UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-K

 

 

Commission File Number 001-33002

 

 

 

 

L-1 IDENTITY SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (203)-504-1100

 

Securities registered pursuant to Section 12(b) of the Act: Common Stock $.001 par value NYSE

 

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

 

 

 

 

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

 

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

 

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. x  Yes o No

 

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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference into Part III of this Form 10-K or any amendment to this Form 10-K.

 

Indicate by a check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer xAccelerated Filer o Non-Accelerated Filer o Smaller Reporting Company o

 

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

 

The aggregate market value of the voting stock held by nonaffiliates of the registrant as of June 30, 2008, was approximately $1,038.9 million.

 

As of February 24, 2009, the registrant had 86,472,745 shares of Common Stock outstanding.

 

 

L-1 IDENTITY SOLUTIONS, INC.
TABLE OF CONTENTS

 

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In this Annual Report on Form 10-K, the words “L-1”, the “Company”, “we”, “our”, “ours”, and “us” refer to L-1 Identity Solutions, Inc. and, except as otherwise specified herein, to our subsidiaries. Our fiscal year ended on December 31, 2008.

 

L-1 Identity Solutions, Inc. and its subsidiaries (“L-1” or the “Company”) is a provider of technology, products, systems and solutions, and services that protect and secure personal identities and assets. Together our business delivers the full range of offerings required for solving complex problems associated with managing identity.

 

The Company operates in two reportable segments: Identity Solutions and Services.

 

 

We evaluate our business primarily through operating and financial metrics such as revenues, operating income (loss), and earning before interest, depreciation and amortization, intangible asset impairments and in process research and development charges, and stock-based compensation expense (“Adjusted EBITDA”) and free cash flow.

 

Our identity solutions and services are organized into several core capabilities:

 

 

This offering includes complete solutions for integration and verification of the entire secure credential lifecycle, from testing through issuance and inspection. L-1 systems are used to produce the majority of U.S. driver’s licenses and our systems support all types of production systems including over the counter, central and hybrid models. L-1 credentialing solutions are used in 20 countries for producing the U.S. passport, U.S. Passport Card and Border Crossing Card, as well as various citizen credentialing programs including voter registration, passports, National ID and others. More than 100 million secure credentials are produced annually with L-1 solutions.

 

 

Biometric solutions are used to capture, manage and move biometric data for positive, rapid ID and tracking of persons of interest. L-1’s biometric solutions provide a full range of finger and palm, facial, iris, and multi-modal biometric technologies that empower the identification of individuals in large-scale identity management programs. Our biometric solutions include a multi-modal automated biometric identification and matching system (ABIS). Our products include finger and palm print scanners, iris-based capture devices (PIER and HIIDE), integrated multi-biometric (finger, face and iris) devices, automated facial recognition systems both static (digital photo or mug shot) and dynamic (video) and automated iris recognition systems (AIRS).

 

These solutions include finger and facial (including 3D) biometric-based readers used to secure buildings and restricted areas. Our enterprise access solutions are offered through more than 400 global partners today and are used by commercial enterprises around the world.

 

 

These services include background checks and processing of applicant data required for federal and state licensed programs and jobs in the banking, finance, insurance, healthcare, child care, legal, real estate, education and other industries. L-1 operates a network of more than 650 convenient and secure centers located across 46 U.S. states and in most Canadian provinces. The centers have enrollment stations, live scan systems and software that are used for fingerprinting and processing as fingerprints for background checks. More than 6.5 million people have been printed to date through L-1 enrollment services, of which more than 1.5 million were printed in 2008.

 

 

These services include a specialized set of capabilities that address the most pressing issues in security facing intelligence agencies today. It includes McClendon Engineering and Analytical Services that focuses on GEOINT and MASINT science; SETA, PMO and acquisition; intelligence analysis and operations; systems engineering and integration and; IT and software development. Advanced Concepts Information Technology Services offers IT services, program management, Cyber security services systems engineering, 911 planning and help desk support. SpecTal Intelligence Services provides intelligence analysis, operations support, training and information technology/technical development.

 

Despite the challenges posed by current economic conditions, the market for identity solutions has continued to develop. We believe that users of identity protection solutions are demanding complete solutions with increased functionality that can solve their spectrum of needs across the identity life cycle. Our objective is to meet those growing needs by continuing to broaden our product and solution offerings, leveraging our existing customer base to provide additional products and services, expanding our customer base both domestically and abroad, and augmenting our competitive position through strategic acquisitions.

 

Reportable Segments and Geographical Information

 

Reference is made to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for financial information about reportable segments and geographic information and revenues by class of products and services.

 

Acquisition History

 

 

 

Financing Activities

 

In October 2006, we entered into a revolving credit agreement under which we could borrow up to $150.0 million, with the potential of increasing the facility to $200.0 million. Borrowings under the revolving credit agreement were primarily used to fund our acquisitions. In August 2008, all outstanding borrowings under this facility were repaid from the proceeds of borrowings under the amended and restated credit facility described below.

 

In May 2007, we issued $175.0 million of Convertible Notes, the net proceeds of which were used to purchase a pre-paid forward contract of $69.8 million and to prepay the then outstanding borrowings under our revolving credit facility.

 

In August 2008, we entered into amended credit facilities under which we could borrow up to $435.0 million consisting of a $300.0 million term loan facility, and a $135.0 million revolving credit facility. The proceeds of the term loan facility of $295.0 million were used to partially fund the acquisition of the Old Digimarc and repay debt outstanding under the then existing revolving credit facility. Under the terms of the revolving credit facility, $120.5 million is available at December 31, 2008, after deducting outstanding letters of credits of $14.5 million, subject to continuing compliance with the covenants contained in the agreement.

On August 5, 2008, pursuant to the terms and conditions of (i) the Securities Purchase Agreement, by and between L-1 and Robert V. LaPenta, our chairman and CEO, (the “LaPenta Agreement”), (ii) the Securities Purchase Agreement (the “Iridian Agreement”), by and between L-1 and Iridian Asset Management LLC (“Iridian”) and (iii) the LRSR LLC Agreement (together with the LaPenta Agreement and Iridian Agreement, the “Investor Agreements”), L-1 issued an aggregate of approximately 8.1 million shares of L-1 common stock and 15,107 shares of Series A Convertible Preferred Stock (the ’Series A Preferred Stock’) convertible into approximately 1.1 million shares of common stock, for aggregate net proceeds to L-1 of $119.0 million, which were used to fund a portion of L-1’s acquisition of Old Digimarc.

 

Industry Overview

 

Biometric Markets and Trends

 

Government-issued “breeder documents” (such as birth certificates and social security cards) and IDs granted based on these documents (such as driver’s licenses or passports) serve as the primary means for confirming the identity of an individual. The integrity, however, of these documents and credentials can be compromised because they can be counterfeited or altered, issued under false pretenses and historically have rarely been linked to an identity database. Failure to provide adequate identification protection can lead to breaches of security and identity theft, the consequences of which can range from national security threats and loss of life to significant economic loss. Within this context, we believe that there is increasing pressure on governments and businesses to accelerate the adoption of advanced technology identity solutions to validate identities.

 

L-1 delivers solutions and services that protect and secure personal identities and assets. A core element to the L-1 identity management value proposition is biometrics. Biometrics are unique, individual physiological or behavioral characteristics, such as fingerprints, palm prints, facial characteristics, iris and voice patterns, hand geometry and handwriting patterns, which can be used to determine or verify an individual’s identity. Technology digitally captures and encodes these individual biometric characteristics and then compares that uniquely personal characteristic against previously encoded biometric data to determine or validate an individual’s identity.

 

Each biometric is unique to each person, making it the best means possible today to verify that a person is whom he/she claims to be. Furthermore, biometric technology provides improved accuracy and security of the credential, as well as convenience and cost-effectiveness for the individual, overcoming the limitations inherent in traditional identification and authentication processes such as paper credentials, passwords, PIN codes and magnetic access cards.

 

Governments and their agencies were the early adopters of biometrics and today remain the primary customers for the industry. For law enforcement, biometric technology permits more efficient criminal booking and processing and also allows officers in the field to identify potential suspects more reliably and efficiently. Within the military biometrics are used for the verification and identification of military personnel and contractors and collection and processing of biometrics from non-military personnel for the purpose of identifying potential hostile persons. At the national level, governments throughout the world have taken steps to improve security in response to heightened concerns over public safety from the threat of terrorism. National governments have mandated increased spending on security measures, implemented new regulations and placed greater emphasis on technology to address growing security concerns.

 

We believe that the market for biometrics will continue to grow significantly. This growth is a function of customer demand and the ability for the industry to meet the demand. We believe that major drivers of biometric growth in the future will include:

 

 

 

In addition, we believe that identity-related mandates within the government will drive growth by increasingly recommending, and in some cases mandating, the use of secure authentication, such as biometrics, as a key component of identity verification. Some of the programs include:

 

 

While fingerprints are expected to continue to be the most prevalent biometric technology in the near term, iris, face, palm print and other technologies are being adopted and combined with fingerprinting in multi biometric applications to provide an additional level of security and accuracy and to allow for increased flexibility for applications where fingerprints are not suitable.

 

Automated Fingerprint Identification Systems (AFIS) / Live Scan is the largest market space for biometrics. These are large scale and highly complex systems used in law enforcement, background checks, and civil identification programs. Live scans are deployed as a front end to most AFIS systems and include hardware and software that captures and processes fingerprint images prior to submission to AFIS systems. This AFIS / Live Scan market is considerably more mature than any other biometric market sector. Increasingly, multiple biometrics are also being incorporated into these systems, augmenting fingerprints with hand/palm prints, facial images and iris patterns.

 

Internationally many countries have established or are establishing more secure national identification, driver’s license, passport, border crossing control and voter registration programs and many of these systems

are expected to utilize biometric technologies. In addition to protecting citizens, some of these programs are also aimed at helping identify potential terrorist threats. The United States established legislation requiring biometric identifiers to be included in the passports of current Visa Waiver countries (countries where citizens are not required to obtain a Visa prior to entering the U.S.). We offer a range of solutions, products and technologies that can be utilized in national identification, and/or passport and border crossing programs to enroll and verify citizens, visitors and potential threats and/or to add biometric identifiers to national identification and/or passport programs. Accordingly we believe that international markets provide an opportunity for revenue growth.

 

While we anticipate consistent revenue growth, the following may adversely affect the rate of this growth, among other factors:

 

 

Government Services Markets and Trends

 

The federal government is the largest consumer of information technology services and solutions in the United States. We believe that the federal government’s spending on information technology and services will continue to increase in the next several years, driven by the expansion of national defense and homeland security programs, the continued need for sophisticated intelligence gathering and information sharing, increased reliance on technology service providers due to shrinking ranks of government employee technical professionals, and the continuing impact of federal procurement reform and Office of Management and Budget mandates regarding IT spending. Federal government spending on information technology has consistently increased in each year since 1980.

 

Across our core intelligence community customers, we believe the following trends will continue to impact spending and dependence on technology and support contractors:

 

 

 

Our Solutions

 

L-1 solutions combine industry-leading face, finger and iris recognition biometric technologies with state-of-the-art credentialing and access control systems, enrollment services and government consulting, to successfully meet all aspects of managing identity. L-1 Identity Solutions maintains specialized offerings for customers across both the public and private sector.

 

U.S. Federal Solutions

 

Federal agencies depend on L-1 Identity Solutions to provide efficient and reliable products and services that help improve the security of the nation and protect citizens, both at home and abroad. Our history of dependability and trust established across all levels of government includes every major U.S. government department and most U.S. military branches. We offer a comprehensive array of solutions that make it easier to implement civilian and criminal identification systems, border security programs and data protection measures. Our solutions are designed to address the federal identity needs set forth by various initiatives, programs and agencies such as:

 

 

 

We also provide solutions for:

 

 

Border Management Solutions

 

L-1’s border management solutions offer a faster and more convenient process for travelers to pass through borders. They also empower border control officers to perform real-time searches against known watchlists and to scan more types of documents faster than ever before, ensuring that unwanted individuals do not enter the country. The flexibility of L-1 solutions enables the process of border management and control to happen seamlessly and with the same level of protection and security regardless of location, whether at a highly populated and wired checkpoint or a remote location connected wirelessly. Our biometric technologies and document authentication readers are tested and deployed by border control agencies all over the world. More than 10,000 L-1 live scan systems are deployed today across a wide range of agencies, including the U.S. Department of Homeland Security for use at the nation’s border crossings. We believe we are the only U.S. company offering multi-biometric solutions for fixed and mobile environments. Our solutions include:

 

 

Law Enforcement Solutions

 

Law enforcement agencies across the U.S. and globally rely on us to provide solutions that help identify suspects and criminals faster and more accurately. With the power to scan millions of criminal records in

seconds, and provide officers in the field with critical identity information in minutes, L-1 Identity Solutions is paving the way for a new era in identification for law enforcement agencies. Our companies have a long history of experience serving the needs of law enforcement agencies. Our solutions are installed in all 50 states and in more than 20 countries around the world. We are known for innovation and setting new standards for the industry that lead the way in greater efficiencies for law enforcement agencies. Our solutions include:

 

 

Civil Solutions

 

Producing valid and secure civil identity documents necessitates a wide range of requirements. Each step in these processes represents the potential for error and fraud that can compromise the integrity of the ID. Civil agencies trust us to provide large-scale secure credentialing systems. We design thousands of card types, deploy more than 6,000 authentication systems globally, and produced more than 700 million ID credentials in the last 10 years alone. Our solutions include:

 

 

 

Commercial Solutions

 

Protection of a business’s valuable information and physical assets in today’s operating environments demands a sophisticated security platform. Regulatory mandates that require proof of requisite steps taken to protect critical personal information is adding to the pressure. We offer the latest innovation in biometric technologies to vet an identity before an individual is hired or granted access to a company’s data and physical assets. We also offer state-of-the-art access control systems. We serve the following markets:

 

 

Enterprise Access Solutions

 

Our enterprise access solutions protect corporate assets, offices and restricted areas with the strongest form of multifactor authentication available using fingerprint or face biometrics. The market leading Veri-Series fingerprint readers and MV-Series embedded fingerprint modules for physical access use advanced, patented pattern- and minutiae-based biometric algorithms for fast and secure verification. Leading-edge VisionAccess 3D face recognition readers use three-dimensional face geometry based algorithms for authentication in under a second. More than 290,000 access control reader units are installed today globally and we maintain a distribution network of more than 400 global partnerships worldwide. Our growing commercial and government market share is fueled by strong relationships within enterprises, government agencies, transportation authorities, insurance and financial institutions, healthcare operations, casino properties and other organizations around the world. Our solutions include:

 

 

Enrollment Services

 

L-1 operates more than 650 enrollment centers across the U.S. and Canada for processing pre-employment civilian background checks. Our customers include daycare workers, health-care personnel, prospective foster parents, and those employed in educational environments such as teachers, administrators, custodians and bus drivers legally required to have criminal history checks. Our centers also handle processing for various financial services, banking and brokerage submissions. Fingerprints are captured quickly in a friendly, professional environment by one of our certified fingerprint technicians. The prints are taken using state-of-the-art live scan equipment that captures fingerprints without the use of ink and submits them electronically. As a result, our customers can receive criminal history results in days. Faster results mean licensing, or putting employees to work, more quickly and with peace of mind. Our services include:

 

 

Government Consulting Services

 

Our highly specialized services encompass the most important areas of security and intelligence in the U.S. today including information technology, engineering and analytics and intelligence services. Intelligence services include counterterrorism, homeland defense, information sharing and analysis, physical, technical and personal security, personnel surety, behavioral science, counterintelligence, vulnerability assessment, forensics, surveillance and surveillance detection, crisis management, computer forensics and operational support. Our IT services span network design, administration, system performance tuning, help desk support, and information assurance through systems security monitoring, threat and risk assessments, reverse engineering and policy development. Our systems and software engineering capabilities offer requirements development and integration, software application development and database design. Scientific, Engineering and Technical Assistance (SETA) capabilities provide mission and collection management, architecture analysis, program and acquisition management support. Our more than 850 consulting personnel represent what we believe are the most qualified professionals in the industry, with approximately 95 percent holding high-level government security clearance. Our team includes all-source regional, functional, and technical analysts; field operations officers; trainers; software engineers; program managers; specialized government consultants; and operational support professionals. Our professional consulting staff provides support to the federal intelligence agencies, law enforcements, and the uniformed military services. Our multi-lingual team speaks 20 languages and are experts in Middle East, Asian and Eastern European countries. Our clients include:

 

 

 

Customers

 

Over 90% of our sales are to federal, state, local and foreign governments and government agencies. Contracts with governments and agencies generally allow the customer to terminate the contract for convenience of or for failure of the government to appropriate funds. For the year ended December 31, 2008, U.S. Federal government agencies accounted for 64% of L-1’s consolidated revenues.

