Digimarc - Q4 2023

Transcript

Operator (participant)

Greetings and welcome to the Digimarc Corporation Q4 FY 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joel Meyer, Chief Legal Officer. Please go ahead.

Joel Meyer (EVP, Chief Legal Officer, Compliance Officer, and Corporate Secretary)

Thank you. Welcome to our Q4 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 Q4 2023 and FY 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 will 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.

Riley McCormack (President and CEO)

Thank you, Joel, and hello everyone. Q4 was another strong quarter for Digimarc. On a YoY basis, we accelerated our ARR growth to 71%, accelerated our subscription revenue growth to 37%, and expanded our subscription gross profit margins more than 1,000 basis points to 87.3%. This performance was a result of our continued execution against our transformation strategy, but it is important to note that our transformation strategy itself continues to evolve, as I hope it always will. While the rate of change is attenuating as we move from the radical transformation stage we entered in Q2 2021 to the constant iteration and continuous improvement stage in which we are now, the fact is we can always be better tomorrow, and thus that will always be our goal.

Constant iteration and continuous improvement can be confusing if not anchored by a consistent true north, and our true north is beautifully simple. Our goal is to support companies progressing in their digital transformation journey, and to achieve that, we need to be easy to begin doing business with and excellent at guiding customers along their journey. The initiatives we are pursuing in pursuit of our true north range in maturation from just exiting ideation to already launched and in execution, and the quality of both the initiatives as well as our execution of those initiatives will dictate the strength of our future performance. I want to use today's call to talk about four initiatives in greater detail because I believe all four are likely to have outsized impacts on our quarterly results for years to come.

The first is the recent launch of our next-generation configuration of digital watermark, an initiative we've been working on for over two years. Our digital watermark is a culmination of a lot of incredible work by a lot of incredible people and represents not just a step change improvement in digital watermarking technology, but also allows us to knock over a barrier that has historically added friction in our quest to digitize the world's products. Yes, the latest configuration of digital watermark delivers dramatic improvement in important areas such as security, adaptability, imperceptibility, and performance, and all of these improvements are important because they all deliver a step change increase in value to our customers.

But it is the addition of powerful new data access and detection controls that I believe will ultimately be what this new configuration is best known for, because these controls not only deliver value to our current offerings, they also enable something never before possible: the application digital watermarking to products and packaging well ahead of adoption of any Digimarc offering. With these new controls, companies can now embed digital watermarks well ahead of planned activation, future-proofing their products during planned packaging refreshes, regional rollouts, or ahead of future product digitization initiatives. This is not only a new capability of ours. It is something that no other data carrier can provide. It becomes yet another point of differentiation for us and our platform while simultaneously allowing Digimarc and our partners to rapidly plant seeds we can harvest for years to come.

The second initiative that I believe will have an outsized impact on future quarters is the evolution of our partner strategy to encompass and incentivize partners not yet ready to build their own products and services on top of Illuminate. This is another step towards our being easy to begin doing business with, in this case not only for our customers but also our partners. Digimarc excels in supporting customers progressing in their digital transformation journey where the identification or the authentication of physical and digital assets is critical. This superpower is applicable to almost every single industry and brings us in contact with an incredible number of potential partners. These partners, in turn, possess existing customers, large pipelines of prospects, many salespeople, and incredible domain expertise.

Our new Center of Expertise, or CoE, program allows us to build a mutually beneficial relationship by combining the strengths we both bring to bear while also allowing us to benefit as we support our shared customers in progressing their digital transformation journey. The CoE program is new, but the early results have been promising. Taking a step back, just like our products themselves, our initiatives should also be accretive, and in the case of the two just mentioned, they indeed are. While the interest in our CoE program was strong ahead of the announcement of our next-generation configuration of digital watermark, post that announcement, the interest has notably increased.

While all the improvements delivered by our digital watermark are resonating, it is the new data access and detection controls that have really spurred partner interest, as they understand these controls not only help them ensure their customers' products and packaging are future-proofed but also allow them to share in our success, and those customers activate those watermarks by subscribing to a Digimarc offering. The third initiative I'd like to discuss was one we announced just a few days ago. In pursuit of being easy to begin doing business with, we have opened a fifth avenue to market for Digimarc Recycle. Under this new avenue to market, Digimarc will license Digimarc Recycle to qualified partners who would then lead the regional or countrywide rollout of our powerful offering to address the plastic packaging pollution crisis. To be clear, our other four avenues are still open.

