Digimarc Corporation

Greetings and welcome to the Digimar Corporation first quarter 2023 financial results conference call. At this time, all participants are in a listen-only mode and the floor will be open for questions following the presentation. If you should require assistance throughout the conference, please press star zero to reach a live operator. As a reminder, this conference is being recorded. At this time, it is my pleasure to turn the call over to Joel Meyer. Sir, the floor is yours.

Thank you, Karen. Welcome to our Q1 conference call. Riley McCormack, our CEO, and Charles Beck, our CFO, are with me on the call. On the call today, we will provide a business update and discuss Q1 2023 financial results. This will be followed by a question and answer forum. We have posted 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. Riley will now provide a business update.

Thank you, Joel, and hello, everyone. Our goal is to digitize the world's products. To accomplish this, we must be easy to begin doing business with and excellent at guiding customers along their DigiMark journey. These simple truths drive everything that we do. We have two distinct ways of going to market. On the direct sales side, by building a growing number of our own accretive products upon our world-leading product digitization engine, the DigiMark Illuminate platform, we are not only ensuring a customer is able to solve the problem that brought them to us today, but also providing them a frictionless path to solve the problems they want to solve tomorrow. Moreover, because our products are accretive, which means that the standalone value they provide is increased by the adoption of additional DigiMark products, this frictionless path forward not just solves new problems, it compounds returns for all products existing and new. On the channel sales side, by licensing the DigiMark Illuminate platform to a growing number of value-added resellers or VARs, We not only gain quickly scalable and high margin revenue as our VARs go to market with their own products and services built upon our world leading product digitization platform. We also increase the amount of items that are digitized using our technology. This creates an ever increasing number of upsell and cross sell opportunities for both us and our VARs. You might recognize these words as they are verbatim from our last earnings call. These words describe where we are going and how we are going to get there and thus are worth repeating. especially as I appreciate that we are a much different company than we were just a short while ago. Last quarter, after providing this preamble, I spent the rest of the call discussing a few of our products. This quarter, I want to spend time discussing our platform because both technologically and commercially, our DigiMark Illuminate platform is quite literally foundational to everything we do. As mentioned earlier, each of our products is built upon our DigiMark Illuminate platform. This allows each of them to benefit from the unique and powerful capabilities that comprise our best-in-class product digitization platform, and also allows them to add a creative value to each other. These two facts are key contributors to our extremely wide modes, and thus it is our platform that ultimately powers our product success. Moving to our Q1 results, while simply a one-quarter snapshot, the majority of both our new logos and our upsells were Digimark Illuminate customers. including one VAR that signed a six-figure deal. This VAR is a large company and a category leader, and we are excited they have begun their DigiMark journey. We are already in discussions with them about licensing additional capacity as they educate their end customers on the value of product digitization. Q1 also signed another new VAR who came to us in response to one of their competitors having a product that is powered by the DigiMark Illuminate platform, and their realization they need our product digitization hyperscaler to compete. And then, of course, there's the DigiMark Illuminate deal we announced today, a $32 million five-year contract to protect the authenticity of precious metals, critical building materials, and a national deposit return system, or DRS, for recycling. There are five things about this deal I want to highlight. First, of course, is the size of the deal, both in terms of revenue and duration. Charles will give a bit more detail about this contract in a minute, but this deal provides our newest far the ability to use the Digimark Illuminate platform as a key component in three of its products, each of which is targeted at one of the three end markets I just mentioned. Due to our customers' confidence in our platform and their confidence in their ability to build wonderful products on top of our platform, they signed a five-year license for each of their products, rollout of which will occur in a staggered fashion for the rest of this calendar year. Second, there is upside to this contract beyond the $32 million. This upside comes from two different areas, an increase in the amount of capacity needed for any of these three products or an increase in the amount of capacity needed because of the launch of additional products. One such additional product is far enough along to be scoped within the contract, and if it were to proceed, provide meaningful upside to the headline dollar amount. We believe there are likely to be other product opportunities even beyond this fourth product, a view shared by our valued customer. At the risk of understatement, we are excited to partner with them as they continue their DigiMark journey. Third, two of the products covered by this deal, the one protecting the authenticity of precious metals and the one protecting the authenticity of critical building materials, represents the first use of our platform in the security printing market. The security printing market is a greenfield opportunity for us on the commercial side of our business, and one where our moat is not just the unique capabilities of our platform, but the credibility, reputation, and expertise we have earned while working with the world's central banks for these last 24 years. We don't talk a lot about our team working with the central banks because we can't talk a lot about that team or the amazing work they do. But across all of our commercial activities, and especially as we enter the world of security printing, this team's history of absolute excellence provides us a moat as deep and as wide as any other we enjoy. Fourth, the third product covered by this deal, the one guarding the integrity of a national deposit return system, represents our entry into an important and exciting new market adjacency. Our ability to help power a more circular world doesn't begin and end with DigiMark Recycle. Our entry into the quickly growing DRS market has three important implications. It provides synergistic benefits to DigiMark Recycle and vice versa. It increases the TAM of our overall opportunity in recycling. and it allows us to make an even more profound impact on our planet. Fifth, the three products being powered by DigiMark Illuminate align perfectly with our purpose. We highlight a product's journey to provide trusted intelligence and promote a prosperous, precious metals, safer, critical building materials, and more sustainable DRS world. Our greatest strengths always has been, is, and always will be our people. For a lot of our team, it is their belief in our purpose that drives them to excel. On a personal note, I find it pretty darn cool this single deal covers all three. I will now turn the call over to Charles to discuss our financial results.

