenses then in production in the U.S. will carry digital watermarks as a means to provide cross-jurisdictional machine authentication. In addition, Digimarc and its licensees have successfully propagated digital watermarking in music, movies, television and radio broadcasts, images and printed materials. Digital watermarks have been used in these applications to provide improved 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 experiences.

Our principal administrative, marketing, research, and intellectual property development facility is located in Beaverton, Oregon. Our secure ID systems business is headquartered in Burlington, Massachusetts, and our logistics center is in Fort Wayne, Indiana.

The substantial majority of our revenue is generated pursuant to long-term contracts with government agencies—primarily U.S. state government agencies responsible for driver license issuance, a consortium of leading Central Banks, and national governments of a number of countries. These customers rely on our systems design, integration and materials science expertise, and proprietary technologies such as digital watermarking, to implement issuance systems and processes that improve the security of identity documents and banknotes.

The remainder of our revenue is generated through commercial applications of our digital watermarking and related technologies, primarily from patent and technology license fees paid by business partners. Our licensing business is built upon our extensive patent portfolio, which contains 300 issued U.S. patents as of December 31, 2006. Private sector media and entertainment industry customers use secure media management solutions from the Company and its business partners to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to improve access to networks and information from personal computers and mobile devices. We expect that patent licensing will continue to contribute most of our revenues from non-government customers for the foreseeable future.

Financial information about geographic areas is incorporated by reference to Note 7 of our consolidated financial statements.

History

Digimarc was incorporated in 1995. The Company was founded to commercialize a signal processing innovation known as “digital watermarking.” Digital watermarking is a technology that allows our customers to infuse digital data into 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 this digital data enables a wide range of improvements in security and media management, and enables new business models for distribution and consumption of media content. We use digital watermarking as a differentiator in nearly all of our product offerings and to increase value to our customers.

Banknote counterfeit deterrence was the first commercially successful use of digital watermarking. Digimarc, in cooperation with an international consortium of leading Central Banks, developed a system to deter the use of digital technologies in the unauthorized reproduction of banknotes. More recently, innovations based on the Company’s digital watermarking technology and experience have been leveraged to create new products to deter counterfeiting and tampering of driver licenses and other government-issued secure credentials. In parallel, Digimarc’s business partners, under patent license from Digimarc,

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are delivering digital watermarking solutions to track and monitor the distribution of music, television, movies and radio to consumers.

On the heels of 9/11, we realized that our expertise in security printing and digital imaging technologies and systems placed us in a position to understand both the digital threats to identity management credentials and the environment and concerns of the issuers of these credentials. In late 2001, we acquired the Large Government Programs business unit of Polaroid Corporation (“Polaroid”). The primary focus of this business is the production of driver licenses and other IDs issued by government agencies. The acquired assets included all relevant software, hardware, services, materials science and distribution assets of Polaroid’s government-issued photo identification business.

In this strategic acquisition, we saw a unique opportunity to assist in efforts to deter identity theft and fraud and thereby enhance transportation safety and Homeland Security through the combination of a new layer of security using our digital watermarking technology and Polaroid’s expertise in secure ID solutions. The resulting business has over 50 years of experience in the delivery and operation of secure ID issuance systems, has produced more than 2 billion issued IDs, and has guided customers through numerous major upgrades and technology migrations in ID security. We are the leader in deploying new solutions to meet driver license security and related service challenges. This includes being first to:

·       produce driver licenses with digital portraits,

·       deploy facial recognition and State-wide fingerprint matching in 1995 and 1996,

·       introduce market leading security features, including digital watermarking, Kinegrams, and secure card materials,

·       produce driver licenses in secure, networked central issuance factories,

·       offer driver license renewal by Internet, and

·       offer a comprehensive and modular ID validation and archiving suite to address recently enacted Federal legislation, such as the federal legislation passed in May 2005 known as the REAL ID Act (the “REAL ID Act”). The Real ID Act imposes certain federal requirements for State-issued driver licenses. These requirements will increase the security of driver licenses, require validation of applicants prior to issuance, and mandate certain changes in business processes relating to security and the sharing and storage of data.

With increasing interest in issues surrounding Homeland Security, prevention of identity theft and fraud, traffic safety, copyright and intellectual property protection and establishment of new business models for digital distribution and use of media content, Digimarc has evolved from a technology-driven early stage company to an important supplier of critical infrastructure to government agencies and a strategic business partner to solution providers supporting the media and entertainment industry.

Customers and Business Partners

The substantial majority of our revenue is derived from long-term contracts with government agencies, primarily State driver license issuers, a consortium of leading Central Banks, and governments of various foreign countries and provinces. The retention rate for our driver license customers is high. The Company’s contract with the Central Bank consortium is in its eighth year. The contract is in the second year of a 5-year extension and provides for two additional 3-year extensions that the Company expects will be exercised.