 

Historically, we have experienced minimal customer turnover. We believe this is a result of our strong product portfolio and emphasis on customer service and support.

 

Our customers include:

 

 

Business Development, Sales, Marketing, Bids and Proposals

 

We market our biometric solutions and services through a direct sales force, through channel partners and through strategic partnerships and alliances. Our direct sales force is responsible for marketing and selling our entire identity solutions and services portfolio. We have a worldwide sales force responsible for delivering customer solutions and services to North and South American, Europe, the Middle East, Africa, Russia, India and Asia Pacific markets. In addition, we have established a dedicated U.S. Federal sales team in Washington, D.C. responsible for marketing and selling to U.S. government agencies such as the Department of Defense, Department of State, Department of Justice and Department of Homeland Security, among others. We have a dedicated sales and services team operating from locations in Germany, the United Kingdom, Australia, UAE and Switzerland, strengthening our coverage and access to the international markets for our products, services and solutions. We have also realigned our marketing efforts to better coordinate the state and local marketing offerings of our divisions. Finally, we have established a team approach to pursuing intelligence agency opportunities to coordinate and provide broader and stronger service offerings to the U.S. intelligence agencies. As of December 31, 2008, we employed 154 people in our business development and sales and marketing organization.

 

We also continue to seek to develop strategic partnerships and distribution channels to broaden our coverage and increase the size of our market worldwide. We have established original equipment manufacturer, or OEM, distribution agreements with partners to leverage our technologies. We have established channels of distribution for our document authentication products to open new markets outside of the U.S. Additionally, we work with systems integrators, solution providers and service organizations to deliver identity solutions in combination with their core capabilities to expand our access to such organizations’ existing relationships, marketing resources and credibility in new markets. Local agents are also utilized to expand our international access to identity solutions opportunities around the world.

 

Our sales strategy is organized around specific markets: federal, state and local, international and commercial. Each sales organization is supported by functional groups, which design, engineer, manufacture,

market, fulfill and support our market-specific offerings. Each of our sales organizations is further supported by a professional service group, which customizes solutions for each market, and a field service group to ensure ongoing performance of our systems at customer sites throughout the world.

 

Substantially all of our government services business and much of our solutions business is won through submission of formal competitive bids. Commercial bids are frequently negotiated as to terms and conditions for schedule, specifications, delivery and payment. With respect to bids for government work, however, in most cases the client specifies the terms and conditions and form of contract. In situations where the client-imposed contract type and/or terms appear to expose us to inappropriate risk, we may seek alternative arrangements or opt not to bid for the work. Our contracts and subcontracts are composed of a wide range of contract types, including firm fixed-price, cost reimbursement, time-and-materials, indefinite delivery/indefinite quantity (ID/IQ) and government wide acquisition contracts such as General Services Administration (GSA) schedule contracts.

 

Substantially all of our sales to new customers have been the result of competitive bidding for contracts pursuant to public sector procurement rules. In some cases, we may be competing with an entity that has a pre-existing relationship with a potential customer, which could put us at a significant competitive disadvantage. In other cases, however, we have pre-existing relationships with customers, which give us an advantage relative to our competitors for that customer. All material bids and proposals are subject to review and approval by senior corporate management prior to submission.

 

Sales and marketing costs were $37.1 million, $27.7 million and $14.4 million for the years ended December 31, 2008, 2007 and 2006, respectively.

 

Research and Product Development

 

We have organized our research and development activities in what we believe is an efficient model using centers of excellence distributed among our divisions. Our research and development team, which totals approximately 271 developers, scientists and engineers, is distributed among focused centers of excellence that are maintained under the Company’s divisions. Their activities are coordinated at the corporate level under the Company’s Chief Strategic Officer to ensure support of the overall innovation goals and mission of L-1 and the realization of synergies in our research and development investment.

 

We focus our research and development efforts on critical components for advanced technology identity solutions. These include but are not limited to proprietary software that addresses image capture, image processing, face recognition, iris recognition, fingerprint and palm recognition, biometric fusion logic and intelligent decision making, information retrieval from identity databases, scalability of search, and the accuracy of searching and matching algorithms within very large databases, and document authentication. In addition, we invest in the development of capture technologies for finger, palm and iris. We also maintain an active program for the development of new security features for credentials.

 

We believe our next generation biometric matching algorithms fingerprint, facial, and iris recognition technology developments will be more reliable and cost effective than current technology, as well as provide additional functionality, including the storage of fingerprint and/or facial and iris templates on smart cards and similar storage devices. In addition, we focus on expanding our capabilities in solutions for the civil identification, criminal identification and border management markets.

 

We also benefit from research and development activities conducted by the manufacturers of the components integrated into our systems such as cameras, database software and computers and research and development, we perform research and development for our customers, including the U.S. government and its agencies.

 

Gross research and development expenditures aggregated to $43.0 million for the year ended December 31, 2008 compared to $26.4 million in the prior year. Virtually all of our research and development costs are attributable to our Identity Solutions segment. As a percentage of Identity Solutions revenues, gross research and development costs were 15% and 13% for years ended December 31, 2008 and 2007, respectively.

Intellectual Property

 

We rely on patent, copyright, trademark and trade secrets and contract law to establish and maintain our proprietary rights in our technology products and manufacturing processes. The success of our business will depend in part on our proprietary technology and protection of that technology. While our intellectual property rights are important to our success, we believe that neither our business as a whole nor any segment of our business is materially dependent on any particular patent, trademark, license or other intellectual property right.

 

We have a portfolio of 213 U.S. and foreign patents. In addition, we have 164 U.S. and foreign patent applications in process for biometrics and document authentication technologies. While the duration of our patents varies, we believe that the duration of our patents is adequate relative to the expected lives of our products.

 

We have filed applications to register the trademarks of “L-1” and “L-1 Identity Solutions”, and both applications have been approved for publication by the U.S. Patent and Office. We have a broad portfolio of other vital registered and pending trademarks in the U.S. and foreign jurisdictions.

 

Backlog

 

Backlog represents sales value of firm orders for products and services not yet delivered and, for long term executed contractual arrangements (contracts, subcontracts, and customer commitments), the estimated future sales value of estimated product shipments, transactions processed and services to be provided over the term of the contractual arrangements, including renewal options expected to be exercised. For contracts with indefinite quantities backlog reflects estimated quantities based on current activity levels. Backlog will not necessarily result in future revenue because firm orders may be cancelled, firm orders from governmental agencies may remain subject to funding options, renewals may not be exercised by the customers, and the quantities ordered, the volume of transaction processed or services to be provided may be less than estimated. Backlog includes deferred revenues. Contractual arrangements could be cancelled by our customers without penalty for lack of performance. Contracts terminated by our customers for convenience generally would result in recovery of actual costs incurred and profit, if any, on work performed through the date of cancellation. At December 31, 2008 backlog, determined as described above, approximated $1.1 billion, of which approximately $520.0 million is expected to be realized in 2009. Revenues from backlog, together with other recurring revenues not in backlog, are expected to approximate $620.0 million or 84% of 2009 revenues. At December 31, 2007, backlog was approximately $715 million.

 

Competition

 

The market for our identity solutions and services is extremely competitive. Our ability to differentiate ourselves from our competition is predicated on:

 

 

 

 

We face competition from a number of companies who are actively engaged in developing and marketing identity management related solutions and services. All of our divisions are also potentially affected by large system integrators entering the market through various avenues. The markets for our solutions and services are characterized by rapid technological change as a result of technical developments exploited by competitors, the changing technical needs of the customers, and frequent introductions of new features. We expect competition to increase as other companies introduce products that are more price competitive, may have increased performance or functionality, or that incorporate technological advances not yet developed or implemented by L-1. In order to compete effectively in this environment, we must continually develop and market new and enhanced products at competitive prices, and have the resources to invest in significant research and development activities.

 

We compete on the basis of the following factors: technology, service and support, product quality, price, reliability, capability to work with large criminal history networks and flexibility in accommodating customer technical and business needs.

 

Specific competitive issues as they relate to our core focus areas include:

 

 

 

Manufacturing

 

We engineer and design the hardware products we sell and develop much of the software embedded in them. Except as described below with respect to secure credentials, we either limit our manufacturing activities to the assembly, repair, and testing of these products or we manage their production through contract manufacturers. In either case, we qualify suppliers for the core components which typically have established supply chains. We believe this permits rapid expansion of production capacity to meet any significant increase in product demand and minimizes both development costs and the cost of scaling of our manufacturing capabilities. We believe that these costs will decline if manufacturing volumes increase.

 

We also engineer, design and produce most of our card products used for the production of secure credentials that have proprietary features or functionality and which account for over 50% of our credentialing volume. We purchase the remaining card products from established sources.

 

We produce driver licenses for 19 states in secure central issuance facilities in Texas, Florida, North Carolina, Pennsylvania, California and Washington and in 2009 we expect to open new central issuance facilities Georgia and Massachusetts to accommodate states converting or expected to convert to central issuance in 2009, 2010 and 2011. We also produce the Mexican voter identifications in a central issuance facility in Mexico City.

 

We purchase certain components, sub-assemblies and finished products used in our manufacturing and supply chain operations from sole source suppliers. While we are careful to partner with stable, reliable suppliers, the partial or complete loss of supplies available from sole sources or limited sources of supply or the delay in receiving supplies from these sources could result in delays in manufacturing and shipping products to customers which may result in the assessment of liquidated damages in certain contracts and which may require the incurrence of development and other costs to establish alternative sources of supply. While we made every effort to maintain inventory on sole sourced components, it may take us several months to locate alternative suppliers if required, or redesign our products to accommodate components from different suppliers.

 

Seasonality

 

Our business in general is not seasonal. However, because most of our government services revenue is earned on a time and material and fixed price level of effect basis, we are impacted by holidays and vacations our employees may take during the summer and holiday seasons. We are also impacted by the fiscal funding and appropriation cycles of our major customers. For example, the U.S. government’s fiscal year ends on September 30 of each year, and it is not uncommon for government agencies to award extra tasks or complete other contract actions in the weeks before the end of the fiscal year in order to avoid the loss of unexpended fiscal year funds. Moreover, in years when the U.S. government does not complete its budget process before the end of its fiscal year, government operations typically are funded pursuant to a continuing resolution that authorizes agencies of the U.S. government to continue to operate, but traditionally does not authorize new spending initiatives. When much of the U.S. government operates under a continuing resolution, as occurred during the federal fiscal year ending September 30, 2008, delays can occur in procurement of products and services, and such delays can affect our revenue and profit during the period of delay.

 

Financial Information about Foreign and Domestic Operations and Export Sales

 

For the years ended December 31, 2008, 2007 and 2006, export sales were approximately $47.7 million, $29.0 million, and $14.6 million, respectively. Foreign operations and export sales may increase in relative and

absolute terms in the future due to our increased focus on markets outside the United States. See Note 12 to our consolidated financial statements for additional information.

 

Capital Requirements

 

Our most significant capital requirements arise primarily from acquisitions in support of our business strategy, capital expenditures for new secure credentialing contracts, expenditures for research and development and working capital needs. For example, when we bid on new state drivers’ license contracts, we must commit to provide up front capital expenditures in order to install systems necessary to perform under the contract. The most significant capital expenditures are related to our Secure Credentialing business, which has increased in size and scope due to the acquisition of Old Digimarc. Accordingly, we expect our capital requirements to increase as we bid on and are awarded new contracts or as contracts are renewed. We expect to meet our requirements from operating cash flows, equity issuances and bank borrowings. See Item 7, Liquidity and Capital Resources.

 

On May 17, 2007, we issued $175.0 million of Convertible Notes with a conversion feature which allows us the option to settle the debt either in shares of common stock or to settle the principal amount in cash and the conversion spread in cash or stock. The net proceeds of the Convertible Notes offering, net of deferred financing costs amounted to $168.7 million of which $69.8 million was used to fund the repurchase of our common stock pursuant to a pre-paid forward contract. The remaining net proceeds of the Convertible Notes offering were utilized to repay outstanding indebtedness. The Convertible Notes and the related forward share repurchase transaction are described in “Item 7-Management’s Discussion and Analysis of Results of Operations and Financial Condition-Liquidity.”

 

On August 5, 2008, we entered into a Second Amended and Restated Credit Agreement (the “Credit Agreement”), among L-1 Identity Operating, L-1, Bank of America, N.A., Wachovia Bank, National Association, Banc of America Securities LLC, Wachovia Capital Markets LLC, Royal Bank of Canada, Societe Generale and TD Bank, N.A. to amend and restate the Amended and Restated Credit Agreement, dated October 19, 2006 by and among L-1, Bank of America, N.A. (“Administrative Agent”), Bear Stearns Corporate Lending, Inc., Bear Stearns & Co., Inc., Banc of America Securities LLC, Wachovia Bank, N.A. and Credit Suisse, Cayman Islands Branch. Other lenders under the Credit Agreement include Credit Suisse, Cayman Islands Branch, the Bank of Nova Scotia, CIT Bank and RBS Citizens N.A. The Credit Agreement provides for a senior secured term loan facility in an aggregate principal amount of up to $300.0 million, with a term of five years, and a senior secured revolving credit facility in an aggregate principal amount of up to $135.0 million. The proceeds of the senior secured facilities were used to (i) fund, in part, the purchase price paid, and fees and expenses incurred, in connection with the acquisition of Old Digimarc, (ii) repay our previous revolving credit facility and (iii) provide ongoing working capital and fund other general corporate purposes of L-1. As of December 31, 2008, the Company has approximately $120.5 million, net of outstanding letters of credit of $14.5 million, available under its revolving credit facility, subject to continuing compliance with the covenants contained in the agreement.

