Digimarc Corporation

Good day and welcome to the Digimark Q3 2022 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal for a conference specialist by pressing star and then zero on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star and then one on your telephone keypad. And to withdraw your question, you may press star and then two. Please note this event is being recorded. I'd now like to turn the conference over to Mr. Joel Meyer, the Chief Legal Officer. Please go ahead, sir.

Thank you. Welcome to our Q3 conference call. Riley McCormick, our CEO, and Charles Beck, our CFO, are with me on the call. On the call today, we will discuss Q3 financial results and provide a business update. This will be followed by a question and answer forum. We have posted and prepared our prepared remarks in the investor relations section of our website, and we'll archive this webcast there. Before we begin, let me remind everyone that today's discussion contains forward-looking statements that have risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. Charles will now comment on our Q3 financial results.

Thank you, Joel, and hello, everyone. First-year commercial bookings were $3.2 million during the third quarter compared to $2.9 million in Q3 last year. Bookings in Q3 last year included $600,000 from our piracy intelligence product that we are now nearly complete and winding down. There will be no future bookings from this product category. Excluding piracy intelligence, our first-year commercial bookings increased 800,000 or 35%. Bookings for the quarter included $1.2 million from a new multi-year agreement we signed in Q3 with Walmart. The new agreement provides for a minimum payment of $2.7 million in year one and more than doubles to $5.8 million in year two. These minimum payments are incremental to the $3 million annual payments we receive under the existing agreement. We expect the remaining contract value of $7.3 million to be booked in the fourth quarter upon receiving customer acceptance. Riley will have more to say about this exciting new development later in the call. Revenue for the third quarter was $7.8 million, up 22% from $6.4 million in Q3 last year. Subscription revenue grew 64% in the quarter from $2.5 million to $4.1 million. The new Walmart contract provided for $1.1 million of subscription revenue during the quarter. We expect a similar quarterly revenue run rate for this contract over the next seven quarters with potential upside above the minimum payments. Beyond the Walmart contract, there are two offsetting factors impacting our year-over-year growth. The addition of subscription revenue from everything, offset by the decline in subscription revenue from sunsetting our piracy intelligence product. The impact of sunsetting this product on the quarter was in line with our expectations of 600,000 less revenue than Q3 last year. There will be a similar year-over-year variance in the fourth quarter. Excluding piracy intelligence, subscription revenue increased 2.2 million, nearly 120% year-over-year. Service revenue was 3.7 million in the quarter, compared to 3.9 million in Q3 last year. The change is largely due to the timing of Holy Grail 2.0 recycling work, as we had significant project work last year, but phase two has since completed. Gross margin for the quarter was 53% compared to 66% in Q3 last year. The decrease in margin reflects $1 million of amortization expense recorded on acquired intangible assets recognized in the acquisition accounting for everything. Excluding amortization, subscription margins were 75% and service margins were 57%. Non-GAAP gross profit margin, which excludes amortization expense and stock-based compensation expense, was 72% for the quarter compared to 71% in Q3 last year. Operating expenses for the quarter were $19.7 million compared to $12.2 million in Q3 last year. The increase reflects 4.1 million of operating expenses from everything post-acquisition and 1.4 million of one-time severance costs incurred for organizational changes we made during the quarter. The severance costs were comprised of $800,000 of cash costs and $600,000 of stock-based compensation expense. These organizational changes were made to streamline the business in order to better optimize our go-to-market strategy. Excluding the impact of everything in the severance charge, Operating expenses were $2 million higher year-over-year, which included $1.7 million from higher compensation costs from annual compensation adjustments and higher headcount. Half of the $1.7 million increase in compensation costs was in the form of stock-based compensation. The increase in compensation and headcount since last year has been necessary in order to retain and attract the talent we need on the team to accelerate our go-to-market strategy. Non-GAAP operating expenses for the quarter were $15.5 million compared to $10.1 million in Q3 last year. The increase reflects $3.3 million of non-GAAP operating expenses from everything post-acquisition and $800,000 from the one-time severance costs I just referenced. While these severance costs are one-time in nature, severance itself is not a non-recurring activity, so we do not back it out in determining our non-GAAP measures. Excluding the impact of everything and the cash severance charge, non-GAAP operating expenses were $1.3 million higher year over year, which included $800,000 from higher cash compensation costs from annual compensation adjustments and higher headcount. As part of the organizational changes to optimize operations, we reorganized some of our reporting structures, which impacted the classification of headcount and related costs between departments. This is evident in comparing Q3 operating expenses to Q2, whereby R&D and engineering increased while sales and marketing and G&A decreased. Net loss per common share for the quarter was $0.76 versus $0.17 in Q3 last year. The net loss in Q3 last year was benefited by a $5.1 million non-recurring gain in other income. Non-GAAP net loss per common share, which excludes this $5.1 million gain last year, was $0.47 versus $0.34 in Q3 last year. We ended the quarter with $56.4 million in cash and investments. We used $12 million of cash and investments during the quarter compared to $8.6 million in Q3 last year. The increase reflects cash usage by everything post-acquisition and $700,000 of the $800,000 of one-time cash severance costs that were paid during the quarter. Excluding the severance costs, cash usage would have been $11.3 million. Last quarter, I mentioned that internally we look at non-GAAP net loss, which excludes non-cash expenses, and later on cash used for capital expenditures and share repurchases as our metric to estimate normalized levels of cash flow. For the third quarter, this metric was $10.1 million, factoring in our non-GAAP net loss of $9.3 million. plus $200,000 of capital expenditures and $600,000 for share repurchases. The difference between the $11.3 million of cash used after excluding the cash severance and the $10.1 million is the timing of cash receipts and payments. We anticipate this swinging in a favorable direction in Q4. For further discussion of our financial results and risks and prospects for our business, please refer to our Form 10-Q that will be filed with the SEC. Riley will now provide a business update.