The remainder of the Company’s revenue is generated through commercial applications of its digital watermarking and related technologies, primarily from patent and technology license fees paid by business partners providing media and rights management solutions to movie studios and music labels, television

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and radio broadcasters, creative professionals and other customers around the world. Patent licensing is expected to continue to contribute most of the revenues from non-government customers for the foreseeable future.

Products and Services

The Company provides financial document security and secure ID solutions to government agencies:

Financial Document Security

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

Secure ID Solutions

As the leading provider of government-issued secure IDs in North America, our systems produce more than 60 million driver licenses and other secure personal IDs per year. Approximately two-thirds of the U.S. States and many foreign governments, including Russia, Latvia, Mexico, Ghana and four Canadian provinces, use Digimarc 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 departments of motor vehicles or other government issuing authorities. Our North American driver license issuance systems vary from jurisdiction to jurisdiction. These systems are typically provided under long-term (normally five or more years) contracts. The systems provided include hardware, software, consumable supplies (such as ribbons, blank or preprinted card materials, and laminates), and on-going support necessary for a “turnkey” solution. They typically involve custom software and/or hardware development, integration services, and implementation services. When we provide a full issuance system to a customer, we generally retain title to all equipment, software and consumables associated with the system and are responsible for maintaining the system over the contractual period.

Digimarc offers solutions that span the entire secure ID lifecycle, including enrollment, production, secure credential designs, and post issuance inspection. The goals of the process are to:

·       Verify the true identity of applicants for licenses and ID cards;

·       Verify the authenticity of information and documents submitted as proof of identity;

·       Verify the authenticity of information presented as proof of residency;

·       Issue secure IDs that deter counterfeiting;

·       Detect and facilitate investigation and prosecution of identity theft and fraud;

·       Secure the issuance process from internal and supply chain fraud; and

·       Provide multiple perspectives—see, feel, machine validate—to the end-users of issued IDs, including the police, merchants, border crossing staff, employers, government agencies, and financial institutions.

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Digimarc’s strategy regarding the anticipated opportunities relating to the REAL ID Act is to provide solutions that embody the key elements of the REAL ID Act: identity verification; document scanning and archiving; individual background checking; data and image sharing; and migration to and production of REAL ID Act compliant driver license documents. These solutions are available to customers as upgrades or complete issuance systems. Digimarc will also offer the States program management assistance to safely migrate to REAL ID Act compliance.

Media and Entertainment

We license our technology and patents and otherwise foster development of the market for digital watermarking-based solutions for commercial as well as governmental uses. These licenses primarily involve use of our technology and patents in the media and entertainment area. Commercial customers use secure media solutions from our business partners and us to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to access networks and information from personal computers and mobile devices. Many movie studios, record labels, broadcasters, creative professionals and other customers rely on digital watermarking as a cost-effective means to:

·       deter piracy and illegal use of movies, music and images;

·       protect entertainment content from copyright infringement;

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

·       monitor advertisements to verify ad placement and measure return on investment; and

·       enable fair and legitimate use of content by consumers.

Our business partners include Activated Content Corporation, AquaMobile, Cinea, Inc., a subsidiary of Dolby Laboratories, Inc., GCS Research LLC, MediaGrid, Mobile Data Systems, Inc., Nielsen, Royal Philips, Signum Technologies Limited, Thomson Multimedia, S.A., USA Video, Verance Corporation, Verimatrix, Inc. and VCP (an affiliate of VEIL Interactive Technologies). Although each partner addresses particular customer needs, as a whole these partners are propagating digital watermarking in music, movies, images, and television and radio as a means to improve media rights and asset management, reduce piracy losses, improve marketing programs, and provide more efficient and effective distribution of valuable media content.

Technology and Intellectual Property

The Company uses intellectual property (“IP”) to differentiate its products and technologies, mitigate infringement risk, and develop opportunities for licensing. Licensing of our digital watermarking and related technologies is supported by a broad patent portfolio covering a wide range of methods, applications, and system architectures.

Most of our patents relate to various methods for embedding digital information in video, audio, and images, whether the content is rendered in analog or digital formats. The digital information is generally embedded by making subtle modifications to the fundamental elements of the content itself, generally at a signal processing level. The changes necessary to embed this information are so subtle that they are generally not noticeable by people during normal use. Because the message is carried by the content itself, it is file-format independent. The message generally survives most normal compression, edits, rotation, scaling, re-sampling, file-format transformations, copying, scanning and printing.

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To protect our significant efforts in creating these technologies, 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 the field of digital watermarking, with 300 U.S. and 70 foreign issued patents and more than 500 U.S. and foreign patent applications on file as of December 31, 2006 in the areas of digital watermarking, personal identification, and related technologies. Separately, we own registered trademarks in both the U.S. and other countries and have applied for other trademarks. We continue to develop and broaden our portfolio of patented technologies, including digital watermarking and related applications and systems, and other technologies related to secure ID systems. For ID systems-related technologies, the focus of patent development has been in the areas of imaging and printing systems, card architecture and materials, and security features. Some patents relate to future product offerings or related technologies like smart cards, laser engraving and alternative card systems.