 

Under the terms of the senior secured credit facility, the Company has the option to borrow at LIBOR (subject to a floor of 3%) plus 2.75% to 4.5% per annum or at prime (subject to a floor of 2%) plus 1.75% to 3.5% per annum. L-1 is required to pay a fee of 0.5% on the unused portion of the revolving credit facility. The senior secured term loan facility requires quarterly principal payments beginning at 5.0% of the outstanding borrowings under such facility for the initial year, increasing over the duration of the facility. All obligations of L-1 Operating under the Credit Agreement are guaranteed on a senior secured basis by L-1 and by each of L-1’s existing and subsequently acquired or organized direct or indirect wholly-owned subsidiaries (subject to certain exceptions). At December 31, 2008, the variable interest rate was based on three month LIBOR plus 4.5% or 7.5%. Subsequent to December 31, 2008, the interest rate was changed to 6.75%.

Under the terms of the Credit Agreement, we may incur, assume or guarantee unsecured subordinated indebtedness in an amount up to $200.0 million, provided that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and we are in pro forma compliance, after giving effect to the incurrence of such subordinated debt, with each of the covenants in the Credit Agreement. Pursuant to the terms of the Credit Agreement, we may incur, assume or guarantee any amount of unsecured subordinated indebtedness, provided, that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and our pro forma Consolidated Leverage Ratio (as defined in the Credit Agreement) after giving effect to the incurrence of such subordinated debt shall be less than 4.75:1.00. The Credit Agreement limits our ability to (i) pay dividends or other distributions or repurchase capital stock, (ii) create, incur, assume or suffer to exist any indebtedness, (iii) create, incur, assume or suffer to exist liens upon any of its property, assets or revenues, (iv) sell, transfer, license, lease or otherwise dispose of any property, (v) make or become legally obligated to make capital expenditures above certain thresholds, (vi) make investments, including acquisitions, and (vii) enter into transactions with affiliates. These covenants are subject to a number of exceptions and qualifications. The Credit Agreement provides for customary events of default which include (subject in certain cases to customary grace and cure periods), among others: nonpayment, breach of covenants or other agreements in the Credit Agreement or the other Loan Documents (as defined in the Credit Agreement), payment defaults or acceleration of other indebtedness, failure to pay certain judgments, inability to pay debts as they become due and certain events of bankruptcy, insolvency or reorganization. Generally, if an event of default occurs, the Administrative Agent may, with the consent of the Required Lenders (as defined in the Credit Agreement) declare all outstanding indebtedness under the Credit Agreement to be due and payable.

 

Environmental Protection Regulations

 

We believe that our compliance with federal, state and local environmental regulations will not have a material adverse effect on our financial position or results of operations.

 

Employees

 

As of December 31, 2008, we had 2,264 full time employees. None of our employees are covered by collective bargaining agreements. We believe that our relations with our employees are good.

 

Officers

 

Our executive officers are appointed by our Board of Directors and serve until their successors have been duly appointed and qualified.

 

Robert V. LaPenta, 63, has served as the Chairman of the Board since December 2005, President and Chief Executive Officer of L-1 since August 2006. Mr. LaPenta is the founder and Chief Executive Officer of L-1 Investment Partners, LLC, a private investment management firm. From April 1997 to April 2005, Mr. LaPenta served as President, Chief Financial Officer and a Director of L-3 Communications Holdings, Inc., which he co-founded in April 1997. From April 1996, when Loral Corporation was acquired by Lockheed Martin Corporation, until April 1997, Mr. LaPenta was a Vice President of Lockheed Martin and was Vice President and Chief Financial Officer of Lockheed Martin’s Command, Control, Communications and Intelligence and Systems Integration Sector. Prior to the April 1996 acquisition of Loral, he was Loral’s Senior Vice President and Controller, a position he held since 1991. He joined Loral in 1972 and was named Vice President and Controller of its largest division in 1974. He became Corporate Controller in 1978 and was named Vice President in 1979. Mr. LaPenta is on the Board of Trustees of Iona College, the board of directors of Core Software Technologies and the board of directors of Leap Wireless International, Inc.

 

Dr. Joseph Atick, 44, joined L-1 in August 2006 as Executive Vice President and Chief Strategic Officer effective with the merger of Identix with L-1. Prior to that, he served as President & Chief Officer of Identix since June of 2002. Prior to that, he had co-founded one of the original facial recognition companies, Visionics Corporation. Over the years, Dr. Atick co-founded and managed several companies focused on technology transfer and development, and has served as a technical advisor to many high-tech enterprises and

organizations, including NATO. He had also led the Computational Neuroscience Laboratory at Rockefeller University and the Neural Cybernetics Group at the Institute for Advanced Study in Princeton, New Jersey. Dr. Atick holds a Ph.D. in Mathematical Physics from Stanford University.

 

James DePalma, 57, joined L-1 as Executive Vice President, Chief Financial Officer and Treasurer effective with the merger of Identix with L-1. He brings three decades of operational and finance experience in the defense and technology industries to his role within the company. Prior to joining L-1, Mr. DePalma was a founding partner of L-1 Investment Partners. Prior to the formation of L-1 Investment Partners, Mr. DePalma served as a consultant to L-3 Communications Holdings, Inc. and was chief executive officer of Core Software Technology, a leading software provider to the intelligence community and an equity investment of L-3 Communications Holdings, Inc. Mr. DePalma has also held high level executive positions with Westinghouse Electric Corporation, CBS Corporation and Viacom International. He also was a senior partner at PricewaterhouseCoopers.

 

Doni Fordyce, 49, joined L-l as Executive Vice President of Corporate Communications effective with the merger of Identix with L-1. Prior to August 2006, she was a founding partner of L-1 Investment Partners and brings two decades of senior executive and investment management experience to the company, serving most recently as chief executive officer, president and chief operation officer of Bear Stearns Asset Management (BSAM) Inc. Prior to that Ms. Fordyce was vice president of Goldman Sachs Inc. from 1986 to 1996 where she was one of the founders of the asset management business. She has also worked in IT solutions consulting, specializing networking, data management and printing for investment banks and financial institutions.

 

Mark S. Molina, 49, joined L-1 in August 2006 as Executive Vice President, Chief Legal Officer and Secretary in August 2006 effective with the merger of Identix with L-1. Prior to joining L-1, he was Executive Vice President, Chief Legal Officer and Secretary at Identix, which he joined as Vice President and General Counsel in 1999. Mr. Molina is a business and technology lawyer with over 20 years experience structuring and negotiating mergers, acquisition, dispositions, joint ventures, technology licenses, financings and investments. He has considerable experience with public offerings and private placements as well as SEC reporting compliance and obligations of publicly traded companies.

 

Joseph Paresi, 53, joined L-1 in August 2006 as Executive Vice President and Chief Marketing Officer effective with the merger of Identix with L-1. He was a founding partner of L-1 Investment Partners LLC. Mr. Paresi brings three decades of executive management, product development, and design engineering experience in the technology and defense industries to his role with the company. Prior to joining L-1 Investment Partners, he served as corporate vice president of product development for L-3 Communications and as president of L-3 security & Detection Systems from 1997 to 2005.

 

Vincent A. D’Angelo, 64, joined L-1 as Senior Vice President of Finance in August 2006 effective with the merger of Identix with L-1. Prior to that, he was a consultant for L-1 Investment Partners. Prior to that, Mr. D’Angelo was a senior audit partner with PricewaterhouseCoopers for more than 35 years where he was involved in all facets of the business, including client service, management, operations, governance, SEC filings, and mergers and acquisitions.

 

There are no family relationships among any of our executive officers and directors.

 

On April 23, 2007, the Company entered into an employee arrangement with Mr. Robert LaPenta, Jr., the son of the Company’s Chief Executive Officer, to serve as Vice President, M&A/Corporate Development.

 

L-1’s Internet Website

 

We maintain a corporate website with the address www.L1id.com. We intend to use our website as a regular means of disclosing material non-public information and for complying with our disclosure obligations under Regulation FD promulgated by the SEC. Such disclosures will be included on our website under the heading “Investor Relations — Events and Presentations.” Accordingly, investors should monitor such portions of our website, in addition to following our press releases, SEC filings and public conference calls and webcasts. We are not incorporating information contained in our website by reference into this Annual Report on Form 10-K. We make available, free of charge through our website, our Annual Reports on Form 10-K,

Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments to these reports as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. You may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the Public Reference Room. The SEC also maintains a website, www.sec.gov containing the reports, proxy and other information we file with the SEC.

 

 

This Annual Report on Form 10-K contains or incorporates a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that we or our management “believe”, “expect”, “anticipate”, “plan” and similar expressions) that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with our consolidated financial statements and notes to consolidated financial statements included in this report. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause our actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties, including those not presently known to us or that we currently deem immaterial, may also impair our business. We expressly disclaim any obligation to update any forward-looking statements, except as may be required by law.

 

Risks Related to Our Business

 

We have a history of operating losses.

 

We have a history of operating losses. Our business operations began in 1993 and, except for 1996 and 2000, have resulted in pre-tax operating losses in each year, which in 2006, 2007 and 2008, include significant asset impairments and merger related expenses, amortization of intangible assets and stock-based compensation expense. At December 31, 2008, we had an accumulated deficit of approximately $618.5 million.

 

We derive over 90% of our revenue from government contracts, which are often non-standard, involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue.

 

More than 90% of our business involves providing solutions and services under contracts with U.S. Federal, state, local and foreign government agencies. Obtaining contracts from government agencies is challenging and government contracts often include provisions that are not standard in commercial transactions. For example, government contracts may:

 

 

Securing government contracts can be a protracted process involving competitive bidding. In many cases, unsuccessful bidders may challenge contract awards, which can lead to increased costs, delays and possible loss of the contract for the winning bidder. Protests, and similar delays, regarding any future government contracts of a material nature that may be awarded to us could result in materially adverse revenue volatility,

making management of inventory levels, cash flows and profitability inherently difficult. Outright loss of any material government contract through the protest process or otherwise, could have a material adverse effect on our financial results and stock price.

 

In addition, government contracts may specify performance criteria that must be satisfied before the customer accepts the products and services. Collection of accounts receivable may be dependent on meeting customer requirements, which may be unpredictable, subject to change by the customer, and not fully understood by us at the time of acceptance of the order, and may require the incurrence of unexpected costs that may be uncompensated and could negatively affect profit margins and our liquidity.

 

Our government contracts are subject to continued appropriations by Congress and availability of funding for state and local programs. Reduced funding could result in terminated or delayed contracts and adversely affect our ability to meet our sales and earnings goals.

 

For the year ended December 31, 2008, U.S. Federal Government agencies, directly or indirectly, accounted for 64% of our consolidated revenues. For the year ended December 31, 2007, U.S. Federal Government agencies, directly or indirectly accounted for 69% of our consolidated revenues. Future sales under existing and future awards of U.S. government contracts are conditioned upon the continuing availability of Congressional appropriations, which could be affected by current or future economic conditions.

 

Similar to federal government contracts, state and local government agency contracts may be contingent upon availability of funds provided by federal, state or local entities. In the current economic environment, many states may reduce expenditures which may result in cancellation or deferral of projects. State and local law enforcement and other government agencies are subject to political, budgetary, purchasing and delivery constraints which may result in quarterly and annual revenue and operating results that may be irregular and difficult to predict. Such revenue volatility makes management of inventory levels, cash flows and profitability inherently difficult. In addition, if we are successful in winning such procurements, there may be unevenness in shipping schedules, as well as potential delays and changes in the timing of deliveries and recognition of revenue, or cancellation of such procurements.

 

We may not realize the full amount of revenues reflected in our backlog, which could harm our operations and significantly reduce our future revenues.

 

There can be no assurances that our backlog estimates will result in actual revenues in any particular fiscal period because our clients may modify or terminate projects and contracts and may decide not to exercise contract options or the estimate of quantities may not materialize. Our backlog represents sales value of firm orders for products and services not yet delivered and, for long term executed contractual arrangements (contracts, subcontracts, and customer’s commitments), the estimated future sales value of estimated product shipments, transactions processed and services to be provided over the term of the contractual arrangements, including renewal options expected to be exercised. For contracts with indefinite quantities backlog reflects estimated quantities based on current activity levels. Our backlog includes estimates of revenues that are dependent on future government appropriation, option exercise by our clients and/or is subject to contract modification or termination. Due to current economic environment and potential spending constraints experienced by state and local governments, in particular, realization of our backlog may be adversely impacted. At December 31, 2008, our backlog approximated $1.1 billion, of which approximately $520.0 million is expected to be realized in 2009. Revenues from backlog, together with other recurring revenues not in backlog approximate $620.0 million or 84% of 2009 revenues. These estimates are based on our experience under such contracts and similar contracts, and we believe such estimates to be reasonable in the circumstances. However, we believe that the estimate of revenues reflected in our backlog for the following twelve months will generally be more reliable than our estimate for periods thereafter. If we do not realize a substantial amount of our backlog, our operations could be harmed and our expected future revenues could be significantly reduced.

Our quarterly results are difficult to predict, and if we miss quarterly financial expectations, our stock price could decline.

 

Our quarterly revenue and operating results are difficult to predict and fluctuate from quarter to quarter. Our operating results in some periods may be below or above the guidance we provide and may not meet investor expectations. If this happens, the market price of our common stock could be adversely impacted. Fluctuations in our future quarterly operating results may be caused by many factors, including:

 

 

We have a long sales cycle, which can result in significant revenue fluctuations between periods.

 

The sales cycle for our solutions and services is typically long and subject to a number of significant risks over which we have little control. As our operating expenses are based on anticipated revenue levels, fluctuations in the revenues as a result of the timing of contract awards and the exercise of options and task orders can cause our operating results to vary significantly between periods. If revenue falls significantly below anticipated levels, our business and the market price of our stock would be negatively impacted.

 

Purchasing decisions for our solutions and services may be subject to delay due to many factors that are outside of our control, such as:

 

 

We may be unable to obtain additional capital required to finance our growth and our acquisition strategy may be adversely affected by the current volatile market conditions.