Thanks, Charles. We made progress on many fronts in Q3, but without a doubt, the highlight of the quarter was the deal we signed with Walmart covering an expanded deployment of the Digimark Illuminate platform. I'm confident you all have many questions about what exactly we are doing with Walmart and what new use case will be powered by this expanded deployment of our platform capabilities. Please know that we are equally eager to discuss this incredibly exciting development and plan to when the time is right. Until then, there's just not a whole lot more we could say Besides, stay tuned for more details in the not too distant future. I do want to spend some time framing the opportunity ahead of us as best as I can. And perhaps the best way to do this is to describe the opportunity sets in terms of serviceable available markets, or SAMs, which in this case refers to the size of the opportunities immediately available to us as a result of this deal with Walmart, and the total addressable markets, or TAMs, which refers to the size of the opportunities that exist for DigiMark beyond the scope of this deal as a result of this new use case. First, I want to touch on the SAM and the TAM for the new use case of our platform capabilities. As Charles mentioned, our deal with Walmart is structured so that the payment of $5.8 million in the second year is more than twice as large as the payment in the first year of the deal. It is important to note that even at the end of year two, there are still multiples of upside remaining before we reach full penetration at Walmart. Hence the SAM, as represented by full penetration of this use case at Walmart, is also multiples higher than the $5.8 million payable to DigiMark in year two of the deal. Moving now to the TAM of this new use case, while Walmart is the largest retailer in the US and the world, the deal we signed with them represents only single digit percentages of the total global opportunity for this expanded use of our platform capabilities, and hence the SAM mentioned above, which again is multiples of $5.8 million, is only single digit percentages of the TAM of this new use case of our platform capabilities. For now, of course, our singular focus is delivering for Walmart. It is a top priority across our company. At the same time, it's also important to note that while not a near-term focus, the opportunity to expand this use of our platform is real and it is meaningful, with an annual recurring revenue, or ARR, opportunity well into the nine figures. Beyond the opportunity for increased platform revenue, This deal also provides expanded product opportunities. For the last few quarters, we've been discussing a new DigiMark product that will benefit from a top-down driver of product digitization demand. Our new partnership with Walmart should act as a powerful anchor for that demand. As a result of this deal with Walmart, the SAM of our soon-to-be-launched product is large. It's large enough to take us to profitability all on its own. And like the relationship between the SAM and the TAM on the platform side, The SAM of our new product at launch is also single-digit percentages of its TAM. Measured in ARR, this new product's TAM is larger than the platform opportunity. Even considering the immediate and longer-term opportunities presented by the SAMs and TAMs of both our platform and our soon-to-be-launched product, we think the most exciting part of today's announcement is how much closer we've gotten to a cutting-edge technology leader. Walmart processes a mind-boggling number of products across multiple touchpoints every day and is laser-focused on using technology to improve all aspects of its operations. We are a product digitization company, laser-focused on digitizing the world's products to enable true digital transformation. Our goal with this expanded partnership is quite simple. Continue to win Walmart's faith in our partnership every day because our future together will have a profound impact on the retail industry and beyond. Walmart is a great company doing innovative things, and we're honored to be partners in their product digitization and digital transformation journey. Rest assured, we're just as impatient to talk about what exactly those innovative things are as you and the world at large are to hear about them. But until we can say more in a very public way, I ask you to respect our commitment to customer confidentiality. We take it very seriously. Moving on from the Walmart news, Q3 also saw us make progress with Digimark