Although we devote significant resources to developing and protecting our technologies, and periodically evaluate potential competitors of our technologies for infringement of our intellectual property rights, these infringements may nonetheless go undetected or may arise in the future. We expect that infringement claims may increase as companies become more concerned with protecting their content from electronic copying.

Markets

Government

We believe that the U.S. driver license market will continue to grow as a result of broadening use of the driver license as a secure credential beyond its traditional role as evidence of competence to drive a motor vehicle; technological innovation; desire among issuers to improve security and efficiency; and new governmental regulations such as the REAL ID Act. We anticipate that these regulations may result in substantial system upgrades by our customers.

Final rules under the REAL ID Act have not yet been promulgated. As result, no significant funding has occurred under the Real ID Act, and the Federal grant process under the REAL ID Act has not yet begun. The Department of Homeland Security published draft regulations in the form of a Notice of Proposed Rulemaking on March 1, 2007. Final rules are not expected until the late spring of 2007, at the earliest.

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

An example of such a potential opportunity is in the market for smart cards. We anticipate that the Western Hemisphere Travel Initiative will require that all U.S. citizens returning from outside the U.S. present either a passport or a new border PASS Card. The Federal government is currently expected to require a Radio-frequency identification (RFID) chip in each Pass Card.  In other applications, the Federal government has been advancing worker identification using smart cards. In response to these moves, we recently announced a smart card option for our driver license solution, which would allow the driver license to contain an optional smart card chip to act as a border PASS Card substitute. We stand ready to provide either our traditional range of secure ID offerings, or smart cards, as driven by customer demand and adoption. We believe that these activities will position us to serve any emerging smart card

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needs among driver license issuers. In addition, we will continue to look for opportunities to participate in smart card ID programs in Europe and other parts of the world where smart cards are more widely used.

Commercial

Our digital watermarking technology is used in various products and solutions affecting a variety of media objects, from movies and music, to banknotes and secure credentials. Each media object enabled by our technology creates the potential for several applications, such as:

·       counterfeiting and piracy deterrence,

·       media identification and management,

·       authentication and monitoring,

·       linking to networks,

·       and enhanced services in support of mobile commerce.

We believe the market for digital watermarking applications is in the early stages of development and that existing solutions represent only a small portion of the potential market for our products, services, and technologies.

Competition

Digimarc competes for government business with system integrators, biometrics suppliers, security printers, card manufacturers, and smart card and other security technology suppliers, including companies like L-1 Identity Solutions, Inc. (formerly Viisage Technology, Inc.) (biometrics), Unisys (system integration) and De La Rue (security printer). Each of these companies is a supplier to U.S. driver license issuers. As U.S. driver licenses gain utility as general credentials and the Federal government is demanding higher security and a certain amount of standardization, competition may increase. For instance, certain aspects of the REAL ID Act may expedite an existing trend toward central issuance of driver licenses. Although the Company is proficient at central issuance, the possible acceleration of this trend could draw new competition from classic security printers such as Canadian Banknote (CBN) and Giesieke & Devrient (G&D).

The possibility of including smart card technologies in driver licenses is generating a great deal of public debate. The smart card industry is generally driven by European chip manufacturers such as Infineon and Gemalto. While successful in bank cards, mobile phone SIMs and phone cards, smart cards have only recently begun to gain distribution as government-issued credentials. The U.S. government is a strong advocate. Federal identity standards are embracing smart cards for the military, transportation workers, and government employees and contractors, and new “ePassports” will carry a portrait in an on-book chip. Despite considerable investment by the federal government, we believe no States have attempted or even piloted smart card driver licenses. We understand that in recent years, at least two States have expressly considered and rejected smart card driver licenses. Emerging border control and Federal traveler programs are considering smart card concepts, but have not gained traction and face privacy issues. The Company anticipates that it will be prepared to support requirements from customers for smart card technology if, and when, such requirements arise.

The Company is seeing increased interest in the U.S. ID market from large systems integrators such as EDS, IBM Global Services, Accenture, and Bearing Point. Smaller application providers are also emerging as point-product competition, including Saber and Archon.

Internationally, Digimarc supplies credentialing systems, components or supplies to numerous foreign governments, including four Canadian provinces, Latvia, Mexico, Ghana and Russia. Competition in

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international markets, like in the U.S., comes from security printers, card producers, biometric companies and systems integrators, such as Sagem, De La Rue, Gemplus, Siemens Nixdorf, Unisys, and Hewlett Packard.

In media and entertainment, Digimarc and its business partners generally compete with application-specific alternative technologies for the security budget of the producers and distributors of the media objects. These alternatives include technologies and solutions based on encryption or on pattern recognition. The Company anticipates that its competitive position within certain markets may be affected by factors such as reluctance to adopt new technologies and, positively or negatively, by changes in government regulations.