 

Our strategy includes growth of our business through strategic acquisitions. In addition, the installation of our secure credentialing systems requires significant capital expenditures. Our need to fund such expenditures has increased following our acquisition of Old Digimarc. During 2008, our expenditures increased to $22.5 million and are expected to increase in 2009. At December 31, 2008, we had cash and cash equivalents of $20.4 million and availability under our line of credit of $120.5 million, subject to continuing compliance with covenants contained in the agreement. While we believe we have adequate capital resources to meet current working capital and capital expenditure requirements and have been successful in the past in obtaining financing for capital expenditures, and acquisitions, we expect to have increased capital needs as we continue to expand our business. In addition, our ability to execute on our acquisition strategy may be adversely affected by the current volatile market conditions, which may continue over a prolonged period. We may be unsuccessful in raising additional financing to fund growth or we may have difficulty in obtaining financing at attractive rates or on terms that are not excessively dilutive to existing stockholders. Failure to secure additional financing in a timely manner and on favorable terms could have a material adverse effect on our

growth strategy, financial performance and stock price and could require us to delay or abandon our expansion plans.

 

We are subject to government regulation, and our failure to comply with applicable regulations could subject us to penalties that may restrict our ability to conduct our business.

 

We are affected by and must comply with various government regulations that impact our operating costs, profit margins and the internal organization and operation of our business. Our failure to comply with applicable regulations, rules and approvals could result in the imposition of penalties, the loss of our government contracts or our disqualification as a U.S. Government contractor, all of which could adversely affect our business, financial condition and results of operations. Among the most significant regulations affecting our business are:

 

 

These regulations affect how we and our customers do business and, in some instances, impose added costs on our business. Any changes in applicable laws and regulations could restrict our ability to conduct our business. Any failure by us to comply with applicable laws and regulations could result in contract termination, price or fee reductions or suspension, debarment or disqualification from contracting with the federal, state and local governments.

 

Biometric technologies have not yet achieved widespread commercial acceptance and our strategy of expanding our biometric business could adversely affect our business operations and financial condition.

 

Part of our strategy is to enhance our leadership in biometric technologies. Pursuing this strategy involves risks. For instance, to date, biometric technologies have not yet gained widespread commercial acceptance. Although there has been more commercial activity recently, there is no assurance that this activity will continue or expand. Some of the obstacles to the use of biometric technologies include a perceived loss of privacy and public perceptions as to the usefulness of biometric solutions. Whether the market for biometric technologies and solutions will expand will be dependent upon factors such as:

 

 

 

We do not know when, if ever, biometric solutions and services will gain widespread commercial acceptance. Certain groups have publicly objected to the use of biometric solutions and services for some applications on civil liberties grounds and legislation has been proposed to regulate the use of biometric security solutions. From time to time, biometric technologies have been the focus of organizations and individuals seeking to curtail or eliminate such technologies on the grounds that they may be used to diminish personal privacy rights. If such initiatives result in restrictive legislation, the market for biometric solutions may be adversely affected. Even if biometric technologies gain wide market acceptance, our biometric solutions and services may not adequately address the requirements of the market and may not gain widespread commercial acceptance.

 

We face intense competition, which could result in lower revenues and higher research and development expenditures and could adversely affect our results of operations.

 

The events of September 11, 2001 and subsequent regulatory and policy changes in the U.S. and abroad have heightened interest in the use of biometric security solutions, and we expect competition in this field, which is already substantial, to intensify. Competitors are developing and marketing semiconductor ultrasonic and optically based direct contact fingerprint image capture devices, or retinal blood vessel, iris pattern, hand geometry, voice or various types of facial structure solutions. Among these companies are Cognitec Systems Corporation, CrossMatch Technologies, Imageware Systems, Inc., SAGEM Morpho Inc., NEC Corporation, Cogent, Inc. and Ultra-Scan Corporation. Our solutions also compete with non-biometric technologies which may be less costly, such as certificate authorities and traditional keys, cards, surveillance systems and passwords. Widespread adoption of one or more of these technologies or approaches in the markets we target could significantly reduce the potential market for our systems and solutions. Some of our competitors have significantly more resources than we have. Our competitors may introduce products that are more price competitive, have increased performance or functionality or incorporate technological advances that we have not yet developed or implemented. To remain competitive, we must continue to develop, market and sell new and enhanced solutions at competitive prices, which will require significant research and development expenditures. If we do not develop new and enhanced solutions or if we are not able to invest adequately in their research and development activities, our business, financial condition and results of operations could be severely and negatively impacted.

 

Unless we keep pace with changing technologies, we could lose existing customers and fail to win new customers.

 

In order to compete effectively in the biometrics market, we must continually design, develop and market new and enhanced products. Our future success will depend, in part, upon our ability to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometric industry require assessments to be made of the future directions of technology and technology markets generally, which are inherently risky and difficult to predict. We may not be able to accurately predict which technologies our customers will support. If we fail to choose correctly among technical directions, or we fail to offer innovative solutions at competitive prices in a timely manner, customers may forego purchases of our solutions and purchase those of our competitors.

 

Security breaches in systems that we sell or maintain could result in the disclosure of sensitive government information or private personal information that could result in the loss of customers and negative publicity.

 

Many of the systems included in the solutions we sell manage private personal information and protect information involved in sensitive government functions. The protective security measures that we use in these

systems may not prevent security breaches, and failure to prevent security breaches may disrupt our business, damage our reputation, and expose us to litigation and liability. A party who is able to circumvent protective security measures used in these systems could misappropriate sensitive or proprietary information or cause interruptions or otherwise damage our products, services and reputation, and the property and privacy of our customers. If unintended parties obtain sensitive data and information, or create bugs or viruses or otherwise sabotage the functionality of our systems, we may receive negative publicity, incur liability to our customers or lose the confidence of our customers, any of which may cause the termination or modification of our contracts. Further, our insurance coverage may be insufficient to cover losses and liabilities that may result from such events.

 

We may be required to expend significant capital and other resources to protect ourselves against the threat of security breaches or to alleviate problems caused by the occurrence of any such breaches. In addition, protective or remedial measures may not be available at a reasonable price or at all, or may not be entirely effective.

 

Our reliance on external suppliers and contract manufacturers may result in delays and loss of sales or customers.

 

The lead-time for ordering certain of products and materials and for building many of our products included in our solutions can be many months. As a result, we must order such products and materials based on forecasted demand. If demand for our solutions lags significantly behind our forecasts, we may purchase more products than we can sell, which can result in increased cash needs and write-downs of obsolete or excess inventory. In addition, if the delivered product purchases are delayed, we may lose customers and sales.

 

We rely on contract manufacturers to produce our hardware products under short term manufacturing arrangements. Although we believe we can find alternative sources of manufacturing our hardware, any disruption of contractual arrangements could result in delaying deliveries or in the loss our sales. We obtain certain hardware and services, as well as software applications, from a limited group of suppliers. Our reliance on these suppliers involves risks, including reduced control over quality and delivery schedules. Any financial instability of our suppliers could result in our having to find new suppliers. We may experience delays in manufacturing and deliveries of our products and services to customers if we lose our sources or if supplies and services delivered from these sources are delayed, which could result in the loss of sales or customers.

 

The market for our solutions is still developing and if the biometrics industry adopts standards or a platform different from our platform, then our competitive position would be negatively affected.

 

The market for identity solutions is still developing. The evolution of this market may result in the development of different technologies and industry standards that are not compatible with our current solutions, products or technologies. Several organizations, such as the International Civil Aviation Organization, sets standards for travel documents that its member states then put into effect, and the National Institute for Standards and Testing, which is part of the U.S. Department of Commerce, set standards for biometrics to be used in identification and documentation. Although we believe that our biometric technologies comply with existing standards for finger, face and iris recognition, these standards may change and any standards adopted could prove disadvantageous to or incompatible with our business model and current or future solutions, products and services.

 

Our plan to pursue sales in international markets may be limited by risks related to conditions in such markets.

 

In the year ended December 31, 2008, we derived approximately 8% of our total revenues from international sales and our strategy is to expand our international operations. However, there is a risk that we may not be able to successfully market, sell and deliver our products in foreign countries.

Risks inherent in marketing, selling and delivering products in foreign and international markets could have a severe negative impact on our financial results and stock price, include those associated with:

 

 

We expect that we will have increased exposure to foreign currency fluctuations. For example during the year ended December 31, 2008, we recorded foreign currency translation losses of $6.6 million, primarily related to goodwill and long-lived assets related to foreign acquisitions, in accumulated other comprehensive income. In addition, we have significant Japanese Yen denominated transactions with Japanese suppliers of hardware and consumables for the delivery to customers under certain contracts. In addition, we have exposure to fluctuations to the Euro, Canadian dollar and the Mexican Peso as a result of operations conducted in such countries, which could result in unexpected fluctuations to our results of operations, which could be material and adverse.

 

If we do not successfully expand our direct sales and services organizations and partnering arrangements, we may not be able to increase our sales or support our customers.

 

We sell substantially all of our services and license substantially all of our products through our direct business development and sales organization. Our future success depends on substantially increasing the size and scope of our direct business development and sales force and partnering arrangements, both domestically and internationally. We will face intense competition for personnel, and we cannot guarantee that we will be able to attract, assimilate or retain additional qualified business development and sales personnel on a timely basis. Moreover, given the large-scale deployment required by some of our customers, we will need to hire and retain a number of highly trained customer service and support personnel. We cannot guarantee that we will be able to increase the size of our customer service and support organization on a timely basis to provide the high quality of support required by our customers. The ability to add additional business development and sales and customer service personnel could result in customer dissatisfaction and loss of customers.

 

We rely in part upon system integrators original equipment manufacturers, or OEM, and distribution partners to sell some of our solutions, technologies and services, and we may be adversely affected if those parties do not actively promote their products or pursue installations that do not use our solutions, technologies and services.

 

A portion of our revenue comes from sales to partners including OEMs, systems integrators, distributors and resellers. Some of these relationships have not been formalized in a detailed contract, and may be subject to termination at any time. Even where these relationships are formalized in a detailed contract, the agreements can often be terminated with little or no notice and subject to periodic amendment.

 

We intend to continue to seek strategic relationships to distribute, license and sell certain of our products. We, however, may not be able to negotiate acceptable relationships in the future and cannot predict whether current or future relationships will be successful.

If our solutions systems and products are not timely delivered or do not perform as promised, we could experience increased costs, lower margins, liquidated damage payment obligations and reputational harm.

 

We often provide complex systems that are required to operate in difficult or sensitive circumstances. The development of such complex systems may be subject to delays or failure to meet performance requirements to customer specifications. The negative effects of any delay or failure to deliver to meet performance requirements could be exacerbated if the delay or failure occurs in systems that provide personal security, secure sensitive computer data, authorize significant financial transactions or perform other functions where a security breach could have significant consequences. If a product launch is delayed or is the subject of an availability shortage because of problems with our ability to manufacture or assemble the product successfully on a timely basis, or if a product or service otherwise fails to meet performance criteria, we may lose revenue opportunities entirely and/or experience delays in revenue recognition associated with a product or service in addition to incurring higher operating expenses during the period required to correct the defects.

 

There is a risk that for unforeseen reasons we may be required to repair or replace a substantial number of systems in use or to reimburse customers for systems that fail to work or meet strict performance criteria. From time to time, in certain critical or complex sale or licensing transactions, we may be compelled to accept liability provisions that vary from our preferred contracting model. There is a risk that in certain contracts and circumstances we may not be successful in adequately minimizing our product and related liabilities or that the protections we negotiate will not ultimately be deemed enforceable. We carry product liability insurance, but existing coverage may not be adequate to cover potential claims. Although we will deploy back-up systems, the failure of our products to perform as promised could result in increased costs, lower margins, liquidated damage payment obligations and harm to our reputation. This could result in contract terminations and have a material adverse effect on our business and financial results.

 

Failure to maintain the proprietary nature of our technology, intellectual property and manufacturing processes could have a material adverse effect on our business and our ability to compete effectively.

 

We principally rely upon patent, trademark, copyright, trade secret and contract law to establish and protect our proprietary rights. There is a risk that claims allowed on any patents or trademarks we hold may not be broad enough to protect our technology. In addition, our patents or trademarks may be challenged, invalidated or circumvented and we cannot be certain that the rights granted there under will provide competitive advantages to us. Moreover, any current or future issued or licensed patents, or trademarks, or currently existing or future developed trade secrets or know-how may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of our already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others. In addition, there is a risk that others may independently develop proprietary technologies and processes, which are the same as, substantially equivalent or superior to ours, or become available in the market at a lower price.

 

We may be required to expend significant resources to monitor and protect our intellectual property rights. We may have to litigate to enforce our patents or trademarks or to determine the scope and validity of other parties’ proprietary rights. Litigation could be very costly and divert management’s attention. An adverse outcome in any litigation may have a severe negative effect on our financial results and stock price. To determine the priority of inventions, we may have to participate in interference proceedings declared by the United States Patent and Trademark Office or oppositions in foreign patent and trademark offices, which could result in substantial cost and limitations on the scope or validity of our patents or trademarks.

 

In addition, foreign laws treat the protection of proprietary rights differently from laws in the United States and may not protect our proprietary rights to the same extent as U.S. laws. The failure of foreign laws or judicial systems to adequately protect our proprietary rights or intellectual property, including intellectual property developed on our behalf by foreign contractors or subcontractors may have a material adverse effect on our business, operations, financial results and stock price.

Legal claims regarding infringement by us or our suppliers of third party intellectual property rights could result in substantial costs, diversion of managerial resources and harm to our reputation.

 

Although we believe that our solutions, products and services do not infringe currently existing and validly issued intellectual property rights of others, we might not be able to defend successfully against a third-party infringement claim. A successful infringement claim against us, our customers or our suppliers could subject us to:

 

 

Our failure to prevail against any third party infringement claim could have a material adverse effect on our business and financial results. Even if we are not found liable in a claim for intellectual property infringement, such a claim could result in substantial costs, diversion of resources and management attention, termination of customer contracts and harm to our reputation.

 

We are dependent on a small number of individuals, and if we lose key personnel upon whom we are dependent, our business will be adversely affected.

 

Much of our future success depends on the continued service and availability of our senior management, including our Chairman of the Board, President and Chief Executive Officer, Robert V. LaPenta, and other members of our executive team. These individuals have acquired specialized knowledge and skills with regards to advanced technology identity solutions. The loss of any of these individuals could severely harm our business. Our business is also highly dependent on our ability to retain, hire and motivate talented highly skilled personnel. Experienced personnel in the advanced technology identity solutions industry are in high demand and competition for their talents are intense. If we are unable to successfully attract, retain and motivate key personnel, our business may be severely harmed.

 

If we fail to recruit and retain skilled employees or employees with the necessary security clearances, we might not be able to perform under our government services contracts or win new business.

 

To be competitive, we must have employees who have advanced information technology and technical services skills and who work well with our customers in a government or defense-related environment. Often, these employees must have some of the highest security clearances in the United States. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. If we are unable to recruit and retain a sufficient number of these employees, our ability to maintain and grow our business could be negatively impacted. In addition, some our government services contracts contain provisions requiring us to commit to staff a program with certain personnel the customer considers key to our successful performance under the contract. In the event we are unable to provide these key personnel or acceptable substitutions, the customer may terminate the contract, and we may not be able to recover certain incurred costs.

 

Certain of our shareholders have significant relationships with us, which could result in it taking actions that are not supported by unaffiliated shareholders.