Thank you, Riley, and hello, everyone. Before I dive into our Q1 financial results, I want to provide some more details on the financial impact of the large new revenue contract Riley mentioned. As a reminder, the annual minimum contract value is $6 million per year, with a contract term for the three products each spanning five years. The contract provides additional payments from the customer if they require more capacity on our DigiMark Illuminate platform. The first year commercial booking will be $5.1 million in the second quarter as the contract was signed in April. The contract provides the customer the ability to use our platform for each of its three products, each with different start dates and payment dates. As a result, $900,000 of the initial $6 million annual fee is payable after the 12-month anniversary of the contract effective date. These fees are non-cancellable, but given the timing of when the payments are due, they do not meet the definition of first-year bookings. It's important to note the remaining $900,000 will not be reported as a first-year booking in subsequent quarters due to the way we calculate and report this metric. The fact we are signing more and more multi-year committed deals has been reducing the value of our reported first-year bookings number, as the out years of multi-year deals never show up in a reported booking number, whereas a renewal would. This is a wonderful trend for our business that we are heavily pursuing, but it comes at a cost of understanding our underlying growth to all of you. We are evaluating additional metrics to share in the future that will better capture our true underlying growth rate. Now onto our Q1 financial results. There are four important trends I want to highlight before digging deeper. During the first quarter, we generated 21% subscription revenue growth on our current products. We realized 80% subscription gross profit margins, and we significantly reduced our recurring operating expenses. As a result, we saw a significant reduction in the level of cash usage, which we expect to continue to improve through the year. First-year commercial bookings were $2.3 million during the first quarter compared to $3.8 million in Q1 last year. Bookings in Q1 last year included $900,000 for Holy Grail project work related to Phase 2, which is now complete, and $300,000 related to our former piracy intelligence product. Excluding these two one-off items, first-year commercial bookings would have been $2.6 million in Q1 last year. The timing of contract renewals also impacted the trend in bookings year over year, as we had two six-figure contracts that renewed in early Q2 this year instead of Q1, both with sizable upsells. Total revenue for the quarter was $7.8 million, an increase of $400,000, or 6%, from $7.4 million in Q1 last year. Excluding revenue from our former piracy intelligence product, revenue increased $1 million, or 15%, year over year. Subscription revenue, which accounted for 50% of total revenue for the quarter, grew 2% from 3.8 million to 3.9 million. Adjusting for the sunsetting of our piracy intelligence product I just mentioned, subscription revenue actually increased 700,000, or 21%. As a reminder, piracy intelligence revenue in the second quarter of 2022 was 300,000. But after that, it essentially went to zero. So this headwind to reported year-over-year growth rates will go away in the second half of 2023. Service revenue grew 9% from $3.6 million to $4 million. The increase is due to a larger annual budget from the central banks for project work in 2023 than 2022, which includes both higher billing rates and project hours. We expect service revenue from the central banks to grow over 10% this year from last year. Subscription gross profit margin improved from 73% in Q1 last year to 80% in Q1 this year. The large increase year over year reflects two positive trends. First, a favorable mix of subscription revenue to our newer products, which carry higher gross profit margins than our legacy products. Second, as we foreshadowed on the last earnings call, our product infrastructure costs are declining, even with increased usage by customers on our platform. We expect these trends to continue, resulting in further expansion to our subscription gross profit margins. On the last earnings call, I stated we expected to drive our subscription gross profit margins to north of 80% in 2023. After the first quarter, we are nearly there with room for continued margin expansion. This is an important development to note given our focus on growing subscription revenue. Service gross profit margin improved from 49% in Q1 last year to 57% in Q1 this year. The increase reflects lower professional services costs this quarter, as we have streamlined our operations function since the acquisition in January last year. We anticipate service gross profit margin to remain in the mid-50s on average going forward, with some fluctuation quarter to quarter depending on labor mix. Operating expenses for the quarter were $19 million compared to $21.4 million in Q1 last year. Included in the $19 million of operating expenses was one-time cash severance costs of $1.5 million and $600,000 of stock compensation costs as a result of our previously announced restructuring plan this past February. Excluding these one-time costs, operating expenses would have been $16.9 million representing a 21% decline from Q1 last year. As you will recall, Q1 last year included costs related to the everything acquisition and integration, as well as higher headcount related costs than as compared to today. Non-GAAP operating expenses for the quarter were $15.5 million compared to $17 million in Q1 last year. Included in the $15.5 million was one-time cash severance costs of $1.5 million as a result of the February restructuring plan. Excluding the one-time costs, non-GAAP operating expenses would have been $14 million representing an 18% decline from Q1 last year. As a reminder, the restructuring of our business, which has now been completed, will result in approximately $8 million of annual expense savings with $7.4 million of those savings being cash-related costs. We continue to be focused on ways to further reduce our non-headcount related costs and drive greater efficiency across the organization. We are working to streamline our processes and leverage new technologies to provide for greater scale without having to make material new investments in headcount. Net loss per common share for the quarter was 70 cents versus 103 cents in Q1 last year. Non-GAAP net loss per share, which excludes non-cash and non-recurring items, was 45 cents versus 69 cents in Q1 last year. We ended the quarter with 43 million in cash and investments. We used 9.5 million of cash and investments during the quarter compared to 16.7 million in Q1 last year. Included, though, in the 9.5 million is 1.5 million of one-time cash severance costs. Excluding the one-time costs, cash usage would have been 8 million, a considerable reduction in the trend of cash usage from last year. We anticipate that cash usage will continue to decline in 2023 as we continue to grow our revenue, reduce our product infrastructure costs, and focus on continued operating efficiencies. For further discussion of our financial results and risks and prospects for our business, please see our Form 10-Q that will be filed with the SEC. I will now turn the call back over to Riley for final remarks.