Backlog

Backlog as of December 31, 2006 was approximately $250 million. We expect more than $85 million of this amount to be recognized as revenue during 2007. This amount includes production volumes reasonably expected to be achieved under currently effective contracts, government orders that are firm but not yet funded, and government contracts awarded but not yet signed. Backlog as of December 31, 2005 was approximately $230 million.

There can be no assurance that our backlog will result in actual revenue in any particular period, because the orders, awards and contracts included in our backlog may be subject to modification, cancellation or suspension. We may not realize revenue on certain contracts, orders or awards included in our backlog or the timing of such recognition may change.

Employees

At December 31, 2006, we had 422 full-time employees, including 59 in sales, marketing, technical support and customer support; 84 in research, development and engineering; 88 in finance, administration, information technology and legal; and 191 in field operations, manufacturing and supply chain. We also had 32 contract workers at December 31, 2006. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. Our employees are not covered by any collective bargaining agreement, and we have never experienced a work stoppage. We believe that our relations with our employees are good.

Available Information

We make available through our website at www.digimarc.com our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these and other reports filed or furnished by us pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we file such materials with the Securities and Exchange Commission.

ITEM 1A:       RISK FACTORS

Certain risk factors that may affect our business, financial condition, results of operation and cash flows, or that may cause our actual results to vary from the forward-looking statements contained in this Annual Report on Form 10-K are set forth in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Factors Affecting Forward Looking Statements,” in this Annual Report on Form 10-K.

ITEM 1B:      UNRESOLVED STAFF COMMENTS

None.

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ITEM 2:               PROPERTIES

Our principal administrative, marketing, research, and intellectual property development facility is located in Beaverton, Oregon. Our secure ID systems business is headquartered in Burlington, Massachusetts, and our logistics center is in Fort Wayne, Indiana. Information about our office leases is set forth below.

We also lease sales and support offices in multiple locations throughout the United States and internationally.

ITEM 3:               LEGAL PROCEEDINGS

Beginning in September 2004, three purported class action lawsuits were filed in the U.S. District Court for the District of Oregon against the Company and certain of its current and former directors and officers on behalf of purchasers of the Company’s securities during the period April 17, 2002 to July 28, 2004. These lawsuits were later consolidated into one action for all purposes. The amended complaint, which sought unspecified damages, asserted claims under the federal securities laws relating to the Company’s restatement of its financial statements for 2003 and the first two quarters of 2004 and alleged that the Company issued false and misleading financial statements and issued misleading public statements about the Company’s operations and prospects. On August 4, 2006, the court granted our motion to dismiss the lawsuit with prejudice and entered judgment in our favor. Plaintiffs have filed a notice of appeal in the Ninth Circuit Court of Appeals. The appeal has been stayed pending the U.S. Supreme Court’s determination in another case of issues relating to the Private Securities Litigation Reform Act. 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 purported shareholder derivative lawsuits were filed against certain of the Company’s officers and directors, naming the Company as a nominal defendant, in the Superior 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 breached their fiduciary duties to the Company’s shareholders and to the Company. The complaint is derivative in nature and does not seek relief from the Company. The Board of Directors appointed an independent committee to investigate the claims asserted in this derivative lawsuit. On July 19, 2005, the court granted the Company’s motion to stay these consolidated actions in favor of a shareholder derivative action to be filed by plaintiffs in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005, the California plaintiffs filed two new derivative lawsuits in the United States District Court for the District of Oregon. On October 17, 2005, defendants filed a motion to dismiss these complaints for lack of subject matter jurisdiction and failure to state a claim. In May of 2006, the Board committee, after completing its investigation, concluded that pursuit of the allegations would not be in the best interests of Digimarc or its shareholders. On August 24, 2006, the court granted defendants’ motion and dismissed the lawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22, 2006. The schedule for submission of appellate briefs has not been set. Due to the inherent uncertainties of litigation, the Company cannot accurately predict the ultimate outcome of the matter.

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Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of the Company’s initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of the Company’s initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company’s initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of the Company’s stock 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 amended complaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a court order dated October 9, 2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, the Company and the other defendants in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including the Company. The claims against the Company under Section 10(b), however, were dismissed. In June 2003, a committee of the Company’s board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. The settlement would provide, among other things, a release of the Company and of the individual defendants for the conduct alleged in the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters. Any direct financial impact of the proposed settlement (other than defense costs incurred and expensed prior to May 31, 2003) is expected to be borne by the Company’s insurers. The court granted the preliminary approval motion on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the Notice Administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members beginning on November 15, 2005 and completed by January 15, 2006. The settlement fairness hearing was held on April 26, 2006, but the court has not yet rendered its decision. If the court determines that the settlement is fair to the class members, the settlement will be approved. On December 5, 2006, the United States Court of Appeals for the Second Circuit issued a decision vacating the order of the United States District Court for the Southern District of New York that had granted class certification for the plaintiffs and remanded the matter for further proceedings. There can be no assurance that the proposed settlement will be approved and implemented in its current form, or at all. Due to the inherent uncertainties of litigation and the recent decision of the Court of Appeals vacating the order granting class certification, the Company cannot accurately predict the ultimate outcome of the matter.