 

In connection with the Aston investment in our Company, Aston became the largest shareholder of L-1, currently owning approximately 8.8% of our outstanding common stock. As a result, Aston (together with its affiliate, L-1 Investment Partners LLC) have an influence on matters requiring approval by our shareholders,

including the election of directors and most corporate actions, such as mergers and acquisitions. In addition, we have significant relationships with each of L-1 Investment Partners LLC and Aston including:

 

 

The concentration of large percentages of ownership in any single shareholder, or in any series of single shareholders, may delay or prevent change in control of the Company. Additionally, the sale of a significant number of our shares in the open market by single shareholders or otherwise could adversely affect our stock price.

 

Risks Related to Our Acquisition Strategy

 

Integration of recently acquired businesses may be difficult to achieve and will consume significant financial and managerial resources, which may adversely affect operations.

 

Our operating philosophy is to let acquired businesses operate in autonomous manner subject to corporate oversight but integrating and rationalizing duplicative functions to achieve revenue and cost synergies. We may encounter substantial difficulties, costs and delays in integrating the operations recently acquired and future acquisitions such as:

 

 

The geographic distance between acquired businesses and their respective offices and operations increases the risk that the integration will not be completed successfully or in a timely and cost-effective manner. We

may not be successful in overcoming these risks or any other problems encountered in connection with the integration of the companies. The simultaneous integration of these acquisitions may place additional strain on our resources and increase the risk that our business may be adversely affected by the disruption caused by the acquisitions. Our strategy contemplates acquiring additional businesses, the integration of which may consume significant financial and managerial resources, and could have a severe negative impact on our business, financial condition and results of operations.

 

Our acquisitions could result in future impairment and other charges which could adversely affect our results of operations.

 

At December 31, 2008, goodwill, intangible assets and property and equipment of $891.0 million, $108.3 million and $81.3 million, respectively and in 2008, we recorded impairment charges aggregating $528.6 million for impairments of goodwill and long-lived assets, primarily related to our biometric businesses. Because goodwill represents a residual after the purchase price is allocated to the fair value of acquired assets and liabilities, it is difficult to quantify the factors that contribute to the recorded amounts and subsequent impairments, if any. Nevertheless, management believes that the following factors have contributed to the amount recorded:

 

 

The recorded amounts at the purchase date for goodwill and other intangible assets are estimates at a point in time and are based on valuations and other analyses of fair value that require significant estimates and assumptions about future events, including but not limited to projections of revenues, market growth, demand, technological developments, political developments, government policies, among other factors, which are derived from information obtained from independent sources, as well as the management of the acquired businesses and our business plans for the acquired businesses or intellectual property. If estimates and assumptions used to initially record goodwill and intangible assets do not materialize, or unanticipated adverse developments or events occur, ongoing reviews of the carrying amounts of such goodwill and intangible assets may result in impairments which will require us to record a charge in the period in which such an impairment is identified, and could have a severe negative impact on its business and financial statements.

 

Subsequent to December 31, 2008 through February 25, 2009 our stock price has averaged $6.67 per share compared $6.24 per share for the 60 days prior to December 31, 2008. However during both periods the price has fluctuated significantly. If our stock price were to decrease and remain and that level for a sustained period of time we may be required to assess the carrying amount of goodwill and long-lived assets of our reporting units before our scheduled annual impairment test. If at that time the estimated fair values of our reporting units are less than their respective carrying amounts, we would need to determine whether our goodwill and long-lived assets would be impaired. Moreover, if economic conditions continue to deteriorate and capital markets conditions continue to adversely impact the valuation of enterprises, the estimated fair values of our reporting units could be adversely impacted, which could result in future impairments.

 

If we do not achieve the expected benefits of the acquisitions we have made, the price of our common stock could decline.

 

We expect that the acquisitions that we consummated in 2006, 2007 and 2008 as well as the acquisitions that we have made previously will enhance our leadership in the identity solutions industry through the combination of their respective technologies. However, the combination of such technologies might not meet the demands of the marketplace. If our technologies fail to meet such demand, customer acceptance of our biometric products could decline, which would have an adverse effect on our results of operations and financial condition. Further, we expect that the additions to our solutions offerings will extend our reach into

our current markets and provide a critical component to our comprehensive offering for new markets in need of identity solutions. However, there can be no assurance that our current customers or customers in new markets will be receptive to these additional offerings. Further, we might not be able to market successfully our products and services to the customers of the companies we acquired. If our solutions offerings and services fail to meet the demands of this marketplace, our results of operations and financial condition could be adversely affected. There is also a risk that we will not achieve the anticipated benefits of the acquisitions as rapidly as, or to the extent, anticipated by financial or industry analysts, or that such analysts will not perceive the same benefits to the acquisitions as we do. If these risks materialize, our stock price could be adversely affected.

 

 

None

 

We do not own any properties. The following describes our most significant leasing arrangements.

 

Our corporate headquarters comprises approximately 17,000 square feet of space in facilities located in Stamford, Connecticut. We sublease space from L-1 Investment Partners LLC. The sublease terminates on the earlier of the date that the Company’s Chairman and Chief Executive Officer ceases employment with the Company or March 2010. We use this property for corporate, administrative, customer support and other general business needs. 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.

 

While we believe that these facilities are adequate to meet our immediate needs, it may become necessary to secure additional space in the future to accommodate any future growth. We believe that such additional space will be available as needed in the future on commercially reasonable terms.

 

Old Digimarc Litigation

 

In connection with the Company’s August 2008 acquisition of Old Digimarc, which consisted of its Secure ID Business following the spin-off of its digital watermarking business, the Company assumed certain legal proceedings of Old Digimarc, renamed L-1 Secure Credentialing , Inc., as described below.

 

In 2004, three purported class action lawsuits were filed in the U.S. District Court for the District of Oregon against Old Digimarc and certain of its then-current and former directors and officers on behalf of purchasers of Old Digimarc’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 restatement of Old Digimarc’s financial statements for 2003 and the first two quarters of 2004 and alleged that Old Digimarc issued false and misleading financial statements and issued misleading public statements about its operations and prospects. On August 4, 2006, the court granted Old Digimarc’s motion to dismiss the lawsuit with prejudice and entered judgment in Old Digimarc’s favor. The plaintiffs appealed to the Ninth Circuit Court of Appeals. The appeal was fully briefed, and oral argument was held before a three-judge panel on August 26, 2008. The Ninth Circuit affirmed the dismissal on January 12, 2009.

 

On or about October 19, 2004, two purported shareholder derivative lawsuits were filed against certain of Old Digimarc’s then-current officers and directors, naming Old Digimarc 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 the identified officers and directors breached their fiduciary duties to Old Digimarc’s stockholders and to Old Digimarc. The complaint is derivative in nature and does not seek relief from Old Digimarc. Old Digimarc’s then-current board of directors appointed an independent committee to investigate the claims asserted in this derivative lawsuit. On July 19, 2005, the court granted Old Digimarc’s motion to dismiss 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, the defendants filed a motion to dismiss these complaints for lack of subject matter jurisdiction and failure to state a claim. In May of 2006, Old Digimarc’s then-current board committee, after completing its investigation, concluded that pursuit of the allegations would not be in the best interests of Old Digimarc or its stockholders. On August 24, 2006, the court granted the defendants’ motion and dismissed the lawsuit with prejudice. The plaintiffs appealed to the Ninth Circuit Court of Appeals. The appeal was fully briefed, and oral argument was held before a three-judge panel on August 26, 2008. On December 11, 2008, the Ninth Circuit upheld the district court’s holding that there is no right of private action under Section 304 of Sarbanes-Oxley. However, they reversed the district court’s holding that Old Digimarc should be re-aligned as a plaintiff, and remanded the case to the district court for further proceedings. Subsequently, the plaintiffs agreed to an order and stipulation of dismissal with prejudice, given that plaintiffs are no longer shareholders of Digimarc. On January 29, 2009 the Chief Judge signed and entered the order and the case was dismissed with prejudice.

 

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 Old Digimarc, and their officers and directors and underwriters as defendants in connection with the initial public offerings of these companies. 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 Old Digimarc’s initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements in Old Digimarc’s initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of Old Digimarc’s stock in the aftermarket subsequent to the initial public offering. Old Digimarc 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. The plaintiffs have continued to litigate their claims primarily against the underwriter defendants. The district court directed that the litigation proceed within a number of “focus cases” rather than in all of the 309 cases that have now been consolidated. Old Digimarc was not one of these focus cases. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court’s class certification decision for the six focus cases. On August 14, 2007, the plaintiffs filed their second consolidated amended class action complaints against the focus cases and on September 27, 2007, again moved for class certification. On November 12, 2007, certain of the defendants in the focus cases moved to dismiss the second consolidated amended class action complaints. The court issued an opinion and order on March 26, 2008, denying the motion to dismiss except as to Section 11 claims raised by those plaintiffs who sold their securities for a price in excess of the initial offering price and those who purchased outside the previously certified class period. The class certification motion was withdrawn without prejudice on October 10, 2008.

 

On October 10, 2007, an Old Digimarc stockholder filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted as lead underwriters for the Old Digimarc initial public offering. The complaint, which also named Old Digimarc as a nominal defendant but did not assert any claims against Old Digimarc, asserted claims against the underwriters under Section 16(b) of the Securities Exchange Act of 1934 for recovery of alleged short-swing profits on trades of Old Digimarc stock. On February 28, 2008, an amended complaint was filed, with Old Digimarc still named only as a nominal defendant. Similar complaints have been filed by this same plaintiff against a number of other issuers in connection with their initial public offerings, and the factual allegations are closely related to the allegations in the litigation pending in the United States District Court for the Southern District of New York which is described above in this Form 10-K. On July 25, 2008, Old Digimarc joined with 29 other issuers to file the Issuer Defendants’ Joint Motion to Dismiss. On that same date, the Underwriter Defendants also filed a Joint Motion to Dismiss. Plaintiff filed her oppositions to the motions on September 8, 2008. Replies in support of the motions were filed on or about October 23, 2008, and oral arguments were heard on January 16, 2009. The Judge has stayed discovery until a ruling is rendered on all motions to dismiss.

 

Other

 

In accordance with SFAS No. 5, Accounting for Contingencies, the Company records a liability for any claim, demand, litigation and other contingency when management believes that it is both probable that a liability has been incurred and can reasonably estimate the amount of the potential loss. Based on current information and belief, the Company believes it has adequate provisions for any such matters. The Company reviews these provisions quarterly and adjusts these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular matter. However, because of the inherent uncertainties of litigation (including the Old Digimarc litigation described above) the ultimate outcome of litigation cannot be accurately predicted by the Company; it is therefore possible that the consolidated financial position, results of operations or cash flows of the Company could be materially adversely affected in any particular period by the unfavorable resolution of one or more of these matters and contingencies.

 

LG Settlement

 

On May 1, 2008, the Company settled its breach of contract and intellectual property litigation with LG Electronics USA, Inc. (“LG USA”) and LG Electronics, Inc. (“LG”) which was based on a historical dispute with Iridian Technologies Inc. (“Iridian”), a wholly owned subsidiary of the Company acquired in August 2006. The settlement resolved all historical issues and disputes among the parties and dismissed with prejudice the litigation in the U.S. District Court for the District of New Jersey. Concurrently with the settlement, LG and LG USA entered into a new license agreement with Iridian to license Iridian’s proprietary 2pi iris recognition software, and LG USA entered into a separate agreement to obtain certain limited telephonic assistance for a period of twelve months from Iridian and L-1. In addition, Iridian agreed to assign to LG USA its “IRIS ACCESS” trademark which was determined to have minimal value to the Company.

 

 

None.

 

 

Market for Our Common Stock

 

Our common stock is traded on the New York Stock Exchange under the symbol “ID.” As of February 24, 2009, there were 813 holders of record of our common stock.

 

The quarterly high and low sales prices, as reported by the New York Stock Exchange or NASDAQ, as applicable, of our common stock during 2008 and 2007 were as follows:

 

 

Dividend Policy

 

We paid no dividends in 2008 or 2007. We presently intend to retain our cash for use in the operation and expansion of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. In addition, we are prohibited from paying dividends pursuant to our revolving credit agreement.

 

Recent Sales of Unregistered Securities

 

None.

 

Repurchases of Common Stock

 

None.

Stock Performance Chart

 

The following performance chart assumes an investment of $100 on December 31, 2003 and compares the change through December 31, 2008 in the market price for our common stock with the Russell 2000 Index, the NASDAQ Composite Index, and a peer group identified by the Company (the “Selected Peer Group Index”). The Selected Peer Group Index was selected to include publicly-traded companies engaging in one or more of the Company’s lines of business.

 

The Selected Peer Group Index is weighted according to the respective issuer’s stock market capitalization and is comprised of the following companies: CACI International, Inc., Cogent, Inc., LaserCard Corporation, AcitvIdentity Corporation, Bio-Key International and ImageWare Systems, Inc.

 

The Selected Peer Group replaces the previous peer group, which consisted of Cogent, Inc. LaserCard Corporation, ImageWare Systems, Inc, which continue to be included in the Selected Peer Group, and Saflink Corporation, Digimarc Corporation and Bioscrypt, Inc. , which are no longer public companies.

 

The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.

 

Stock Performance Chart

 

 

 

The financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements as of December 31, 2008 and 2007 and for each of the three years in the period ended December 31, 2008 and the related notes included elsewhere in this Annual Report on Form 10-K. The historical results of operations are not necessarily indicative of future results.

 

 

 

 

 

Introduction

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes thereto included in “Item 8. Financial Statements and Supplementary Data”of this Annual Report on Form 10-K.

 

Business Overview

 

L-1 Identity Solutions, Inc. provides identity protection solutions that enable governments, law enforcement agencies and businesses to enhance security, reduce identity theft, and protect personal privacy. Our solutions are specifically designed for the identification of people and include secure credentialing, biometrics, automated document authentication, real-time identity databases, automated testing of identity and identity information, and biometrically-enabled background checks, as well as systems design, development, integration and support services. These identity solutions enable our customers to manage the entire life cycle of an individual’s identity for a variety of applications including civil identification, criminal identification, border management, anti-terrorism, and security. The Company also provides comprehensive consulting, training, security, technology development and information technology solutions to the U.S. intelligence community.

 

The Company’s identity solutions include products and related services, comprising of hardware, components, consumables and software, as well as maintenance, consulting and training services integral to the sale of hardware and software. In addition, the Company provides fingerprinting enrollment services and government consulting, training, security, technology development and information technology services. A customer, depending on its needs, may order solutions that include hardware, equipment, consumables, software products or services or combine hardware products, consumables, equipment, software products and services to create a multiple element arrangement.

 

The market for identity solutions has continued to develop. In particular, consumers of identity protection solutions are demanding end-to-end solutions with increased functionality that can solve their spectrum of needs across the identity life cycle. Our objective is to meet those growing needs by continuing to broaden our product and solution offerings to meet our customer needs, leveraging our existing customer base to provide additional products and services, expanding our customer base both domestically and abroad, and augmenting our competitive position through strategic acquisitions.

