Thursday, November 29, 2012

High Digital Marks

Digimarc (DMRC) has seen tremendous stock price volatility in recent quarters, which is generally par for the course for most small cap companies. Currently, the stock trades almost 60% below its 1.5 year high, potentially offering value investors an opportunity.

Despite cash and marketable securities of about $43 million (and no debt) along with free cash flow generation of $9 million per year, the company trades for just $128 million. For a company in a declining industry, perhaps this seems reasonable. But Digimarc may hold a moat in what appears to be a growing industry.

Digimarc provides technology for digitally "watermarking" various media, including images, audio and video. Media content itself is encoded with digital information in such a way that it is imperceptible to the eye, and yet can be decoded digitally. This allows the watermarked product to survive compression, format conversion and other changes that can otherwise strip out the information that is meant to be preserved.

Applications for this technology include combating piracy, verifying authenticity and enhancing search capability. Digimarc's licenses are protected via a combination of copyrights, patents and trade secrets, giving the company a potential competitive advantage in an in-demand industry.

One thing worth noting, however, is that the company's free cash flow is deceptively high relative to its earnings. This is because Digimarc appears to be rather generous with its stock options; as a result, while the company has spent some $25 million on share repurchases over the last three years, the share count has barely budged! There remain a great deal of options outstanding, so be sure to take these into account in your valuation.

Finally, it's also worth pointing out that only five customers represent 94% of the company's revenue. Included in these figures, however, are revenues from partners that license Digimarc's technology for the sole purpose of re-licensing it to other customers as part of a more complete solution. As such, the customer concentration figure is likely significantly overstated.

If no competing solutions are identified for marking/protecting digital assets, it's hard to imagine a scenario where Digimarc's stock does not generate strong returns from its current price. At the same time, however, there are a number of competitors (including Digimarc's own partners) working on trying to circumvent Digimarc's patents or render them obsolete. At the current price, it appears Mr. Market is betting on the latter.

Disclosure: No position

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