ITEM 4:               SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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PART II

ITEM 5:               MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURTIES

Our common stock is traded on The Nasdaq Global Market under the symbol “DMRC.” The closing price of our common stock on The Nasdaq Global Market was $9.52 as of January 31, 2007. The following table lists the high and low sales prices of our common stock for the periods indicated, as reported by The Nasdaq National Market.

At February 28, 2007, there were 119 stockholders of record of our common stock, as shown in the records of our transfer agent.

We have never declared or paid cash dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future earnings, if any, to finance the future growth of our business.

The following table sets forth information regarding the Company’s purchases of its equity securities during the quarter ended December 31, 2006, all of which were shares subject to restricted stock awards that we purchased from five of our executive officers to cover applicable tax withholding obligations when these awards vested.

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STOCK PERFORMANCE GRAPH

Not withstanding anything to the contrary set forth in any of the Company’s previous filings under the Securities Act of 1933, as amended (the “Securities Act”), or the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that might incorporate future filings, in whole or in part, the following graph shall not be deemed to be “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such graph be incorporated by reference into any such filings, nor shall the following graph be deemed to be incorporated by reference into any future filings under the Securities Act or the Exchange Act.

The following graph compares the performance of our common stock with the performance of (i) the Nasdaq U.S. Index, (ii) a peer group selected by the Company and (iii) the companies included in Standard Industrial Classification (“SIC”) Code 7373—computer Integrated Systems Design (the peer group used for purposes of the stock performance graph included in the proxy statement relating to our 2006 annual meeting of stockholders). The comparison assumes $100 was invested on December 31, 2001 in our common stock at the closing price on such date and in each of the other three indices at the closing price on such date and assumes reinvestment of any dividends. We have changed our peer group from the companies included in SIC Code 7373 to a peer group consisting of companies within the security software and government information technology industries. We believe that the companies in the latter group are more comparable to the Company in terms of line-of-business, market capitalization, revenues, and number of employees and, therefore, comprise a more appropriate peer group for purposes of comparing stock performance. The comparisons in the graph are based on historical data and are not indicative of, nor intended to forecast, future performance of the Company’s common stock.

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ITEM 6:               SELECTED FINANCIAL DATA

The selected financial data set forth below should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report. The consolidated statement of operations and balance sheet data as of and for each of the five years in the period ended December 31, 2006, are derived from our audited consolidated financial statements.

See Note 1 to the consolidated financial statements for information regarding the reclassification of long-term deferred revenue.

ITEM 7:               MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 Item 7, under the caption “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

Although Digimarc believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and Digimarc does not intend to update or revise any forward-looking statements as a result of new information, future events or otherwise. Readers are urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption “Factors Affecting Forward Looking Statements” in this Item 7, the audited

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consolidated financial statements and related notes included in this Annual Report on Form 10-K, and other reports and filings made with the SEC.

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 Form 10-K.

Overview

Digimarc is a leading supplier of secure identity solutions and digital watermarking technology for use in media management. Our solutions enable governments and businesses around the world to enhance traffic safety and national security, combat identity theft and fraud, facilitate the effectiveness of voter identification programs, improve the management of media content, deter counterfeiting and piracy and support new digital media distribution models that provide consumers with more choice and access to media content.

The substantial majority of our revenue is generated pursuant to long-term contracts with government agencies—primarily U.S. state government agencies responsible for driver license issuance, a consortium of leading Central Banks, and national governments of a number of foreign countries. These customers rely on our systems design, integration and materials science expertise, and proprietary technologies such as digital watermarking, to implement issuance systems and processes that improve the security of identity documents and banknotes. The remainder of our revenue is generated through commercial applications of our digital watermarking and related technologies, primarily from patent and technology license fees paid by business partners.

Secure ID Solutions

We issue more than 60 million IDs annually and are the leading supplier of government-issued citizen IDs in North America and produces more than two-thirds of all driver licenses issued in the U.S. Most of our U.S. revenue is generated through the issuance of State driver licenses and is paid in the form of a fixed price per credential issued. Our secure ID solutions typically include hardware (including specialized cameras, printers, personal computers and servers), software, consumable supplies (such as ribbons, blank or preprinted card materials and laminated and related consumables) and ongoing support services.