Thanks, Charles. In thinking how I wanted to end this call, I realize that how I ended the last call also still rings true word for word. This consistency and message is made possible by an incredible team all rowing in the same direction, aligned in their focus on changing the world. I also realize that by dedicating today's prepared remarks to talk about our platform, it is possible one might question what's going on with our products, similar to it being possible that leaving the last call the inverse concern could have been true, and recent events would have quickly proven unfounded. I am thus going to end this call like I began it, reiterating what I said just a few months ago with added emphasis on one key area I perhaps didn't emphasize enough last time. 2022 saw us set the foundation for the years ahead, and we are excited to continue to build upon that foundation in 2023 and beyond. We are seeing momentum across all areas of our business and are hard at work continuing to increase that momentum as we create a market that we are uniquely positioned to lead for years to come. a market that at scale has the opportunity to be as large, if not larger, than the other legs of the digital transformation stool. There are trillions of items produced each year, and our goal is to sell multiple DigiMark products into each of them, adding exponentially accretive value as we digitize the world's products. Karen, we will now open up the call for questions.

Thank you. Ladies and gentlemen, the floor is now open for questions. If you do have a question, please press star 1 on your telephone keypad at this time. Again, that's star 1 if you do have a question or comment. Please hold as we poll for questions. And we'll take our first question from Jeff Van Ree from Craig Hallam. Please go ahead, Jeff.

Great. Thanks for taking the questions. Several. Obviously, a lot going on here. Maybe, Riley, just start with the use cases. I mean, you hit them pretty quickly, but go a little deeper. What are you doing in each of these three cases? Because they're in some ways similar, but in more ways they're not similar. Just talk a little deeper about what exactly you're doing in each of those use cases.