 

We evaluate our business primarily through financial metrics such as revenues, operating income (loss) and earnings before interest-net, income taxes, depreciation and amortization, asset impairments and in-process research and development charges, and stock-based compensation expense (“Adjusted EBITDA”), and free cash flow.

 

Our revenues increased to $562.9 million for the year ended December 31, 2008 from $389.5 million for the year ended December 31, 2007. Our net loss for the year was $548.7 million compared to net income of $17.7 million in 2007. The 2008 loss includes impairments of long-lived assets of $98.6 million and goodwill of $430.0 million, as well as merger related expenses of $1.1 million. In addition, the 2008 results reflect an increase in the deferred tax valuation allowance of $48.0 million and an income tax benefit of $37.4 million for the tax benefit of the impairment of long-lived assets. Also in 2008 we incurred interest expense of $23.3 million compared to interest expense of $11.3 million in 2007, as a result of increased borrowings to fund our acquisition of Old Digimarc. The 2007 results include an income tax benefit of $21.8 million resulting from the reduction of a portion of the deferred tax asset valuation allowance and intangible asset impairments of $5.0 million. Our Adjusted EBITDA increased to $82.1 million form $60.1 million in 2007.

 

Sources of Revenues

 

Our Secure Credentialing Division which prior to December 15, 2005 comprised our sole business, generates revenues from the sales of solutions consisting of bundled proprietary software with commercial off-the-shelf equipment and related maintenance and services, the sale of secure printing solutions and related consumables, and the design, customization and installation of secure credential issuance systems which

generate revenues as the credentials are issued by the customer. The division also generates revenues from solutions using biometric technologies of other divisions. The division is included in our Identity Solutions segment.

 

Our Biometrics division, also included in our Identity Solutions segment, generates revenues from the sale of biometric solutions incorporating fingerprint, facial, skin and iris biometrics and system components necessary for the biometric capture and knowledge discovery and the sale of biometrics solutions using proprietary multi-biometric capture devices bundled together with our proprietary software and other biometric technologies, as well as sales of licenses and software. The division’s offerings include Live Scan and mobile systems and services for biometric capture and identification, systems and biometric solutions that include modules and software for biometric matching and verification, and related maintenance services. Revenues are generated by sales of hardware, software and maintenance and other services.

 

Our Enterprise Access division provides solutions that include biometrics-based readers used to secure buildings and restricted areas. The division is included in our Identity Solution segment.

 

Our Enrollment Services division, included in our Services segment, generates revenues through the sales of enrollment and background screening products and fingerprinting services.

 

We provide government consulting services through SpecTal, McClendon and ACI. SpecTal provides comprehensive security consulting services to U.S. government intelligence agencies. McClendon provides technical and professional services to the U.S. intelligence and military communities. ACI provides information technology and network security solutions, and system engineering and development services for the U.S. intelligence and military communities. All these businesses are included in the Services segment.

 

We market our solutions and services primarily to U.S. and foreign, federal, state and local government agencies and law enforcement agencies. We also are working to expand the use of our solutions in commercial markets, particularly financial services, transportation and healthcare. In a typical contract with a government entity for an identity solution, we design the system, supply and install equipment and software and integrate the solution within the entity’s existing infrastructure and provide maintenance services. These contracts may be structured as fixed price contracts with payments made upon completion of agreed milestones or deliveries and with each milestone or delivery typically having a value specified in the contract. Alternatively, these contracts may be paid at a fixed price per credential issued as is typical in the drivers’ license market. For services contracts, we are compensated at per fingerprint delivered in the case of our fingerprinting services or on a time and material, fixed price level of effort and cost reimbursable basis for our government services.

 

Our growth in revenues is due principally to acquisitions we consummated, as well as increased demand for our identity solutions related to heightened emphasis on security, secure credentials, document authentication and biometrics, as well as increased demand for our government security services. We anticipate that the U.S. government agencies will continue to be major customers for the foreseeable future. We also expect to experience increased demand from a number of other government entities as they deploy identity solutions, particularly document authentication, at points of entry and exit, including borders, seaports and airports and in connection with national identification programs. Notwithstanding our expectations regarding demand for these solutions, the quantity and timing of orders from both U.S. and foreign government entities depends on a number of factors outside of our control, such as the level and timing of budget appropriations. Any funding delays or other changes in the rollout of government programs utilizing our solutions, products and services could cause our revenues to fall short of expectations

 

Acquisitions

 

We have pursued strategic acquisitions to complement and expand our existing solutions and services. Our acquisitions since January 1, 2006 include:

 

 

 

The acquisitions have resulted in the consolidation of certain marketing resources, corporate functions of the separate entities and are expected to have a continuing material effect on our operations resulting from, but not limited to:

 

 

Reportable segments and geographic information

 

We operate in two reportable segments, the Identity Solutions segment and the Services segment. During the first quarter of 2008, we integrated the authentication and identification business of ComnetiX in the Identity Solutions segment and the fingerprinting services business in the Services segment. Accordingly, the segment data for 2007 has been reclassified to conform to 2008 presentation. We measure segment performance based on revenues, operating income (loss) and Adjusted EBITDA and free cash flow. Operating results by segment, including allocation of corporate expenses, for the three years ended December 31, 2008 are as follow (in thousands):

 

 

In 2008, the Identity Solutions and Services reportable segments include goodwill and long-lived asset impairments of $527.2 million and $1.4 million, respectively, and the Identity Solutions segment includes

merger related severance costs of $1.1 million. For 2007 and 2006, the Identity Solutions segment included asset impairments and merger related costs of $5.0 million and $22.8 million, respectively.

 

Revenue by market comprises the following for the years ended December 31, 2008, 2007 and 2006 (in thousands):

 

 

Revenues are attributed to each region based on the location of the customer. The following is a summary of revenues by geographic region for the years ended December 31, 2008, 2007 and 2006 (in thousands):

 

 

Adjusted EBITDA

 

We use Adjusted EBITDA as a non-GAAP financial performance measurement for segments. Adjusted EBITDA is calculated by adding back to net income (loss): interest-net, income taxes, depreciation and amortization, goodwill, long lived asset impairments, in-process research and development charges, and stock-based compensation. Adjusted EBITDA is provided to investors to supplement the results of operations reported in accordance with GAAP. Management believes Adjusted EBITDA is useful to help investors analyze the operating trends of the business and to assess the relative underlying performance of businesses with different capital and tax structures. Management also believes that Adjusted EBITDA provides an additional tool for investors to use in comparing our financial results with other companies in the industry, many of which also use Adjusted EBITDA in their communications to investors. By excluding non-cash charges such as amortization and depreciation, stock-based compensation expense, goodwill and long lived asset impairments and in-process research and development charges, as well as non-operating charges for interest-net and income taxes, investors can evaluate our operations and can compare our results on a more consistent basis to the results of other companies in the industry. Management uses Adjusted EBITDA to evaluate potential acquisitions, establish internal budgets and goals, evaluate performance of our business units and management, and to evaluate compliance with debt covenants.

 

We consider Adjusted EBITDA to be an important indicator of our operational strength and performance of our business and a useful measure of our historical and prospective operating trends. However, there are significant limitations to the use of Adjusted EBITDA since it excludes interest income and expense, income taxes and goodwill and long lived asset impairments, all of which impact our profitability as well as depreciation, and amortization related to the use of long-lived assets that benefit multiple periods. We believe that these limitations are compensated for by providing Adjusted EBITDA only with GAAP performance measures and clearly identifying the difference between the two measures. Consequently, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss), or operating income (loss) presented in accordance with GAAP. Adjusted EBITDA as defined by the Company may not be comparable with similarly named measures provided by other entities.

A reconciliation of GAAP net income (loss) to Adjusted EBITDA is as follows (in thousands):

 

 

Dependence on Significant Customers

 

For the year ended December 31, 2008, U.S. Federal Government agencies, directly or indirectly, accounted for 64% of consolidated revenues. For the years ended December 31, 2007 and 2006, U.S. Federal Government agencies, directly or indirectly accounted for 69% and 55% of consolidated revenues, respectively. Accounts receivable from U.S. Government agencies amounted to $53.6 million and $60.4 million at December 31, 2008 and 2007, respectively.

 

Consolidated Results of Operations

 

Our comparative results of operations have been affected by the February 2006 acquisition of SecuriMetrics, the August 2006 merger with Identix and acquisition of Iridian, the October 2006 acquisition of SpecTal, the February 2007 acquisition of ComnetiX, the July 2007 acquisitions of ACI and McClendon, the March 2008 acquisition of Bioscrypt and the August 2008 acquisition of Old Digimarc (collectively the “Acquisitions”).

 

In addition to the impact of the Acquisitions, the following items impacted our operating results, net of related tax effects, if applicable (in millions):

 

 

Information regarding the impact of the Acquisitions on our results of operations is provided below.

 

Comparison of 2008 to 2007

 

Revenues

 

The following details revenues by major categories of products and services for the years ended December 31, 2008 and 2007 (in thousands):

 

 

Revenues increased by $173.4 million for the year ended December 31, 2008 of which $121.1 million related to the Acquisitions. Excluding the impact of the Acquisitions, revenues increased $52.2 million or 15% from the year ended December 31, 2007. The increase from the prior year period reflects growth related to our secure credentialing solutions and government consulting services, offset by lower biometric revenues primarily du to unusually large shipments of biometric products in the fourth quarter of 2007.

 

Approximately 50% and 46% of our revenues in 2008 and 2007, respectively, were derived from long-term service contracts with the U.S. Federal and state governments included in our Services segment. These contracts are fixed unit price contracts for which we are compensated as we provide the services, as fingerprints are transmitted to the appropriate government agency for fingerprinting services and on a time and material, fixed price level of effort or cost reimbursable basis for government services.

 

Approximately 12% and 8% of our revenues in 2008 and 2007, respectively, were derived from long-term contracts for the production of drivers’ licenses and credentials for which we are compensated on a fixed unit price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

 

Our remaining revenues, including other revenues from the drivers’ licenses contracts which are not based on card production volumes, comprise 38% and 46% of revenues for the years ended December 31, 2008 and 2007, respectively, and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance and services. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of our research and development and sales and marketing costs are related to generating these revenues.

 

Cost of revenues and gross margins (in thousands)

 

 

Cost of revenues increased by $126.4 million for the year ended December 31, 2008 compared to the year ended December 31, 2007, of which $77.3 million is related to the Acquisitions. Excluding the Acquisitions, cost of revenues increased by $49.1 million or 20% in 2008 compared to the previous year which is consistent with increased sales. Gross margin for 2008 was 30% compared to 31% in 2007. The decrease was due to changes in the revenue mix resulting from lower biometric revenues and higher revenues from secure credentialing and services.

Included in the cost of revenues in 2008 were $24.7 million of amortization of intangible assets, which decreased by approximately $2.4 million from the prior year primarily due to lower amortization resulting from impairment of long-lived assets which included the acquired intangible assets (see Note 14) offset by the Acquisitions. Amortization of intangible assets reduced consolidated gross margins by 4% and 7% for the years ended December 31, 2008 and 2007, respectively.

 

Sales and Marketing Expense (in thousands)

 

 

Sales and marketing expenses increased by approximately $9.3 million for the year ended December 31, 2008 compared to the prior year, of which the Acquisitions accounted for $8.1 million. Excluding the effects of the Acquisitions, sales and marketing expenses increased by $1.2 million for the year ended December 31, 2008. These increases are attributable to additional investments made to expand our focus on U.S. government and international opportunities. Sales and marketing expenses consists primarily of salaries and related personnel costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

 

Research and Development Expenses (in thousands)

 

 

Research and development expenses increased by approximately $6.8 million for the year ended December 31, 2008 compared to the prior year, of which approximately $4.3 million is due to the Acquisitions. Excluding the effects of the Acquisitions, research and development expenses in 2008 increased by $2.5 million, as we continued to focus on the development of biometric technology. Research and development expenses were offset by higher utilization of research and development resources in the performance of contracts, the cost of which is included in cost of revenues. Research and development expenses consist primarily of salaries, stock-based compensation and related personnel costs and prototype costs related to the design, development, testing and enhancement of our products. Gross research and development expenditures aggregated to $43.0 million for the year ended December 31, 2008 compared to $26.4 million in the prior year. Virtually all of our research and development costs are attributable to our Identity Solutions segment. As a percentage of Identity Solutions revenues, gross research and development costs were 15% and 13% for years ended December 31, 2008 and 2007, respectively.

 

General and Administrative Expenses (in thousands)

 

 

General and administrative expense increased approximately $24.4 million for year ended December 31, 2008 compared to 2007, of which approximately $20.5 million are directly related to the Acquisitions. Excluding the effects of acquisitions, the increase was $3.9 million over the year ended December 31, 2007 and relates to stock-based compensation expense, legal, accounting and auditing and other professional services. As a percentage of revenues, general and administrative expenses decreased to 15%, as compared to

16% in the prior year as we continue to leverage our cost structure over a larger revenue base. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for our executive and administrative personnel, professional and board of directors’ fees, public and investor relations and insurance.

 

Asset Impairments and Merger Related Expenses (in thousands)

 

 

In 2008, assets impairments consist of goodwill of $430.0 million and long-lived assets of $98.6 million, principally intangible assets recorded in connection with acquisitions, and relate principally to the Company’s biometrics businesses included in the Identity Solutions segment. The impairment charges result from the deteriorating economic conditions that manifested themselves in the fourth quarter of 2008 as well as capital market conditions that adversely impacted valuation of businesses we acquired and the Company’s stock prices and market capitalization. The remaining $1.1 million related to merger related expense for the Old Digimarc acquisition. In 2007, an impairment charge of $5.0 million was recognized related to certain acquired product lines of the biometrics business. See Note 14 to the consolidated financial statements.

 

Amortization of Acquired Intangible Assets (Operating Expenses) (in thousands)

 

 

Amortization expense of intangible assets increased by $0.5 million for the year ended December 31, 2008 from the comparable period in the prior year due to the Acquisitions.

 

Interest

 

Interest Income and Expense (in thousands)

 

 

For the year ended December 31, 2008, interest expense-net increased by approximately $12.2 million compared to the prior year as a result of the issuance of senior convertible notes in May 2007 and borrowings under our revolving credit facility and term loan incurred primarily to fund the Acquisitions.

 

Other Expense, Net (in thousands)

 

 

Other expense, net includes realized and unrealized currency transaction gains and losses on yen-denominated purchases, as well as unrealized gains and losses forward currency contracts.

Income Taxes (in thousands)

 

 

The 2008 results reflect an income tax expense of $11.7 million, primarily reflecting an increase in the deferred tax asset valuation allowance of approximately $48.0 million offset by the deferred benefit of $38.7 million primarily related to the impairment of long-lived assets recorded for the year (excluding the impact of the goodwill impairment which is not deductible for income tax purposes) and a current tax provision of $2.4 million. During the fourth quarter of 2008, management evaluated the adequacy of the valuation allowance in light of the results for the year and determined that, based on the cumulative results of operations for the three years ended December 31, 2008, after considering items that do not enter in the determination of taxable income, and the likely future operating results, it was more likely than not that the portion of the tax benefits of its net operating loss carryforwards that would not be realized would be higher than previously recorded. As a result, the Company increased the deferred tax asset valuation allowance to reflect the estimated tax benefits it expects to realize.