Seasonality.   We have observed seasonality in our U.S. driver license issuance revenues, with larger revenues in the second and third quarter of the year, and generally lower revenues in the first and fourth quarters. The fourth quarter is usually the seasonally lowest quarter each year. We use the straight line method of depreciation and amortization for program-related assets. The combination of the seasonality of our revenues and straight line depreciation and amortization can cause significant variations in quarterly gross margin trends, generally increasing margins in the second and third quarters when our issuance revenues are higher and decreasing margins in the first and fourth quarters when our issuance revenues are typically lower, while having a neutral effect on a yearly basis.

International.   In international markets, where we provide driver license, national identification, and voter identification systems, services, and components in partnership with local card producers, security printers, system integrators, and others, we may serve as prime contractor or sub-contractor, depending on the circumstances. As a sub-contractor, we generally are responsible for delivering hardware, software, or consumables, and some degree of integration services to the prime contractor; whereas as a prime contractor, we are responsible for integrating all components of the system to the customer’s specifications.

International revenues are typically generated from sales of equipment and/or consumables to government agencies or their prime contractors. These sales may occur at irregular intervals, carry relatively low margins and cause variations in quarterly revenue and gross profit trends. We enter into low margin contracts and transactions from time to time to maintain market presence and build relationships

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with customers and business partners, as often transition to more profitable digital technologies over time. Due to the nature of such international programs and customers, the timing of these sales is less predictable than our service revenues provided by domestic customers and, consequently, international sales can occur unevenly during the course of a year.

Backlog.   Based on projected government-issued credential production volumes and other commitments we have for the periods under contract with our respective customers, we anticipate our current contracts as of December 31, 2006 will generate approximately $250 million in revenue during the contractual terms of such contracts, currently up to seven years. We expect more than $85 million of this amount to be recognized as revenue during 2007. This amount includes production volumes reasonably expected to be achieved under currently effective contracts, government orders that are firm but not yet funded, and government contracts awarded but not yet signed. Backlog as of December 31, 2005 was approximately $230 million.

Some factors that lead to increased backlog are:

·       Competitive bid wins,

·       Renewals with current customers,

·       Add-on sales to current customers, and

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

Some factors that lead to decreased backlog are:

·       Recognition of revenue associated with backlog currently in place,

·       Low bid activity,

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

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

The mix of these factors, among others, dictates whether our backlog increases or decreases for any given period. For example, during the year ended December 31, 2006, we had a high level of awards and extensions, and as a result we have increased our backlog during the year. Over the next year or so, we anticipate several States to request bids or negotiate extensions on their driver license issuance system programs. This period of expected high bid and potential extension activity could lead to additional backlog if we are successful with our bids. Another example is our variable revenue model. From time to time we have sales to our customers that are not characteristic of our price-per-card model, but instead included hardware and consumable sales. Although these types of revenue models are positive growth indicators for our business, they can lead to lower reported backlog.

There can be no assurance that our backlog will result in actual revenue in any particular period, because the orders, awards and contracts included in our backlog may be subject to modification, cancellation or suspension. We may not realize revenue on certain contracts, orders or awards included in our backlog or the timing of such recognition may change.

Depreciation.   Starting January 1, 2006, we changed our policy for depreciating fixed assets that were specifically used to provide services under long-term contracts to the shorter of the original contract term plus 2.75 years or estimated useful life. Through December 31, 2005, we depreciated these assets over the shorter of the original contract term or estimated useful life. This change in estimate was supported by an analysis we completed during the first quarter of 2006 which showed that historically 95% of contracts were extended beyond the original contract term, that the average contract had at least two contract

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extensions during its life and that these extensions added on average 2.75 years to the length of the contracts’ original terms.

Since contract-specific program assets are tracked on a contract basis, the finding that contracts are routinely extended beyond the original term and that these extensions are not generally accompanied by significant incremental capital investment indicates that the useful life of contract-related assets is generally longer than the original term of the contract. Given these findings, we concluded that it was appropriate to change the estimated useful lives of these assets for purposes of depreciation. In addition, the change in useful lives achieves a better matching of the utility of these assets with the resulting revenues. For the year ended December 31, 2006, we performed an updated analysis on contract specific assets which resulted in no change to our previous conclusions. We will continue to analyze the useful lives of contract specific assets in future periods. The financial impact of this change is discussed below in the Cost of Revenue.

Restructuring

During the last half of 2005 and continuing during 2006, the Company restructured it operations to improve productivity and reduce fixed costs. During the second quarter of 2006 we accelerated those activities significantly, resulting in a reduction of our workforce by nearly 20%. Overall, our workforce was reduced by over 30% since mid 2005. Our actions included the redeployment and reallocation of resources to better align with our operating strategies. The discussion and analysis of our operations presented below reflects the improvement in the operating results for the year ended December 31, 2006 as compared to the year ended December 31, 2005.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”) requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, intangible assets, income taxes, restructuring, long-term service contracts, warranties, investments, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Certain of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term service contracts, impairments and estimation of useful lives of long-lived assets, inventory valuation, reserves for uncollectible accounts receivable, and contingencies and litigation. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue recognition on long-term service contracts:   We recognize revenue on long-term identification and driver license production contracts using primarily a price-per-card method. We use actual monthly volume amounts, if available, or we estimate the card production volume on a monthly basis for certain of these contracts in order to recognize revenue earned during the period. In the case of estimates, when the actual production information becomes available, which is typically within four weeks, we bill the customer accordingly and any differences from the estimates are recognized in the month the billing occurs. These amounts represent our best estimates of cards produced and are based on historical trends, known events during the period, and discussions with contract representatives. Prior to publicly reporting results, our practice is to compare the actual production volumes to estimated production volumes and adjust revenue amounts as necessary. Any estimated amounts are included in unbilled receivables on the balance sheet until the actual production