Yeah, sure. And I will to the extent we can. Obviously, when it comes to authentication and product authentication issues, Customers don't really like us talking too much about it. But on the precious metals and the critical building materials, the customer is using Illuminate to protect the packaging of those items. And then on the DRS, it's similar. It's using Illuminate to digitize items, products that would be part of a DRS system.

When you say protect packaging, are you talking about serialization so each individual package is individually identified or just authenticity, generally speaking?

I really don't want to go into exactly what they're doing. There's a lot of wonderful capabilities in Illuminate that any of our VARs could take advantage of to build their own products. Again, so if you're familiar with all of the capabilities in Illuminate, they have access to Illuminate and they're building their own products using those capabilities.

Yeah, yeah, that's some of the challenge. It's very diverse in terms of what it does, but I appreciate the privacy requirements. Charles, in terms of the contract itself, forgive me, but maybe you could revisit. The RevRec, is this going to be ratable? And then I was unclear, you said a little bit about the bookings and the recognition of the bookings, but I'm curious on the cash collection and the revenue recognition.

Yeah, so we're working through the revenue recognition right now. I would suspect that it's going to generally be ratable. There are three different products, though, that start at different points in time. So you're not just going to be able to take the $6 million and ratably take it from there because each of the products are phased. And that's the same with the cash. And that's why $900,000 of the cash falls outside of the first 12 months of the contract and therefore doesn't meet our definition of a first-year booking.

Okay, so $900K is out, so $5.1 of the cash comes in year one? Correct. Okay.

And then revenue will ramp as those products come online.

Okay. And the timelines, I mean, obviously we've got to build a model. Can you give us some sense of timing on when these three are going to layer in? How do we approach that?

Well, the majority of it's being paid in the first year, so all of the products are starting within one year. Okay.

Less than one year. Yep. Okay, got it. And then, obviously, you're not naming the VAR, but these are pretty diverse use cases. I mean, I don't know, just... How many other VARs are there similar to this? This is, I don't know, a unique customer. I'm trying to understand exactly what their practice is.

Anybody who creates, touches the product packaging ecosystem, Jeff, is a potential VAR for us. So there's a ton of VARs out there that we haven't even begun to talk to yet.

Mm-hmm. Okay. Okay. And just to be clear, the $6 million, you know, roughly a year is guaranteed.

I mean, think about, Jeff, there are trillions and trillions of items produced every year. Each of those are produced with a broad ecosystem, right? So there's just a ton. I'll leave it at that.

Yeah. Okay. I'll leave it there. Thank you. Thanks, Jeff.

Once again, that's star one if you do have a question or comment. And we'll take our next question from Robin Nipp from Janie Montgomery. Please go ahead.

Hey, Raleigh. Great quarter. Thanks for taking the question. Are you able to share with us any more insight as to which country this national deposit return system for recycling is referring to?

No. We've shared what we can share, unfortunately.

Okay, so I've got to get on a plane and travel the world with my Digimark Discover. Okay, thanks. Once again, great quarter.

Thanks, Robin.

Thank you. And we'll take our next question from Matt Tollard from PCB Advisory. Please go ahead, Matt.

Hey, Riley. Hey, Charles. Great quarter. Congratulations. Could you, Riley, could you talk for us a little bit, With the maturing of these VAR relationships, you know, you started signing them last year, and you're continuing to sign them, and obviously it sounds from the tone of the call the activity continues to spike. So in these VAR discussions, how is there – enthusiasm or how is their interest in the illuminate or the products digimarks offers changing and I guess I'm interested in where I'm going with this is it seems like a lot of these of our deals have minimum contracts and then I don't you mentioned service addressable markets on top of that I'm just trying to see how what their enthusiasm or how their enthusiasm is growing yeah you know

It's growing. I mean, if you think about our most likely VAR candidates, and some of them are publicly known, right? These are people in the packaging space that what we have currently in Illuminate, what we're building in Illuminate, it's a full-time job, right? And so the ability to have a hyperscaler, I think I use the word hyperscaler during the prepared remarks on purpose. I think most people think of hyperscalers and AWS, Azure, as CPU and memory hyperscalers. We're a product digitization hyperscaler for people who don't have the capacity or the interest or, um, you know, for whatever reason where they don't want to invest, uh, in the platform to build their own, um, build their own platform for product digitization, but produce packaging, produce products and realize this is a trend. Um, We're a great outsourced partner there, so they can license our platform just like anybody can license AWS or Azure or GCP and build their own products and services on top of it. So it's an area of great excitement, and it's a mutually beneficial win-win-win, actually, for us, for the VAR, and for the end customers. I talked a little bit, Matt, on the last call. I think actually you and I discussed it in the Q&A on the last call, but it's pretty exciting.

