Digimarc Corporation

Greetings, and welcome to the Digimark Corporation 3rd Quarter 2024 Earnings Conference Call. At this time, all participants will be in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star then zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, George Karamanos. Please go ahead, Sol.

Welcome, everyone, 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'll provide a business update and discuss Q3 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, George, and hello, everyone. Looking forward, Q3 was the most significant quarter I've witnessed since I joined the company.

Invention and market development are the twin pillars upon which all future opportunities are built. In both of these critical areas, we not only made significant progress on things underway, we also opened new areas of opportunity we previously didn't believe addressable in the near term. Looking back, we acknowledge Q3 revenue doesn't reflect the reality just described. The gap between what lies ahead and what lies behind has never been this large. As noted in the 10Q that we published today, Our third quarter results were impacted by the delayed renewal of a commercial contract. The financial component of this deal is meaningful as it represents a significant upsell. The strategic component will prove transformational, not only to our company, but also to the massive industry will revolutionize. In fact, it is exactly this broad industry impact that has led to this deal taking longer to close than all involved originally believed. Trading time to close for strategic scope is an outcome I unequivocally support. We run our business to maximize long-term value, and we expect our current path to do exactly that. In addition, our decision to invest a large amount of company resources in Q3 to support this deal versus other opportunities is another decision behind which I unequivocally stand, even knowing as we do now that the expenditure of those resources wouldn't fall in the same order in which the deal was signed. Because of the transformational nature of this deal from both a financial and strategic perspective, if it closes before our next scheduled call, as we currently believe is likely, we will hold an interim call. On any such call, we will provide more details on the specific deal, as well as a more complete discussion of what lies ahead, providing the context we know we owe you as to why we believe the gap between looking forward and looking backward has never been this large. For reasons that will be clear, Our ability to provide the full picture today is impacted by our inability to discuss the specifics of this deal. Instead of providing a partial picture by discussing the other important developments I noted earlier, I will reserve the rest of my prepared remarks for this interim call.

I will now turn the call over to Charles to discuss our Q3 financial results.