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information is available and the billing occurs. Any estimation process involves inherent risk. We reduce the inherent risk relating to production estimation through our approval and monitoring processes related to accounting estimates. We also evaluate contracts for multiple elements and account for these items under the appropriate accounting literature.

Revenue from professional services arrangements is generally determined based on time and material or a cost plus a profit margin measure. Revenue for professional services is recognized as the services are performed. Losses on contracts, if any, are provided for in the period in which the loss becomes determinable. Billing for services rendered generally occurs within one month following when the services are provided. Revenue earned which has not been invoiced is classified as unbilled trade receivables, which is included in the balance of trade accounts receivable, net in the consolidated balance sheets.

Impairments and estimation of useful lives of long-lived assets:   We periodically assess long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraised values, depending on the nature of the asset. Also, we periodically review the useful lives of long-lived assets whenever events or changes in circumstances indicate that the useful life may have changed. If the estimated useful lives of such assets do change, we adjust the depreciation or amortization period to a shorter or longer period, based on the circumstances identified.

Inventory valuation:   Inventory consists primarily of consumable supplies that are used in the production of driver licenses and products held for resale to customers. We value inventory at the lower of cost or market value (which lower amount is the net realizable value). We reduce the value of our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

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

Contingencies and Litigation:   We periodically evaluate all pending or threatened contingencies or commitments, if any, that are reasonably likely to have a material adverse effect on our operations or financial position. We assess the probability of an adverse outcome and determine if it is remote, reasonably possible or probable as defined in accordance with the provisions of SFAS No. 5, Accounting for Contingencies. If information available prior to the issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of our financial statements, and the amount of the loss, or the range of probable loss can be reasonably estimated, then such loss is accrued and charged to operations. If no accrual is made for a

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loss contingency because one or both of the conditions pursuant to SFAS No. 5 are not met, but the probability of an adverse outcome is at least reasonably possible, we will disclose the nature of the contingency and provide an estimate of the possible loss or range of loss, or state that such an estimate cannot be made.

Stock-based compensation:   On January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment (Revised 2004), which requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stock options and employee stock purchases under a stock purchase plan based on estimated fair values. Under SFAS 123(R), we use the Black-Scholes option pricing model as our method of valuation for stock-based awards. Our determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited, to the expected life of the award, our expected stock price, volatility over the term of the award and actual and projected exercise behaviors. Although the fair value of stock-based awards is determined in accordance with SFAS 123(R), the Black-Scholes option pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results.

Results of Operations

The following table presents our consolidated statement of operations data for the periods indicated as a percentage of total revenue.

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Years Ended December 31, 2006 and 2005

Revenue

Service.   Service revenue consists primarily of:

·        card production on a price-per-card basis,

·        software development services, and

·        hardware and software maintenance.

The majority of service revenue arrangements are typically structured as price-per-card product agreements, time and materials consulting agreements, or fixed price consulting agreements.

Service revenue increased primarily due to increased program work from the consortium of central banks, increased production for certain programs that reached full production in 2006 including programs for state driver license issuers in Florida and Alabama. These increases in service revenue were offset by decreased revenue from the Mexico program due to a hiatus before national elections, changes in driver license renewal terms in California and Massachusetts, and the completion of our contract with West Virginia.

Product and subscription.   Product revenue consists primarily of the sale of equipment and consumables related to identification card production systems and software licenses that are variable in nature and occur from time to time. Subscription revenue consists primarily of royalty revenue from our intellectual property licenses and the sale of our web-based subscriptions related to various software products, both of which are more recurring in nature.

Product and subscription revenue increased primarily from the addition of three large international programs with Yemen, Ghana and Russia, related to either new ID programs or increased volume of consumable sales. The product and subscription revenue was offset by decreased revenue from certain domestic customers due to lower hardware sales in 2006.

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Revenue by Geography

The increase in domestic revenue was primarily due to increased revenue from the state driver license issuers in Florida and Alabama as these programs reached full production levels, offset by lower production revenues in West Virginia, lower hardware sales in Ohio and certain other States that occurred as a result of normal fluctuations in issuance volumes that we may experience from time to time.