This is not a replacement but an augmentation of the options available. And like I imagine many of our successful initiatives will be, this new avenue to market was informed by conversations we had with multiple stakeholders who added their feedback to improve our final offering while sharing their excitement about its potential to open their markets. This new avenue excites us as well because its potential to not just be time to revenue but also time to broad adoption. And when it comes to Digimarc Recycle, our interest in shortening time to adoption comes not just from the opportunity Digimarc Recycle presents us as a business but also the opportunity that widespread adoption of Digimarc Recycle presents us as a planet. Finally, as discussed at an investor conference last month, we are putting the finishing touches on some major updates to Digimarc Engage.

Being easy to begin doing business with and excellent at guiding customers along the journey sometimes entails providing the market something they've never had the ability to do before: new capabilities that lead to a better-end customer experience while also revealing data that has never before been available for the revealing. Our upgrade to Digimarc Engage will not only provide new functionality for physical products, it will also take the industry-leading capabilities of Digimarc Engage into the digital domain. Moreover, it will allow for a seamless experience between these two domains, something that is not possible with any other consumer engagement offering. We are excited to share more on this very, very soon. The results of our initiatives don't just show up in our quarterly results. They also allow our participation in important conversations focused on driving the world forward.

As the pioneer and global leader digital watermarking, we welcome the world's understanding of the power of this technology and believe it is our responsibility to lend our almost 30 years of experience and expertise to conversations in digital watermarking is a topic. Throughout the Q4, we participated in a series of meetings in Washington, D.C., with leaders from both the executive and legislative branches on the critical topic of AI security. We were afforded this opportunity given our expertise and proven track record of protecting some of the world's most recognized brands and critical assets. In November, we were invited to participate in one of the Senate AI Insight Forums hosted by Senate Majority Leader Chuck Schumer and Senators Todd Young, Martin Heinrich, and Mike Rounds.

It was there that I testified to the need of digital watermarks in the fight for online authenticity given the advent of artificial intelligence. We remain steadfast in our belief that among the many benefits GenAI will bring, perhaps the most powerful will be catalyzing the safer, fairer, and more transparent internet we all deserve. In addition to our work inside the beltway, Digimarc was appointed co-chair of the C2PA Working Group digital watermarking, once again establishing our credibility and leadership in the authenticity ecosystem, a position we look forward to maintaining. Whether it be individual events or ongoing engagements, two things are becoming clear to more and more digital watermarking is a technology of unlimited potential, and Digimarc is a company best positioned to bring that technology to the world. I will now turn the call over to Charles to discuss our financial results.

Charles Beck (EVP, CFO, and Treasurer)

Thank you, Riley, and good afternoon, everyone. Building on the positive financial trends we delivered in the Q3, we saw continued progress in our financial performance during the Q4 in several key areas. Ending ARR grew to $22.3 million, representing a 71% YoY growth. Subscription revenue increased 37% YoY. Subscription gross profit margin reached 87.3%, a 1,000 basis point improvement. OpEx decreased 2% from Q4 last year. Non-GAAP net loss decreased $2.5 million or 31%, and free cash flow usage improved $2.2 million or 29%. I highlight these areas as they are all critical drivers toward reaching positive free cash flow. ARR increased 71% from $13 million at the end of 2022 to $22.3 million at the end of 2023. The increase in ARR largely reflects the impact of new customer contracts and, to a lesser extent, several important customer upsells during the year.

As a reminder, we believe ARR is the best leading indicator for future commercial subscription revenue growth. Subscription revenue will lag ARR growth as subscription revenue is recognized ratably over the contract term versus ARR is recognized upfront upon entering into a contract. Total revenue for the quarter was $9.3 million, an increase of $2.1 million or 29% from $7.2 million in Q4 last year, reflecting strong growth in both subscription and service revenue. Subscription revenue, which accounted for 60% of total revenue for the quarter, grew 37% from $4.1 million to $5.6 million. The increase reflects subscription revenue recognized on new customer contracts as well as upsells on existing customer contracts. Commercial subscription revenue grew at an even higher rate at 40%. Service revenue increased 18% from $3.1 million-$3.7 million.

The increase primarily reflects a larger annual budget from the central banks for project work in 2023 than in 2022. Subscription gross profit margin improved from 77% in Q4 last year to over 87% in Q4 2023. The large increase YoY reflects a favorable mix in subscription revenue to our newer products, which have higher gross profit margins than our legacy products. This bodes well for continued expansion of our subscription gross profit margins as we both migrate existing customers to our newer products and we sign up new customers. Service gross profit margin was flat at 56% in Q4 for both years. We continue to expect service gross profit margin to be in the mid-50s on average going forward, with some fluctuation quarter-to-quarter depending on labor mix. OpEx for the quarter were $16.8 million compared to $17.1 million in Q4 last year, a decrease of 2%.