Thank you, Riley, and hello, everyone. I normally begin my discussion of our financial results by providing a snapshot of our key financial metrics. because I believe this overview provides useful context ahead of discussing each metric in turn. As a result of the significance of the delayed contract Riley just referenced, today I'm going to forego providing that snapshot because Q3 results are not a true representation of the state of our business. In addition to having an outsized impact on ending ARR, the delay in resigning resulted in no revenue being recognized or cash collected from this contractor in Q3. By significantly impacting some of our most important financial metrics, this delay means quarterly financial results are not reflective of our expected go-forward performance, even before considering this contract renewal is expected to include a large upsell. Ending ARR was $18.7 million compared to $19.6 million at the end of September last year. ARR decreased $900,000, which reflects a $5.8 million decrease due to the delayed contract I just referenced. as the original contract has expired and is therefore excluded from ending ARR. The decrease in ARR from this contract is partially offset by new net additions to ARR. While some companies include forecast renewals in their ARR metric, we take a more conservative approach by only including contracts that are booked in ARR. Total revenue for the quarter was $9.4 million, an increase of $500,000, or 5%, from $9 million in Q3 last year. Subscription revenue, which accounted for 56% of total revenue for the quarter, grew 9% from 4.8 million to 5.3 million year-over-year. The increase reflects subscription revenue recognized on new customer contracts, as well as upsells on existing customer contracts, offset by no revenue being recognized from the impacted contract, as I mentioned earlier. Subscription revenue growth would have been significantly higher if the delayed contract had closed within Q3, as we originally expected. Service revenue was flat at $4.2 million year-over-year, reflecting higher commercial service revenue from Holy Grail recycling projects, partially offset by lower government service revenue due to timing. Subscription gross profit margin improved slightly to 86% in Q3 this year, compared to 85% in Q3 last year and 89% in the prior quarter. The sequential drop in subscription gross profit margin is due to the absorption of fixed costs over a lower subscription revenue number. This metric would have been significantly higher on both a year-over-year and sequential basis if the aforementioned contract had closed in Q3. Service growth profit margin improved from 54% in Q3 last year to 61% in Q3 this year, reflecting a favorable change in labor mix. We expect to generate mid-50% service growth profit margins on a normalized basis with some fluctuation quarter-to-quarter. Operating expenses for the quarter were $17.3 million compared to $16.4 million in Q3 last year, an increase of 5%. Included in the Q3 operating expenses this quarter, though, was $600,000 of one-time cash severance costs for organizational changes made during the quarter to better align our operations. Additionally, operating expenses were $400,000 higher due to lower labor costs allocated to cost of revenues. due to the amount and mix of billable labor hours incurred during the quarter. Total expenses, which excludes the impact of allocations, were flat year over year when removing the 600,000 of one-time severance costs. Non-GAAP operating expenses, which excludes non-cash and non-recurring items, were 14.1 million for the quarter, up 7% compared to 13.2 million in Q3 last year. The increase in non-GAAP operating expenses closely mirrors the increase in GAAP operating expenses that I just explained. And like total GAAP expenses, total non-GAAP expenses were flat when excluding one-time severance costs and the impact of allocations. Net loss per share for the quarter was 50 cents versus 53 cents in Q3 last year. Non-GAAP net loss per share was 29 cents in both periods. We ended the quarter with 33.7 million in cash and short-term investments. Free cash flow usage was $7.3 million to the quarter compared to $400,000 in Q3 last year. The variation year over year is primarily due to the timing of cash receipts from the contract we've been referencing throughout our prepared remarks. If this contract, as currently drafted, had been executed and paid within the third quarter, free cash flow would have been positive in Q3. While we are working diligently to finalize this contract in Q4, the receipt of payment will lag contract execution by standard payment terms. Even if we do not receive payment from this contract before the end of the year, we expect Q4 free cash flow usage to be significantly improved from Q3. If we do receive payment before the end of the year, we expect Q4 free cash flow to be significantly positive. For further discussion of our financial results and risks and prospects for our business, please see our Form 10-Q that has been filed with the SEC. I will now turn the call back over to Riley for final remarks.

Thank you, Charles.

I will keep my closing remarks as brief as my opening remarks. Q3 was the most significant quarter I have witnessed since I joined the company. What lies ahead looks much different than what can be seen in any lagging indicator.

We look forward to closing this gap as soon as we are able. We will now open the call up for questions.

Thank you, Sal. At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star then 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star and then 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Again, if you would like to ask a question, please press star and then one now. The first question that we have comes from Joshua Reilly of Needham & Co. Please go ahead.

All right. Well, thank you for taking my questions. Maybe just starting off here, what are the risks that we should be considering in terms of this large commercial deal closing that's been delayed? And maybe what's your level of confidence in ultimately getting this deal closed?

Thanks, Josh. Let me start off by reiterating a few things I said in my prepared remarks. This deal is taking longer to close than everyone involved expected, and that has happened for a good reason. It will transform a massive industry, and we are always going to be willing to trade time to close for scope. It's the best thing to do for the long term. So the reason I highlighted this, and I will answer your question more specifically, but the reason I wanted to highlight this is because I think it's important to remember that deadlines can extend for many reasons, and not all of them are bad or concerning. But like I said, I understand why you're asking, so let me provide you some more detail. We are not only key to one of this valued customer's top long-term strategic initiatives, we are also key to helping them achieve an important shorter-term KPI as well. And the fact that we are instrumental to their achieving both short-term and long-term results is important to note. Moreover, I'm confident that this customer not only recognizes the critical role we play in allowing them to achieve these results, but that we are unique in being able to play this role. Outside of very normal and very healthy paranoia that nothing is 100% until the ink is dry, I'm not worried on the if, at least from the customer perspective. But to fully answer your question, the biggest risk on the if actually relates to how I started this call, which is there are many exciting developments in Q3 in which we could be investing our resources in this opportunity, while itself really, really exciting, but just one of them. We do take our responsibility of ensuring that the company resources are always deployed in pursuit of maximizing long-term value very seriously. In fact, I would say that the allocation of company resources might be the single biggest conversation we have internally across the business. And while we fully appreciate the visibility we have into our valued customers' business, and I fully understand the reason this has taken longer to close than anyone involved, There are no sacred paths and we make decisions based solely on ROI. So I want to be clear, I bring this up not because I think it really is any way the likely outcome, but simply for you to understand that we understand our responsibility to allocate resources wisely. And that includes the cost of holding important internal resources for this or any opportunity versus deploying in other areas. We're just simply not afraid of making tough decisions. We make them constantly. And assigning these valuable resources to unlock other opportunities is a decision that, well, to be clear, again, not one I expect we will need to make. It is also not one we would be afraid to make if the situation warranted. Our true north is and always will be how we can create the greatest long-term value.