 

The 2007 results reflect an income tax benefit of $24.0 million, reflecting the reduction of the deferred tax asset valuation allowance of approximately $21.8 million. During the fourth quarter of 2007, management determined that based on the cumulative results of operations for the three years ended December 31, 2007, after considering items that do not enter in the determination of taxable income, and the expected future operating results, it is more likely than not that the Company will realize a substantial portion of the tax benefits of its net operating loss carryforwards. As a result, the Company reduced its previously recorded deferred tax asset valuation allowance to reflect the estimated benefits it expected to realize.

 

Comprehensive income (loss) (in thousands)

 

 

The change in comprehensive income (loss) results from the net loss in 2008 of $548.7 million compared to $17.7 million net income in 2007, the components of which are described above, as well as foreign currency translation losses of $6.6 million and gains of $5.7 million in 2008 and 2007, respectively, resulting from the strengthening of the U.S. dollar in 2008 and the weakening in 2007 relative to foreign currencies which include the Euro and the Canadian Dollar. Also in 2008, we recorded an unrealized loss of $1.1 million, net of related tax effect of $0.7 million, in comprehensive income for the fair value of an interest rate protection agreement.

 

Comparison of 2007 to 2006

 

Revenues

 

The following details revenues by major categories of products and services for the years ended December 31, 2007 and 2006 (in thousands):

 

 

Revenues increased by $225.1 million for the year ended December 31, 2007 of which $186.3 million related to the Acquisitions. Excluding the impact of the Acquisitions, revenues increased $38.8 million or 35% from the year ended December 31, 2006. The increase from the prior year period is primarily due to increased sales of the Company’s identity solutions, primarily related to sales of multi-modal biometric solutions, passport and credentialing sales to the U.S. State Department and U.S. Department of Defense.

 

Approximately 46% and 29% of our revenues in 2007 and 2006, respectively, were derived from long-term service contracts with the U.S. Federal and state governments included in our Services segment. These contracts are fixed unit price contracts from which we are compensated as we provide the services, as fingerprints are transmitted to the appropriate government agency for fingerprinting services and on a time and material or fixed price level of effort basis for government services.

 

Approximately 8% and 19% of our revenues in 2007 and 2006, respectively, were derived from long-term contracts for the production of drivers’ licenses and credentials for which we are compensated on a fixed unit price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract, which range from 4 — 5 years. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

 

Our remaining revenues, including other revenues from the drivers’ licenses contracts which are not based on card production volumes, comprise 46% and 52% of the revenues for the years ended December 31, 2007 and 2006 and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance and services. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of our research and development and sales and marketing costs are related to generating these revenues.

 

Cost of Revenues and Gross Margins (in thousands)

 

 

Cost of revenues increased by $154.9 million for the year ended December 31, 2007 compared to the year ended December 31, 2006, of which $139.2 million is related to the Acquisitions. Excluding the Acquisitions, cost of revenues increased by $15.7 million or 21% in 2007 compared to the previous year. Gross margins in 2007 were positively impacted by increased sales of higher margin multi-modal biometric solutions and adversely impacted by the solutions and services revenue mix.

Included in the cost of revenues in 2007 were $27.1 million of amortization of intangible assets, which increased by approximately $13.2 million from the prior year primarily due to Acquisitions. Amortization of intangible assets reduced consolidated gross margins by 7% and 8% for the years ended December 31, 2007 and 2006, respectively.

 

Sales and Marketing Expense (in thousands)

 

 

Sales and marketing expenses increased by approximately $13.3 million for the year ended December 31, 2007 compared to the prior year, of which the Acquisitions accounted for $7.6 million. Excluding the effects of the Acquisitions, sales and marketing expenses increased by $5.7 million for the year ended December 31, 2007. These increases are attributable to additional investments made to expand our focus on U.S. government and international opportunities. Sales and marketing expenses consists primarily of salaries and related personnel costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

 

Research and Development Expenses (in thousands)

 

 

Research and development expenses increased by approximately $6.9 million for the year ended December 31, 2007 compared to the prior year, of which approximately $5.5 million is due to the Acquisitions. Excluding the effects of the Acquisitions, research and development expenses in 2007 increased by $1.4 million, as we continued to focus on the development of biometric technology. Research and development expenses were offset by higher utilization of research and development resources in the performance of contracts, the cost of which is included in cost of revenues. Research and development expenses consist primarily of salaries, stock-based compensation and related personnel costs and prototype costs related to the design, development, testing and enhancement of our products.

 

General and Administrative Expenses (in thousands)

 

 

General and administrative expense increased approximately $32.3 million for year ended December 31, 2007 compared to 2006, of which approximately $21.7 million are directly related to the Acquisitions.

Excluding the effects of acquisitions, the increase of $10.6 million for year ended December 31, 2007 compared to the prior year period, relates to stock-based compensation expense, legal, accounting and auditing and other professional services. As a percentage of revenues, general and administrative expenses decreased to 16% for the year ended December 31, 2007, as compared to 18% in the corresponding period in the prior year. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for our executive and administrative personnel, professional and board of directors’ fees, public and investor relations and insurance.

 

Asset Impairments and Merger Related Expenses (in thousands)

 

 

In 2007, the Company recorded a charge of $5.0 million for the impairment of intangible assets related to certain acquired product lines. In 2006, in connection with our merger with Identix, the Company incurred significant personnel costs for severance and other contractual compensation arrangements with the former management team and the Board of Directors of Viisage. These personnel and other severance costs totaled approximately $5.4 million. Additionally, the Company reviewed its long-lived assets in light of the strategy and plans of the combined Company and evaluated the carrying value of the assets that would be impacted by that strategy. This resulted in impairment charges of $13.5 million relating to facial recognition technology, documentation authentification technology, patents, and other long-lived assets. Additionally, the Company reviewed its long-term commitments and determined that it would cease to use certain services in the future; accordingly, the Company recorded a charge of $1.1 million pursuant to SFAS No. 146. The Company also recorded a charge for in-process research and development of $2.7 million related to the Identix merger in 2006.

 

Amortization of Acquired Intangible Assets (Operating Expenses) (in thousands)

 

 

Amortization expense of intangible assets increased for the year ended December 31, 2007 from the comparable period in the prior year due to the Acquisitions.

 

Interest

 

Interest Income and Expense (in thousands)

 

 

For the year ended December 31, 2007, interest expense-net increased by approximately $11.1 million compared to the prior year as a result of the issuance of senior convertible notes in May 2007 and borrowings under our revolving credit facility incurred primarily to fund the Acquisitions.

 

Other Expense, Net (in thousands)

 

Other expense, net includes realized and unrealized currency transaction gains and losses on yen-denominated purchases, as well as unrealized gains and losses forward currency contracts.

 

Income Taxes (in thousands)

 

 

The 2007 results reflect an income tax benefit of $24.0 million, reflecting the reduction of the deferred tax asset valuation allowance of approximately $21.8 million. During the fourth quarter of 2007, management determined that based on the cumulative results of operations for the three years ended December 31, 2007, after considering items that do not enter in the determination of taxable income, and the expected future operating results, it is more likely than not that the Company will realize a substantial portion of the tax benefits of its net operating loss carryforwards. As a result, the Company reduced its previously recorded deferred tax asset valuation allowance to reflect the estimated benefits it expected to realize.

 

The 2006 provision for income taxes represents a deferred tax provision related to the amortization of tax deductible goodwill and state and local income tax provisions.

 

Comprehensive income (loss) (in thousands)

 

 

The change in comprehensive income (loss) results from the net income in 2007 of $17.7 million compared to a $31.0 million loss is 2006, the components of which are described above, and reflect foreign currency translation gains of $5.7 million and $3.1 million in 2007 and 2006, respectively, resulting from the weakening of the U.S. dollar primarily related to the Euro.

 

Liquidity and capital resources

 

Capital Requirements

 

Our most significant capital requirements consist of acquisitions, capital expenditures for new secure credentialing contracts, research and development and working capital needs. The most significant capital expenditures are related to our Identity Solutions segment. When we bid on new state drivers’ license contracts, we must commit to provide up front capital expenditures in order to install systems necessary to perform under the contract. It is expected that with the acquisition of Old Digimarc, our capital requirements will increase as we bid on and are awarded new contracts or as contracts are renewed. In 2008, our capital expenditures increased to $22.5 million compared to $13.0 million in 2007 and are expected to increase again in 2009 as we are required to fund capital expenditures of Old Digimarc for the full year. We expect to fund our capital requirements from operating cash flows and with issuance of debt and equity securities. However, if current volatile market conditions continue for a prolonged period, we may be unsuccessful in raising additional debt and equity financing at acceptable rates or on terms that are not excessively dilutive to existing shareholders.

 

Liquidity

 

As of December 31, 2008, excluding current deferred income taxes, we had $13.3 million of working capital including $20.4 million in cash and cash equivalents. In addition, we have financing arrangements, as further described below, available to support our ongoing liquidity needs, pursuant to which we have available $120.5 million at December 31, 2008, net of outstanding letters of credit of $14.5 million, subject to continuing compliance with covenants in the agreement. We believe that our existing cash and cash equivalent balances, existing financing arrangements and cash flows from operations will be sufficient to meet our

operating, debt service and capital expenditures requirements for the next 12 months. However, it is likely that we will require additional financing to execute our acquisition strategy and in that connection, we evaluate financing needs and the terms and conditions and availability under of our credit facility on a regular basis and consider other financing options. There can be no assurance that such financing will be available on commercially reasonable terms, or at all. Our ability to meet our business plan is dependent on a number of factors, including those described in the section of this report entitled “Risk Factors.”

 

Credit Agreement

 

On August 5, 2008, L-1 entered into a Second Amended and Restated Credit Agreement (the “Credit Agreement”), among L-1 Identity Operating, L-1, Bank of America, N.A., Wachovia Bank, National Association, Banc of America Securities LLC, Wachovia Capital Markets LLC, Royal Bank of Canada, Société Générale and TD Bank, N.A. to amend and restate the Amended and Restated Credit Agreement, dated October 19, 2006, by and among L-1, Bank of America, N.A. (“Administrative Agent”), Bear Stearns Corporate Lending, Inc., Bear Stearns & Co., Inc., Banc of America Securities LLC, Wachovia Bank, N.A. and Credit Suisse, Cayman Islands Branch. Other lenders under the Credit Agreement include Credit Suisse, Cayman Islands Branch, the Bank of Nova Scotia, CIT Bank and RBS Citizens, N.A. The Credit Agreement provides for a senior secured term loan facility in an aggregate principal amount of up to $300.0 million, with a term of five years, and a senior secured revolving credit facility in an aggregate principal amount of up to $135.0 million. The proceeds of the senior secured facilities were used to (i) fund, in part, the purchase price paid, and fees and expenses incurred, in connection with the acquisition of Old Digimarc, (ii) repay L-1’s existing revolving credit facility and (iii) provide ongoing working capital and fund other general corporate purposes of L-1. As of December 31, 2008, the Company has approximately $120.5 million available under its revolving credit facility, net of outstanding letters of credit of $14.5 million, subject to continuing compliance with covenants contained in the agreement.

 

We have the option to borrow under the Credit Agreement at a rate equal to LIBOR (subject to a floor of 3%) plus 3.75% to 4.5% per annum or Bank of America’s prime rate (subject to a minimum of 2%) plus 1.75% to 3.5% per annum. We are required to pay a fee of 0.5% on the unused portion of the revolving credit facility. The senior secured term loan facility requires quarterly principal payments beginning at 5.0% of the outstanding borrowings under such facility for the initial year, increasing over the duration of the facility. All obligations of L-1 Operating under the Credit Agreement are guaranteed on a senior secured basis by L-1 and by each of L-1’s existing and subsequently acquired or organized direct or indirect wholly-owned subsidiaries (subject to certain exceptions). At December 31, 2008 the variable rate was based on LIBOR plus 4.5% or 7.5%. Subsequent to December 31, 2008, the interest rate was changed to 6.75%.

 

We are required to maintain the following financial covenants under the Credit Agreement:

 

 

Scheduled principal payments under the term loan are included in the calculation of the Consolidated Debt Service Coverage Ratio. In 2009 such principal payments increase from from $3.8 million to $18.8 million; consequently the covenant will become more stringent in 2009. The Company expects to be in compliance with the covenant, however should the results of operations be less than expected we may need to seek relief from the lenders.

 

Under the terms of the Credit Agreement, L-1 Operating may incur, assume or guarantee unsecured subordinated indebtedness in an amount up to $200.0 million, provided that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and the borrower and its subsidiaries are in pro forma compliance, after giving effect to the incurrence of such subordinated debt, with each of the covenants in the Credit Agreement, including, without limitation, the financial covenants mentioned above. Pursuant to the terms of the Credit Agreement, L-1 may incur, assume or guarantee any amount of unsecured subordinated indebtedness, provided, that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and the pro forma Consolidated Leverage Ratio (as defined in the Credit Agreement) of L-1 and its subsidiaries after giving effect to the incurrence of such subordinated debt shall be less than 4.75:1.00. The Credit Agreement limits the ability of L-1 to (i) pay dividends or other distributions or repurchase capital stock, (ii) create, incur, assume or suffer to exist any indebtedness, except as described above, (iii) create, incur, assume or suffer to exist liens upon any of its property, assets or revenues, (iv) sell, transfer, license, lease or otherwise dispose of any property, (v) make or become legally obligated to make capital expenditures above certain thresholds, (vi) make investments, including acquisitions, and (vii) enter into transactions with affiliates. These covenants are subject to a number of exceptions and qualifications. The Credit Agreement provides for customary events of default which include (subject in certain cases to customary grace and cure periods), among others: nonpayment, breach of covenants or other agreements in the Credit Agreement or the other Loan Documents (as defined in the Credit Agreement), payment defaults or acceleration of other indebtedness, failure to pay certain judgments, inability to pay debts as they become due and certain events of bankruptcy, insolvency or reorganization. Generally, if an event of default occurs, the Administrative Agent may, with the consent of the Required Lenders (as defined in the Credit Agreement) declare all outstanding indebtedness under the Credit Agreement to be due and payable.

 

In October 2008, the Company entered into an interest rate protection agreement to reduce its exposure to the variable interest rate payments on its term loan. The interest rate protection agreement has a notional amount of $62.5 million, and expires in November, 2011. Under the term of the agreement, the Company pays the counter party a fixed rate of 4.1% and receives variable interest based on three-month LIBOR (subject to a floor of 3.0%). The counterparty to this agreement is a highly rated financial institution. In the unlikely event that the counterparties fail to meet the terms of the interest rate swap agreement, the Company’s exposure is limited to the interest rate differential on the notional amount at each quarterly settlement period over the life of the agreements. We do not anticipate non-performance by the counterparties.