Great. And I guess to build on that, it seems like the enthusiasm from the VARs is, you know, we look at historically, obviously, we've got this holy grail effort kind of looming, if you will. And, you know, as shareholders, we're all looking towards the end game where there'll be some legislative support for recycling and for extended producer responsibilities and all that. But it doesn't seem like You know, all of ours are coming to you with much different propositions, much different challenges that need solutions versus thinking ahead towards that end game.

Yeah, so DigiMark Recycle is a product we've built on our platform. So, again, just taking a quick step back, right? DigiMark Illuminate platform contains all of our capabilities, right, everything we can do. We either license the platform to the VARs to build their own products and services, or that's what we use internally to build our products and services. So Digimark Recycle is a product that we build. That is something that we'll be offering directly to the world's brands and retailers. So they're different. And I talked a little bit in the last call, right, where our VARs license our platform. They're not reselling our products. We sell our products direct to the world's brands and retailers.

Got it. All right. I'll jump back in the queue. Appreciate it. Thanks, Matt.

Thank you. Once again, that's star one if you do have a question or comment. And we'll take our next question from Harvey Morka. Please go ahead, Harvey.

Hi, Robbie. Thanks for taking the call. Based on our low share price right now, and the large moat that we have, and the extensive patent library.

Is there anybody taking a look at us as far as an acquisition? Harvey, I think every time you're on the call, you ask the same question. The answer is no. Nobody's looking yet. Okay. Thank you.

Thank you.

And we'll take another question from Jeff Van Ree from Craig Hallam. Please go ahead, Jeff.

Yeah, great. Thanks for the follow-up. You commented on the restructuring and the reduced cash burn expectations. Can you put some numbers around that? How should we think about the remainder of the year in terms of cash burn?

Yeah, Jeff, I mean, we don't give exact guidance. What I can do is kind of broad strokes, right? So we've got growing revenue, we've got margin expansion, and we've got about $8 million lower run rate in OPEX.

Okay.

Those are the two drivers.

Okay. And then, Riley, you commented on the VARs. You know, you can sell product or you can sell platform. This is a platform to the VAR to go build applications. To the extent they have to go build something yet, what does that look like?

Depends on each relationship, right? I think, Jeff, maybe the best way to picture it is just picture what AWS and Azure and GCP offer people, right? It's outsourced. It's a hyperscaler for compute and for memory. And some people build really, really intricate applications products and services on top of those, and some people build very little. So it really depends on the VAR and the products that they want to build.

Okay. And then from a margin standpoint, I think I know the answer, but if you're selling this to the VAR and you're not providing any of the service, then this is just a pure licensing deal. There's no other. So this should be almost pure gross margin.

Yeah, I mean, there's obviously costs. So the way we meter out access to our platform is, well, we meter out access, right? So we have cost of goods sold of the platform. But you're right. The nice thing about the VAR, there's a lot of wonderful things about the VAR channel as a go-to-market channel. But among them is quick ability to ramp. right? These are, VARs are built, they're building something internally, and then a lot of times they have hundreds and hundreds of customers that they're going to roll it out to, but it's also extremely high margin.

Okay, great. Thank you.

And we'll take our next question from Kevin Hanrahan from KMH. Please go ahead, Kevin.

Hi, Charles. I had a question about the NOL. I know you did your 10K recently. If you had that number, could you update us And if you don't have it, could you give me that number offline?

Yeah, I don't have the number memorized. I'll send you a note.

Okay, that's fine. Thank you, Charles.

As a reminder, that's star 1 if you do have a question or comment.

And there appear to be no further questions at this time. I'll turn the floor back to Mr. McCormick for closing remarks.

Well, thank you, Karen, and thank you, everybody. I hope you have a great rest of your day. Take care.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time, and have a great day.