Got it. That's helpful. And then wanted to get an update on the gift card opportunity. I know you had some momentum there with trade shows in the quarter. Are there any updates that you can provide in terms of when investors could expect some ARR and revenue from this opportunity?

Yeah, well, actually, we recorded some gift card revenue in Q3. We expect more in Q4, and we expect gift cards to be a significant contributor to our 2025. But, Josh, as I said in my prepared remarks, we will provide you a full rundown on everything as soon as reasonably possible because as exciting as these data points are in isolation, we're more excited by how they all tie together.

Got it. And then maybe just one more – You know, last quarter, you know, you noted that there were some changes to some of the partner relationships and the way the contracts were structured in terms of minimum ARR amounts. Just curious if that had any impact in the Q3 ending ARR number that investors should be considering and any successes you want to highlight in terms of the new structure with the Center of Excellence for the partners. Thanks.

Yeah, so the transition, no impact, although I do, again, want to reiterate some of my remarks. The work on this deal has required significant resources, not just across the company, but specifically in Rev Team, and is an investment I stand behind, even if the work didn't coincide with the deal closing in the same quarter that that work came. This is something I'm happy to revisit if you still have questions or we can describe what this deal entails, although I imagine when you see it, you will understand what I'm saying completely. And then in terms of other areas I'd like to highlight, yeah, there are a ton, but again, I ask I think it will become clear when we can talk more about this deal and everything else that transpired in the quarter. It was a significant quarter in many ways. I just want to deliver all of it at the same time so you all can understand how this all ties together.

Got it. Thank you. I'll pass the cue.

Thanks, Josh. Thanks.

Thank you. The next question we have comes from Jeff Funnery of Craig Hallam Capital Group. Please go ahead.

Sounds good. Great. Thanks. A couple for me. Riley, on the large customer, they've got a gap, I guess, here in the existing contract. I think you had a couple contracts, but this one in particular was going to renew here and looks like it didn't. How do they operate in this gap if the contract isn't renewed? Are they still using the platform? Just how does that work? And then was there not a scenario where they could have just renewed or extended the old contract, at least for this interim period?

Yeah, Jeff, both great questions. I get really uncomfortable talking about any individual customer. I would tell you that, you know, we do have customers that have multiple contracts with us. They could be for very different things. And so if there is a gap in the contract, they lose access. in between doesn't mean that there was access to everything. It would just be whatever that contract covers. So I think that was the best I can answer your first question. And what was your second question? Was there not like a shorter-term renewal, I guess?

Yeah, just an opportunity just to do an extension or some sort of short-term renewal until the new contract comes into play.

Yeah, Jeff, this is exactly what I was saying earlier in my pair of remarks. I will always trade time to close for better scope, and I would rather get a really good deal that we're trying to accomplish over the next multiple years together, as opposed to a quick band-aid, I guess. We're focused on a long-term job, I think you know that, and I'm not afraid to take time to close for broader scope. I fully support that decision. Got it.

Recycling Europe, I know you had some aspirations the second half here. Just any updates on the recycling and timing on large deals in Europe?