Recycle. Some visible, some not, but all of which is significant. Starting with what was visible, a few weeks ago, we released the top line results of the Canadian Circular Plastic Task Force pilot, which yet again confirmed that DigiMark Recycle is exceedingly effective in improving the accuracy of recycling sortation and provides an ability to sort material that current optical sorting technology simply cannot. Not only are the results from the trial incredibly high, with 99% accuracy, they were also consistent with similar tests recently performed. I highlight this because this consistency in performance, regardless of the material, form factor, type of commingled waste, geography, or stakeholder group, proves repeatability. This third test at DigiMark Recycle shows the exact same accuracy rates as the prior two. There should be zero doubt as to the real step change value we can provide. For those of you unfamiliar with the CPT, they aim to drive projects to improve plastic packaging recycling with the within the evolving extended producer responsibility landscape in Quebec and Canada more broadly. Their focus in working with us is on improving the recovery rates of flexible plastic packaging because today's current sortation technology cannot distinguish between monomaterial recyclable packaging and multi-material structures, lowering overall bale quality. We are energized by the opportunity to support CPTs to execute against their vision for more effective recycling in Canada. Beyond Canada, we are discussing how Digimark Recycle can be a game changer with multiple stakeholders in other geographies, and interest is growing. We are prioritizing opportunities where there is real urgency and commitment, because there truly is no time to waste. I'm borrowing the rallying cry of no time to waste from the Business Coalition for a Global Plastic Treaty, a group of 80-plus companies, including Digimark. that launched in Q3 and is committed to supporting the development of an ambitious, effective, and legally binding UN Global Treaty to end plastic pollution. One of the convening organizations, the Ellen MacArthur Foundation, recently published a document that shows that the implementation of high-quality recycling wouldn't just have a large impact on carbon emissions reductions, but that the carbon emissions reduction can be achieved at a negative cost. No time to waste, indeed. And DigiMark is committed to being part of the solution. Looking forward a bit, at the end of this month, the European Commission, the main EU regulatory authority, will publish its proposal to revise the rules for packaging and packaging waste for the European market. They wish to upgrade the 1994 rules by tackling the growing production of packaging waste and the low level of packaging circularity. We expect the Commission to unveil several measures to achieve these objectives, including mandatory recyclability of packaging and recycled content targets, new labeling requirements, and greener public procurement. As many of you know, DigiMark is uniquely positioned to support stakeholders in achieving these objectives. We look forward to the Commission's proposal at the end of the month. And post-release, we are prepared to educate policymakers and other key stakeholders about our technology, including brands and retailers, who we can support so they are better prepared to meet the forthcoming requirements. For those interested, the revision of the Packaging and Packaging Waste Directive will be published on the Commission's website and discussed in a press conference and press release on November 30th. Before we open up the call to questions, I want to recognize a big milestone in the work that we began six quarters ago, as we took the time to question every assumption and come up with the right answers, and in doing so, transformed our company in many ways, big and small. In early Q3, we launched our refreshed website, reflecting not just our new look, but also revealing a lot of new content that is a result of our transformation. For those of you who haven't visited our website recently, I encourage you to do so. There is so much going on at our company, it is difficult to adequately convey all of it on these quarterly calls. Speaking now to my teammates, whose hard-inspired work over these past six quarters has gotten us to where we are now and will only continue to take us to new heights. You all know our thematic goal for this quarter. It's time. Let's do this. Operator, we will now open the call for questions.