The slight increase in international revenue was primarily due to increased revenue from Yemen, Ghana and Russia related to either new ID programs or an increase in consumable sales. These increases are not expected to continue in a linear manner or recur at regular intervals. The increase in international revenue was offset by reduced revenue from our Mexico program due to a hiatus before national elections and decreased product sales to Honduras.

Cost of Revenue

Service.   Cost of service revenue primarily includes:

·        costs of consumables used in delivering a service,

·        compensation for software developers, quality assurance personnel, product managers, field operations personnel, business development personnel and outside contractors,

·        depreciation charges for machinery, equipment and capitalized software,

·        deployment costs used specifically for service delivery,

·        provisions for obsolete and excess inventories,

·        travel costs directly attributable to service and development contracts,

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·        stock based compensation expense, and

·        charges for infrastructure and centralized costs.

Cost of service revenue decreased primarily due to:

·        decreased depreciation expense, net of $3.4 million, as a result of the estimated decrease of $8.0 million attributable to the change in estimated useful lives of program assets as of December 31, 2005, as discussed below, offset by an increase of $4.6 million related to programs that were deployed in 2005 and for which we realized a full year of depreciation in 2006 and an increase in depreciation attributable to upgrades made to certain other programs,

·        decreased contract and temporary labor of $2.6 million as part of the cost cutting initiative where a number of contractors were converted to employees at lower average costs,

·        decreased other operating expenses such as small tools and repairs and maintenance of $0.7 million related to cost cutting initiatives, offset by

·        increased employee compensation-related expenses of $5.7 million resulting from:

·       converting contract labor to permanent labor at a lower average cost per person,

·       redeploying resources to program activities as part our restructuring initiative undertaken throughout the year,

·       allocating resources to fixing or improving existing programs, rather than to capital projects relating to the development of new programs, which occurred primarily during the first half of the year,

·       increase in stock option expense related to the adoption of SFAS 123(R) regarding stock-based compensation as discussed below, and

·        increased allocated infrastructure and centralized costs of $0.9 million primarily due to system upgrades and enhancements in our information technology operations.

Product and subscription.   Cost of product and subscription revenue primarily includes costs of equipment and consumables related to our ID production systems, as well as Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers.

Cost of product and subscription revenue increased primarily due to:

·        increased direct consumable costs related to three international customers of $2.5 million, offset by

·        lower direct hardware costs related to a domestic customer of $1.8 million.

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The costs components included in our cost of revenue are comprised of three categories as described below:

Variable costs include:

·        price of materials and labor to produce an identification card,

·        direct costs of hardware and software delivered, and

·        other costs that are variable in nature.

While the variable cost as a percentage of revenue remained the same, the increase in variable costs is primarily due to the increase in sales of consumables and product sales to our international customers.

Fixed field support and manufacturing includes:

·        field operations and support,

·        manufacturing,

·        supply chain costs, and

·        charges for infrastructure and centralized costs.

These costs are considered fixed with respect to supporting current contracts. As new contracts are entered into and delivered, the overall level of fixed costs increases. The increase in fixed costs are primarily due to newer contracts requiring additional headcount, as well as travel costs to support them. During the first two quarters of the fiscal year, we focused on improving certain existing programs and as a result fewer expenditures were capitalized to the balance sheet. As a result of these actions, fixed support costs increased. After improving the efficiencies in these programs, our fixed costs returned to more normal levels during the second half of the year.

Program depreciation primarily consists of amortization and depreciation of costs incurred during the delivery process, where such costs are capitalized and then amortized or depreciated over the useful lives of the assets to which the costs relate. Program depreciation decreased in relation to the other components of cost of revenue primarily due to the change in the estimated useful lives of program-related fixed assets.

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The following table shows the effect of this policy of reducing depreciation expense in 2006 for assets in place at December 31, 2005, as well as the expected effect in the future periods specified:

For the year ended December 31, 2006, the change in estimating the useful lives of program-related fixed assets had the effect of reducing depreciation expense by $8.0 million and increasing basic and diluted earnings per share by $0.39. Given that the depreciation expense attributed to contract-specific assets is included in cost of revenue, the decrease in depreciation expense also caused gross margins to increase by the amount of the reduction in depreciation expense.

The primary factor offsetting the reduction in program depreciation was higher than average costs to deploy certain new programs where we provided a complete system replacement using advanced technologies. These programs were completed in late 2005 and 2006 and are now in production. These installations were particularly challenging for us, representing a more expanded scope than that of our historical system deliveries. We were successful in delivering these programs, but at higher costs than have been customary. In another case, we bid a program aggressively as part of a broader market development strategy that we believe will yield good long-term performance. The fixed costs for these systems, which include amortization and depreciation of costs capitalized during the delivery process, as well as field service and operational costs to manage and maintain them, are higher than average and, thus, reduce reported margins. We anticipate that we will be able to improve profit margins in these accounts over time and earn a better return on investment over the life of the account relationship.

Gross Profit