Yeah, absolutely. And again, you know, there was an email that I know that Ian sent out to some webinar participants that referenced the Q4 signing with us. I don't know if that's what you're referring to, but I know that was emailed around. We're thankful for the industry's work, not just in Belgium but also Germany, and there seems to be a genuine intent to make a real difference to fight plastic pollution. It's a noticeable change, and whether it's driven by upcoming regulation or an understanding of the massive ROI that could be unlocked or a sense of inevitability or maybe all three, it's hard to know. But it's encouraging. It's appreciated. But again, Jeff, not to sound like a broken record, but as I said in my prepared remarks, Can't wait to provide a comprehensive update on everything because as exciting as these data points might be in isolation, we're more excited how they all tie together.

Got it. Okay. And I guess in that scope then, given there's not a lot you can say about the key things we've been talking about other quarters, it is notable to me that government business, which gives you a good underpinning, throws a lot of cash, not really the growth engine and not why most are here, but it does give you a good floor, down 4%, down 5% year over year. I know there was some reference to timing. That was a bigger year-over-year decline than we've seen in a while. Just any wiggles there of note that are worth talking about?

Yeah, I'll let Charles answer that in a minute, Jeff. I just want to maybe correct or point out. It's not that we can't talk about all this stuff. We're choosing to tell it all at the same time just so it's more understandable. But, Charles, you want to answer the –

Yeah, there's nothing really unusual going on in trends. It can fluctuate year to year just depending on – because we have generally a fixed budget that we're operating against, and we have to internally resource that, and those resources can get pulled in all sorts of different directions depending on strategic priorities. And so sometimes that work can be more front-end loaded. Sometimes it's more back-end loaded. It really depends oftentimes on what's going on in the commercial business to make sure that we've got good resourcing there. So it really is just item. Yeah. Okay, great.

At this point, Jeff, you did see that, you know, services, there was a big holy grail component in Q3. Correct.

Okay. Okay, good. All right. Thank you.

Thanks, Jeff.

The next question we have comes from Robin Knipp of Janie Montgomery Scott. Please go ahead. Thanks very much. My question has already been answered.

Thanks, Robin.

Thank you. The next question we have comes from Jeff Barnstein of Silverbug Barnstein Capitals. Please go ahead.

Hi, guys. Yeah, so I wanted to just go back on that email. So the European Brands Association, AIM, sent out an email to people who were on their webinar about this flexible packaging solution. commercial-scale circularity trial they're doing in Belgium. And in it, they basically said, we have three participating CPGs, PepsiCo, Mondelez, and Ferrero Candies. and that they were signing a contract with Digimark in Q4. So in this case, you guys don't have to talk about a customer who hasn't announced. I guess it's been announced for you, but can you give us any kind of details on this? I realize this is a demo program, but commercial scale sounds like it's actually a fair amount of volume, so anything you could say around that. And then I had a couple follow-ups.

Yeah, I mean, the email gave a pretty good rundown, and I know there's been webinars that have been talking about this is the beginning of a rollout in Belgium, right? And I know that Amos has also talked about Germany. And like I said, you know, in response to the other Jeff's question about recycled, there seems to be a real genuine intent to make a difference, and the change is palpable. And again, whether it's from upcoming regulation or finally understanding the ROI or a sense of inevitability, it's all wonderful. So truly appreciative of the industry. You know, AIM obviously is a European organization, and so they're really focused on Europe. There's other great things going on, but just appreciative of all the hard work and the intent to solve this problem because Yeah, it's great for us as a company, don't get me wrong, but it's great for the planet, and so this is wonderful to see.

All right, and then could you, is there anything more that you can say? Because there's a fair amount of flow of news on recycling in Europe. Can you just synopsize a little bit of, you know, any milestones that are expected, you know, or mandates or anything we should be paying attention to, you know, in Europe?

There is, Jeff. And again, I don't want to sound like a broken record. All of these data points are great, right? And they're exciting in isolation. They're all exciting when we can tie this all together. And so I would prefer to really give a full rundown when we're able to and when we've got all this deal and give a fuller, broader description of everything going on. But I think you're over it. I mean, I know that's not really quite satisfactory, especially in the answer. So I think you're all over it. I mean, AIM and the Linestand Plastic Waste are being very transparent about the works in Belgium and the work in Germany, and I think those are great avenues to stay abreast of as they continue to update. Okay. And we're supportive of them sharing all that. I mean, this is wonderful. It's their initiative, and we're just a supplier to do it, and so we're happy to do that. I just would rather talk about what it means to us when I can talk more broadly about everything going on across our business.