 

In accordance with SFAS No. 133 Accounting for Derivatives and Hedging Activities, at its inception the company designated the agreement as a cash flow hedge of the interest payments due under the term loan, and deemed the hedge effective. The fair value of the interest rate protection agreement is the estimated amount that we would pay or receive to terminate the agreement at the reporting date, taking into account current interest rates, the market expectation for future interest rates and our current creditworthiness. At December 31, 2008 the fair value resulted in an unrealized loss of $1.7 million, , which is reflected in accumulated other comprehensive income for the year ended December 31, 2008 net of the related tax effect of $0.7 million It is expected that that approximately $0.6 million of the unrealized loss will be reflected in net income for the year ending December 31, 2009.

 

Convertible Senior Notes

 

On May 17, 2007, the Company issued $175.0 million of Convertible Notes with a conversion feature which allows the Company the option to settle the debt either in shares of common stock or to settle the principal amount in cash and the conversion spread in cash or stock. The proceeds of the Convertible Notes offering, net of deferred financing costs amounted to $168.7 million. In connection with the issuance of the

Convertible Notes, we entered into an agreement with Bear Stearns (now JP Morgan) to purchase approximately 3.5 million shares of our common stock for approximately $69.8 million. The shares will be delivered in May 2012; however, we settled our obligation at closing for a cash payment.

 

The Notes are governed by an indenture, dated May 17, 2007 (the “Indenture”), between the Company and The Bank of New York, as trustee. The Notes will be convertible only under certain circumstances, as described below. If, at the time of conversion, the daily volume-weighted average price per share for a 25 trading day period calculated in accordance with the Indenture (as defined in greater detail in the Indenture, “VWAP”) of the Company’s common stock is less than or equal to $32.00 per share, which is referred to as the base conversion price, the Notes will be convertible into 31.25 shares of common stock of the Company per $1,000 principal amount of the Notes, subject to adjustment upon the occurrence of certain events. If, at the time of conversion, the VWAP of the shares of common stock of the Company exceeds the base conversion price of $32.00 per share, the conversion rate will be determined pursuant to a formula resulting in holders’ receipt of up to an additional 14 shares of common stock per $1,000 principal amount of the Notes, subject to adjustment upon the occurrence of certain events and determined as set forth in the Indenture. As an example, if the volume-weighted price per share (VWAP) of the Company stock were to increase to $40.00 per share, the additional shares issuable upon conversion would be 2.8, and the shares issuable per $1,000 principal amount of the Notes would be 34.05.

 

The Notes are convertible until the close of business on the second business day immediately preceding May 15, 2027, in multiples of $1,000 in principal amount, at the option of the holder under the following circumstances: (1) during the five business-day period after any five consecutive trading day period (the “measurement period”) in which the trading price per Note, for each day of such measurement period was less than 98% of the product of the last reported sale price of shares of common stock of the Company and the applicable conversion rate for such trading day; (2) during any fiscal quarter after December 31, 2008, if the last reported sale price of shares of common stock of the Company for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the base conversion price on the related trading day; (3) if the Company calls any or all of the Notes for redemption; and (4) upon the occurrence of specified corporate transactions described in the Indenture. Upon conversion, the Company has the right to deliver shares of common stock based upon the applicable conversion rate, or a combination of cash and shares of common stock, if any, based on a daily conversion value as described above calculated on a proportionate basis for each trading day of a 25 trading-day observation period. In the event of a fundamental change as specified in the Indenture, the Company will increase the conversion rate by a number of additional shares of common stock specified in the Indenture, or, in lieu thereof, the Company may in certain circumstances elect to adjust the conversion rate and related conversion obligation so that the Notes will become convertible into shares of the acquiring or surviving company.

 

The Notes bear interest at a rate of 3.75% per year payable semiannually in arrears in cash on May 15 and November 15. The Notes will mature on May 15, 2027, unless earlier converted, redeemed or repurchased. The Company may redeem the Notes at its option, in whole or in part, on or after May 20, 2012, subject to prior notice as provided in the Indenture. The redemption price during that period will be equal to the principal amount of the notes to be redeemed, plus any accrued and unpaid interest. The holders may require the Company to repurchase the Notes for cash on May 15, 2012, May 15, 2017 and May 15, 2020.

 

Equity Securities

 

On August 5, 2008, pursuant to the terms and conditions of (i) the Securities Purchase Agreement, by and between L-1 and Robert V. LaPenta (the “LaPenta Agreement”), (ii) the Securities Purchase Agreement (the “Iridian Agreement”), by and between L-1 and Iridian Asset Management LLC (“Iridian”) and (iii) the LRSR Agreement (together with the LaPenta Agreement and Iridian Agreement, the “Investor Agreements”). L-1 issued an aggregate of 8,083,472 shares of L-1 common stock and 15,107 shares of Series A Convertible Preferred Stock (the ’Series A Preferred Stock’) for aggregate net proceeds to L-1 of $119.0 million which were used to fund a portion of L-1’s acquisition of Old Digimarc.

Pursuant to the terms and conditions of the LaPenta Agreement, L-1 issued 15,107 shares of Series A Preferred Stock and 750,000 shares of L-1 common stock to Mr. LaPenta. Subject to stockholder approval at the Company’s 2009 annual meeting, each share of Series A Preferred Stock will become convertible into a number of shares of L-1 common stock equal to the liquidation preference then in effect, divided by $13.19. Accordingly, the 15,107 shares of Series A Preferred Stock will become convertible into 1,145,337 shares of L-1 common stock. The Series A Preferred Stock is automatically convertible at any time Mr. LaPenta, the initial holder, transfers such shares of Series A Preferred Stock to an unaffiliated third party. In the event that approval of conversion is not obtained at L-1’s 2009 annual meeting, L-1 will be obligated to seek stockholder approval for such conversion at the three annual meetings following the 2009 annual meeting. The Series A Preferred Stock is entitled to receive dividends equally and ratably with the holders of shares of L-1 common stock and on the same date that such dividends are payable to holders of shares of L-1 common stock. Pursuant to the terms and conditions of the LaPenta Agreement, Mr. LaPenta is entitled to a contractual price protection right to receive up to 2,185 additional shares of Series A Preferred Stock if the volume weighted average price of a share of L-1 common stock as reported by Bloomberg Financial Markets for the 30 consecutive trading days ending on the last trading day prior to June 30, 2009 is less than $13.19. Subject to stockholder approval or transfer to unaffiliated third party, he 2,185 shares of Series A Preferred Stock will be convertible into 165,655 shares of L-1 common stock, at a conversion price of $13.19 per share.

 

Consolidated Cash Flows

 

 

Comparison of 2008 to 2007

 

Cash flows from operating activities increased by approximately $11.8 million for the year ended December 31, 2008 as compared to the prior year. Our net loss for the year ended December 31, 2008 was $548.7 million, and includes non-cash items aggregating $609.3 million compared to $29.5 million in 2007 and are comprised of $528.6 million related to long-lived asset impairments, $49.4 million for depreciation and amortization, $18.1 million for stock-based compensation, non-cash income tax charges of $8.6 million, amortization of deferred financing costs and debt discount of $4.2 million and other non-cash charges of $0.4 million. Cash flows from operating activities before changes in operating assets and liabilities reflects the results of operations including the impact of acquisitions. Changes in operating assets and liabilities had the impact of reducing cash and cash equivalents by $7.7 million in 2008 and $6.3 million in 2007.

 

Cash flows used in investing activities increased by approximately $199.0 million for the year ended December 31, 2008 as compared to the prior year. During 2008, we used $320.5 million in connection with the Acquisitions, net of acquired cash, primarily related to the acquisition of Old Digimarc. The cash paid for acquisitions in 2007, net of cash acquired, approximated $132.8 million and primarily related to the acquisitions of ACI, McClendon and ComentiX.

 

Capital expenditures were approximately $22.5 million and $13.0 million for the years ended December 31, 2008 and 2007, respectively, and primarily related to the Company’s drivers’ licenses product line. The increase is primarily related to the acquisition of Old Digimarc. Expenditures for the additions to intangible assets were $8.0 million in 2008 and $6.3 million in 2007.

 

Net cash provided by financing activities in 2008 was $310.8 million compared to $114.1 million in 2007. The proceeds from the issuance of the term loan aggregated $295.0 million and common and preferred stock issued in a private placement resulted in proceeds of $119.0 million, net of financing costs, which were used for the acquisition of Old Digimarc. In addition, net payments under the revolving credit agreement were

$84.0 million, and proceeds from the issuance of common stock to employees were $5.5 million , purchases of treasury stock were $6.2 million and payments of financing costs were $14.0 million In 2007, we borrowed $175.0 million by issuing convertible notes and purchased a prepaid forward for $69.8 million.

 

Comparison of 2007 to 2006

 

Cash flows from operating activities increased by approximately $28.4 million for the year ended December 31, 2007 as compared to the prior year. Our net income for the year ended December 31, 2007 was $17.7 million, and includes non-cash items aggregating $29.5 million compared to $51.3 million and are comprised of $5.0 million related to intangible asset impairments, $39.2 million for depreciation and amortization, $11.0 million for stock-based compensation, a deferred income tax benefit of $24.7 million and $1.0 million for other non-cash credits, net. Cash flows from operating activities before changes in operating assets and liabilities, increased to $47.2 million from $20.3 million for the year ended December 31, 2007 compared to the prior year and reflect the results of operations, including the impact of acquisitions. Changes in operating assets and liabilities had the impact of reducing cash and cash equivalents by $6.2 million in 2007 compared to $7,7 million in 2006.

 

Cash flows used in investing activities decreased by approximately $10.5 million for the year ended December 31, 2007 as compared to the prior year. During 2007, we used $132.8 million in connection with the Acquisitions, net of acquired cash. The cash paid for acquisitions in 2006, net of cash acquired, approximated $154.7 million.

 

Capital expenditures were approximately $13.0 million and $6.8 million for the years ended December 31, 2007 and 2006, respectively, and primarily related to the Company’s drivers’ licenses product line. Expenditures for the additions to intangible assets were $6.3 million in 2007 and $1.3 million in 2006.

 

Net cash provided by financing activities in 2007 was $114.1 million compared to $82.3 million in 2006. Proceeds from the issuance of convertible notes aggregated $175.0 million of which $69.8 million was used to pay for the pre-paid forward contract and the remainder, net of financing costs, was used to repay borrowings under the revolving credit agreement. In addition, net borrowings under the revolving credit agreement were $4.0 million, and proceeds from the issuance of common stock were $12.0 million.

 

Working Capital

 

December 31, 2008

 

Accounts receivable related to our March 2008 Bioscrypt acquisition and August 2008 acquisition of Digimarc, (“2008 Acquisitions”) were approximately $18.2 million at December 31, 2008. Excluding the 2008 Acquisitions, accounts receivable decreased by approximately $2.8 million as of December 31, 2008 compared to December 31, 2007, primarily due to improved collections. Days sales outstanding improved from December 31, 2008 to 65 days from 73 days at December 31, 2007.

 

Excluding $6.6 million related acquisitions, inventory increased by $6.4 million at December 31, 2008 compared to December 31, 2007. The increase related primarily to our building inventory to meet future contract delivery of multi-modal biometric recognition devices and solutions, fingerprint scanning devices and consumables.

 

Accounts payable, accrued expenses and other current liabilities related to the 2008 Acquisitions were $22.6 million at December 31, 2008. Excluding the impact of the 2008 Acquisitions, accounts payable, accrued expenses and other current liabilities increased by $14.1 million at December 31, 2008 from December 31, 2007 primarily due to timing of vendor payments and payroll, increased workforce, increases in purchases of materials and more efficient cash management.

 

Total deferred revenue related to the 2008 Acquisitions was $10.4 million at December 31, 2008. Excluding the impact of the 2008 Acquisitions, deferred revenue increased by $3.0 million related to maintenance, service and software contract deliverables.

December 31, 2007

 

Accounts receivable related to our February 2007 acquisition of ComnetiX and July 2007 acquisitions of ACI and McClendon, (“2007 Acquisitions”) were approximately $20.8 million at December 31, 2007. Excluding the 2007 Acquisitions, accounts receivable increased by approximately $7.9 million as of December 31, 2007 compared to December 31, 2006, primarily due to increased sales and timing of collections. Days sales outstanding at December 31, 2007 were comparable to those at December 31, 2006.

 

Inventory increased by $10.6 million ($10.1 million excluding acquisitions) as of December 31, 2007 compared to December 31, 2006. The increase related primarily to our building inventory to meet future contract delivery of multi-modal biometric recognition devices and solutions, fingerprint scanning devices and consumables.

 

Accounts payable, accrued expenses and other current liabilities related to the 2007 Acquisitions were $9.1 million at December 31, 2007. Excluding the impact of the 2007 Acquisitions, accounts payable, accrued expenses and other current liabilities increased by $14.8 million at December 31, 2007 from December 31, 2006 primarily due to timing of vendor payments and payroll, increased workforce, increases in purchases of materials and more efficient cash management.

 

Total deferred revenue related to the 2007 Acquisitions was $2.3 million at December 31, 2007. Excluding the impact of the 2007 Acquisitions, deferred revenue increased by $0.6 million.

 

Contractual obligations

 

The following table sets forth our contractual obligations as of December 31, 2008:

 

 

Included in debt is $175.0 million outstanding under our Convertible Notes which bears interest at 3.75% and a $300.0 million term loan that has a term of five years and bears interest at 7.5% at December 31, 2008. The amount shown for debt includes interest assuming the Convertible Notes are redeemed at the end of five years.

 

The Company has consulting agreements with two related parties under which each receives annual compensation of $0.1 million through the earlier of January 2012 or commencement of full time employment elsewhere. In addition, the Company is subject to a royalty arrangement with a related party whereby the Company is subject to royalty payments on certain of its face recognition software revenue through June 30, 2014, up to a maximum $27.5 million.

 

In connection with the merger with Identix, Aston Capital Partners, LLC, an affiliated company, and L-1 have agreed in principle that the Company may, subject to the approval of the Board of Directors, purchase AFIX Technologies, Inc., a portfolio company of Aston, at fair market value to be determined by an independent appraiser retained by the Company’s board of directors.

 

Contingent obligations

 

Our principal contingent obligations consist of cash payments that may be required upon achievement of acquired businesses’ performance incentives. Such obligations include contingent earn out payments in connection with our SpecTal and ACI acquisitions. The maximum potential consideration aggregates to $7.6 million of which approximately $2.9 million is expected to be paid in 2009. See Note 13 to the consolidated financial statements.

Off Balance Sheet Arrangements

 

We do not have any off balance sheet arrangements, transaction, obligations or other relationships with unconsolidated entities that would be expected to have a material effect on our financial condition, results of operations or cash flows.

 

Inflation

 

Although some of our expenses increased with general inflation in the economy, inflation has not had a material impact on our financial results to date.

 

Critical accounting policies and significant estimates