Thank you very much. We will now begin the question and answer session. To ask a question, you may press star and then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the star keys. If at any time your question has been addressed and you would like to withdraw your question, please press star and then two. At this time, we will pause momentarily to assemble the roster. The first question comes from Matt Collard from PCB Advisory. Please proceed with your question, Matt.

Hey, Riley. Congrats to you and the team on the overall progress and the Walmart deal in the quarter. a lot is being made about the digital twins strategy in this tech landscape. And you recently highlighted a McKinsey interview on the topic. I wanted to know, how is the evolving digital twin definition or understanding shaping or framing your conversations with your customers or soon-to-be customers?

Yeah. Hey, Matt. It's a great question. You know, we started calling what we have digital twins when we closed the acquisition of everything. And what was so interesting about the McKinsey article, it was the first time, or I guess an interview or a podcast. It was the first time that a major group, and obviously McKinsey, I don't think anybody has called me as an introduction to McKinsey, but started referring to the term as we do. So a digital twin is just a digital representation of an item. But for the last couple of years, the industry has been talking, normally using that term to mean a complex system like a factory floor or oil or refinery, something like that. Products deserve digital twins, too. And so there's a lot better understanding of what we're doing. Product digitization is still pretty early in terms of people really understanding the value. This is what we talked about when we announced the Everything Acquisition, which is everybody understands the value of ERP. I mean, that's a massive market. Everybody understands the value of CRM. It's also a massive market. But the items that are produced that go from the enterprise resources and go to the customers, those two need to be digitized in order to reach true digital transformation. And the fact that McKinsey and there was actually Gartner has now started talking about what they call discrete digital twins, which is what we do. The fact that these massive thought leaders are coming around and seeing things the way that we see it, It just helps drive clarity, right? So we don't need to spend, and we're still early even in their driving clarity, right? But as the analysts pick up this term more and more and start talking about the world the way that we see it, we don't need to spend the first 20 minutes of a conversation with a customer or a prospect talking about what is exactly what we do. We can say we're the leading digital twin company. Let's talk about our products. So it's a wonderful unlock. It's a wonderful validation of what the team's done here. I was just excited to see it. It was exciting to see it. Great.

I appreciate the explanation. I'll jump back into the queue. Awesome. Thanks, Matt.

And thanks for the kind words at the beginning, too.

Thank you. The next question comes from Martin, etc., who is a private investor. Please proceed with your question, Martin.

Congratulations on the Walmart pump. Thanks, Martin. All right. To be clear, you think that alone could be a hundred million dollars in revenue annually? You said nine figures.

I'm sorry. I'm having a hard time hearing you.

To be clear, you think the Walmart deal alone could be nine figures, a hundred million dollars a year in revenue?

No, what we said is the same. So at 5.8 million, which is the second year of the Walmart contract, there's still multiples left of before we reach full penetration of Walmart. So we haven't defined exactly what that means, but the, there is upside from the 5.8 just from the Walmart deal.

But then we also, sorry, I'm trying to get my head around a hundred million dollars.

So the total addressable market. So, so we are, we are licensing our platform to Walmart for a undisclosed use case. We, the, That same use case outside of Walmart, that's what we were talking about, could be the nine figures. Not with Walmart directly. I understand.

Last question, if you don't mind. Before this takes off, have you had any discussions about taking your company private?

No.

No. Excellent. All right. I look forward to riding this rocket ship with you.

Okay, thank you. The next question comes from Jeff Bernstein from Cohen. Please proceed with your question, Jeff.

Hey, Riley. So congratulations on the deal, and I guess this is the application that you talked about, sort of having to have the impetus from the other party to get done. And so maybe you could confirm that.

Yeah, so we've been talking about a top-down driver of product digitization. What we said is the ultimate timing of the release of that product is outside of our control. And what we said today is that the deal we signed with Walmart is a very powerful anchor in the launch of that new product.

Gotcha. And then I just wanted to understand the particulars a little bit, and you have talked about this in general terms previously. So there's an application here that Walmart is going to license your platform for There's going to be an impetus for their supply chain partners to utilize DigiMark barcode in order to facilitate Walmart's development of that capability. There may be other Walmart-type customers for that application, and they may have the cooperation of their supply chains that would then need to adopt DigiMark barcode as well. And that constitutes the kind of entire TAM available.