Yep. No, that's fine. And then just wondering on, you had the reseller several quarters ago who had won a deal with precious metals marking and a deposit return scheme. And just kind of wondering if there was any, you know, progress report you could give there. And as part of that, I think you mentioned in the press release, that there was some subscription revenue growth from existing contracts and just sort of wondering if you could give any color on that.

Yeah, I'll let Charles handle the second one in terms of our partner there. I mean, they're wonderful. The... there's an opportunity to expand our relationship with them, which we're looking forward to, but they've proven to be a wonderful partner. And we just, you know, like to support our partners and nothing, nothing I think is better validation for us as a trusted supplier than when people say things are going great, how can we expand our relationship? And so that's really what we're focused on with that customer is adding more value to them through an expansion of what we're doing with them. Charles, you want to talk about the... Yeah, so I mean...

Yeah, so growth is really a function of new customers and upsell of existing customers. And there have been several quarters where we've had really nice upsells from existing customers, and that's a big focus. With several of our customers, we're in the early stages. We have a lot of runway to continue to grow those relationships, and so we're continuing to try and find more and more ways to drive more revenue from our existing customers. Obviously, a lot easier to sell to an existing customer than a new customer. So it's really a function. The growth is really a function of both.

So Charles, we don't understand.

Sorry. Jeff, I was going to say one thing that Charles said is we are a nation and a lot of our customers are what we could be. And like a real-time example, there was an internal call or the call that some of our teammates had with a customer that we're really intent on growing. The call started off with a senior person from this company starting off the call by saying that we are the best technology vendor they've worked with. As part of as part of a call that was scheduled to how we can expand that relationship That's incredible. I mean, that's the kind of stuff Yes, we absolutely want to grab new logos and we are grabbing new logos and expanding but it's that kind of stuff there Every quarter that we have an upsell or an expansion of relationship It's a validation of the team here and the technology because you got to prove that every day and so like that's just a One of the private things I've heard in the last week was how that last call started. I just wanted to share it here in a public forum for those of my teammates who are listening who are part of that contract and that relationship.

Thank you for that.

Appreciate that. And then, so should we understand that when a subscription is signed, there's sort of some amount of volume that can be implied? And so, you know, for example, when this precious metals thing, you know, ramps up, there isn't necessarily a growth in revenue on a growth in volume. That'll kind of already be wrapped into the subscription, or how does that work? So all of our contracts are different.

A lot of our contracts, and this one in particular, there's a capacity they have. If they were to go above that, there would be overage. Just like any platform, you buy them. The reference that I was talking to you about, about opportunity... that we feel pretty good about for next year, it's a brand-new program. But it's a brand-new program we earned because we've been working for the last couple of years, and we're like, you know, there's something else we'd love to bring you guys into. And it's validation, and it's wonderful validation. It's a reflection, like I said, of, you know, the incredible teammates I have and we have here and our technology. That's how you win expansion deals. You earn them every day.

And then lastly, and then I'll let somebody else ask, the AI watermarking legislation in California, you know, didn't get through at the end of the legislative session in the summer. I guess kind of bundled along with the other AI stuff that maybe some people had greater interest. um, uh, issues with, um, just, you know, kind of status check, uh, and generally on AI watermarking and, and how you see that, uh, proceeding or not proceeding.

Yeah. So, so obviously we're disappointed the California Senate decided to move forward with another bill, uh, because they did have the opportunity to lead the way forward for the safer, fairer, more authentic internet we all deserve. And we also believe that though they did decide to progress will fail because the solution for scratch will not work period. You know, we believe that was a bad decision. We are super appreciative of Assemblymember Witts, who was the original sponsor of 3211. She gets this. She understands the reality. And she stated that she plans on bringing 3211 or, you know, the same content as 3211. I don't know if I'll have the same bill number. But she's going to bring it forward again next year. Because what California progressed doesn't work. It won't work. Just applying watermarks to genetically created content isn't going to work. There is not a single authentication program in the world that relies on identifying inauthentic content as inauthentic. There's just too many problems with that, right? It's the opposite that works. And this isn't our view. This is the view of 2,000 years of fighting counterfeits. So disappointed with the outcome, but, you know, again, we take a very long-term view on a lot of things, and we have folks like Assemblymember Wicks who gets it and saying, we'll do it again next year.

It's wonderful. Okay, that's great. Thank you.

Thank you.

Ladies and gentlemen, just a reminder, if you would like to ask a question, please press star and then one now. The next question we have comes from Janik Goyani of Altide Capital. Please go ahead.

Hey, Riley and Charles. I have a question about the gift card opportunity. We had a chance to attend the Retail Gift Card Association Conference last month, and there was a lot of discussion around the prevalence of gift card fraud and the level of regulatory pressure that the gift card industry is facing. In addition to this, there was a lot of buzz around the potential for digital watermarks to address this issue on an industry-wide level. I was curious to get your thoughts on the potential for digital watermarks to become that industry-wide solution That's my first question. My second question is, could you talk more about your partnership with Blackhawk Network?

Yeah, so on the latter part, we haven't announced any partnerships. I mean, obviously, there's some 800-gallon gorillas in the industry, and Blackhawk and others are one of those 800-gallon gorillas. You might be referencing at the show there was some signage with us. I mean, they're wonderful. And our reception in this industry is, has been phenomenal. This is an industry that has been super, super growth and is starting to run into existential concerns. It's impacting the growth because of fraud. We have a really, really powerful solution. The industry is desperately searching or eager to find novel solutions because there is a lot of bad actors focused on this industry. It's basically a trillion dollar TAM or NAV, I guess, you know, the value of gift cards is a trillion dollars. And so it's an area that, you know, the bigger you get, the worse and the more organized and the smarter the bad guys are that come after you. You know, I mentioned in response to, I think it was Josh's question, we have some gift card revenue in Q3, we expect more in Q4, and we expect it will be a big contributor to our 2025 numbers. But again, It's exciting that those data points out, Janet. I'd love to update everybody on everything when we can tie this all together. But yeah, definitely an area that we're excited. Definitely an area where the industry is looking for a solution. There's regulation driving this as well. DHS is involved and governments are involved because of the sophistication of these bad actors. They're doing really bad things with the proceeds of this fraud. So we're happy to join the fight and help the gift card industry. Obviously, we have a long history of protecting currency. To us, this is another type of currency.

It's stored value on gift cards.

Great. Thank you, guys. Thanks, John.

Thank you. The last question we have comes from Matt Collett of PCB Advisory. Please go ahead.

Hey, Riley. Hey, Charles. Thanks for taking my call here at the end. I'm walking the fine line of asking about the contract, but not putting you in a position where you have to give me the standard answer. But as we prepare for the closing of this deal, hopefully, and how should we think about the upsell opportunity of it? You referenced or used the term transformational in your prepared remarks. Should we be thinking about it in terms of the evolution of the flywheel effect that's been referenced in the past in terms of setting our expectations?

Yeah, again, we're in negotiations, right? So I don't want to over... We've got to be careful what we say. I don't throw it around the world transformational lightly. Charles gave some scenarios for quarterly cash flow you could take a look at. But we've got to get this deal across the finish line and can't wait to, when we do that, meet again.

Fair enough. Thank you, Sal.

Ladies and gentlemen, we have reached the end of our question and answer session, and I would like to turn the call back to Riley McCormack for closing remarks. Please go ahead, sir.

Thanks, Danae, and thanks, everybody, for joining us on this call today. We hope you have a great rest of your day. Thanks.

Thank you. Ladies and gentlemen, that then concludes today's conference. Thank you for joining us. You may now disconnect your lines.