Jeff, I understand why you're asking. I really don't want to talk about this. I mean, this is, as we said, we take customer confidentiality very seriously. But let me try, maybe try it another way, right? We have signed a deal with Walmart for the access to our platform, okay? That is the deal we announced today. There are other people in the world who can benefit from this use case outside of the Walmart. So that's the SAM and the TAM on the platform side. We are about to launch a product which will benefit from a top-down driver of product digitization. And this deal that we signed with Walmart is a powerful anchor in that. That's all I'm comfortable saying. That's all I really want to say right now.

That's great. That's great.

But important, I think, you know, the immediate opportunity here is even in the second year of this contract, we are not fully penetrated at Walmart. And the new product we will launch has an undisclosed TAM, but we were trying to give some ballpark figures, which is the immediately addressable opportunity for the new product by itself is enough to take us to profitability as a company.

Yeah, I understand. That's great. And then I had two quick other questions for you around some things going on with GS1. They've got this new global location numbers. Sounds like it's something that would be very positive for everything applications, as well as a program, Sunrise 2027, to make sure that POS systems at retail can handle 2D barcodes. Just touch on those for a minute.

Yeah, well, so first of all, the second thing you're talking about is Digital Link, which everything was a – big part of writing that standard. And so it's something we welcome. And in general, you know, we're big fans of GS1. What GS1 allows is for the global industry to trade with each other, right? And so the easier that is, the more standards that are built so that the supply chain can work, the more we're going to benefit as a product digitization company. So we're big fans of everything that GS1 does. But specifically, the last thing you're referencing, this 2027 sunrise, that's a standard called digital link. And that's something that everything actually was a, you know, one of the big, was heavily involved in crafting that standard. Great. Thank you.

Thank you. And ladies and gentlemen, just another reminder, if you'd like to ask a question, please press star and then 1. The next question comes from Jeff Van Rie from Craig Helen Capital Group. Please proceed with your question, Jeff.

Hey, guys. This is Daniel Long for Jeff Van Rie. Yeah, very exciting to hear about the Walmart deal. Just interested on the first and second year, maybe I missed it, but just understanding when these years fall, I assume, are we talking fiscal years? So fiscal year 2023, fiscal year 2024, are we talking years starting now here from Q3, just what do we mean by first and second year?

Yeah, it's starting as a Q3. So it's a term of the contract. The first year of the contract runs from Q3 to Q2 and then the following year, the same time period.

Okay, great. That's helpful. And then on everything, just looking at the numbers and the sequential year-over-year, if I understand correctly, is everything running around 1.3 million? First, is that correct? And then second, How is the everything integration going, and how is that in terms of meeting expectations?

Yeah, so I'll end on the second part, and I'll turn it over to Charles for the first part. The integration is great. The integration is complete. We had an internal target we were calling day alpha, which is each functional group by functional group went through at the close of the acquisition. and said, what is the list of things that we need to do to be operating as one company? And we achieved that in Q3. That was probably a highlight. I should have included my transcript. But we set out a goal. I said something internally. When we announced the acquisition, myself and some of the Digimark leadership team were over in London, and I said, my goal is that a year from now, nobody will remember what name was on their business card a year ago. And it's, you know, we are one team. We are one company. So the integration is in the rearview mirror, and it's going great. And Charles, you want to talk about, I think maybe we're talking about, we're talking about the 1.3 number you're talking about.

Yeah, so we're intentionally not breaking that out because we're selling a combined product now. So you can kind of do some back-end math to say what it might kind of be, but we're selling a combined product, so there's no way to really allocate that out. So we're not reporting individual everything revenue and bookings numbers.

Yeah, and one thing I keep in mind as you're trying to do that math is you can imagine everything had non-U.S. dollar exposure. And so as you're looking, you know, what's happened to the dollar versus every other currency, it's strengthened since the beginning of the year. So that's been a headwind to that number as well.

Thanks. That's all I had. Thanks for taking my question.

Thank you. This concludes our question and answer session. I'd now like to turn the conference over to Riley McCormick for closing remarks. Thank you, sir.

Well, thank you, Claudia, and thank you, everybody, for dialing in, and we look forward to speaking with you again soon. Have a great rest of your day. Bye.

Thank you. The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect your lines.