Despite the impact of annual compensation adjustments for our employees, we were able to reduce our OpEx YoY as we continue to focus on ways to maximize our productivity and efficiency as an organization. Non-GAAP OpEx, which excludes non-cash and non-recurring items, were $13.4 million for the quarter, down 6% compared to the $14.3 million in Q4 last year. Net loss per share for the quarter was $0.52 versus $0.62 in Q4 last year, and non-GAAP net loss per share was also considerably lower for the quarter at $0.28 versus $0.41 in Q4 last year. We ended the year with $27.2 million in cash and investments. Free cash flow usage was $5.6 million for the quarter compared to $7.8 million used in Q4 last year. We used an additional $700,000 of cash in Q4 for share repurchases.

Our free cash flow usage was down considerably in the second half of 2023 as compared to the first half of the year, largely reflecting the impact of growing our ARR. And as promised, free cash flow usage was noticeably less in the second half of 2023 as compared to Q2. Given cash flows can fluctuate quarter to quarter depending on the timing of cash inflows and outflows, we continue to believe that a good proxy for a normalized level of free cash flow is using non-GAAP loss and adding capital expenditures. While the trend in free cash flow has significantly improved over the past two quarters and we expect it to continue to improve, we do expect Q1 2024 to be higher than Q4 2023 due to year-end-related expenses, including annual incentive payments.

As I'm sure you are all aware by now, we entered into a registered direct stock transaction over the weekend whereby we raised $32.5 million of gross cash proceeds by selling 929,000 shares of our common stock at a price of $35 per share. The price represented only a 2.5% discount to the last trade. This transaction not only topped off our balance sheet, it expanded our roster of both long-term and value-added shareholders. A special thank you to Rishi and the team at Altai Capital for the introduction to these new shareholders, their efforts in bringing this deal together, and their continued partnership. After completing this transaction, we also decided to terminate our At-the-market, or ATM, stock program that we had established back in 2019. The ATM program will be terminated effective March 1st, 2024.

For the FY, we made considerable progress in the underlying fundamentals of our business. Subscription revenue increased 25% from last year and 33% if you include the impact of our retired piracy intelligence product, while commercial subscription revenue grew at an even higher rate at 38% excluding piracy intelligence. Subscription gross profit margin averaged 84.3% for the year, a 1,000 basis point improvement over last year, and OpEx decreased $8.8 million or 11% despite the headwinds from inflation. As a result of accelerating our subscription revenue growth, expanding our subscription gross profit margins, and lowering our OpEx, non-GAAP loss decreased $12.1 million or 31% for the year, and free cash flow usage was more than cut in half, decreasing from $45.9 million in 2022 to $22.7 million in 2023. We took a giant step in 2023 to move the company down the path to cash flow positive.

We still have work to do, but we will remain maniacally focused on continuing to grow ARR, expanding our gross profit margins, and effectively managing our expenses to shorten that path. For further discussion of our financial results and risks and prospects for our business, please see our Form 10-K that will be filed with the SEC later this week. I'll now turn the call back over to Riley for final remarks.

Riley McCormack (President and CEO)

Thank you, Charles. Q4 was another strong quarter for Digimarc, made possible by the progress we have made on multiple important initiatives we have been pursuing since we began our transformation in Q2 2021. While we are through the most radical part of our transformation, we will always be focused on what's next, guided by our simple mantra of being easy to begin doing business with and excellent at guiding customers along their journey. I believe the four initiatives we share today are likely to become inputs to future strong quarterly reports, and it is important to note they are just a sampling of the things on which we are hard at work every day.

I share my teammates' excitement about where we are going as well as our urgency to get there, urgency that comes from knowing there is a massive market waiting for us to unlock it and that we are in a unique position to do just that. Strong results are wonderful, and as we've said consistently over the last 2.5 years, we expect you to judge us on nothing but our results. But they are only made possible by never settling for the status quo and by always planting the seeds for future growth. The only constant, at least at Digimarc, is improvement, and I don't expect that will ever change. The combination of this team and this tech is a scarily powerful mix, and as a team, we are excited by what the future holds. Stacy, we will now open up the call for questions.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two 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. One moment, please, while we pull for questions. Once again, that's star one if you would like to ask a question. First question comes from Robin Knipp with Janney Montgomery Scott. Please go ahead.

Robin Knipp (VP)

Thanks for taking the question. Riley, could you elaborate a little bit on the less than $1 per capita, what that means, and who that is going to be applying to?

Riley McCormack (President and CEO)

Yeah. So thanks, Robin, for the question. How you been?

Robin Knipp (VP)

I've been well, thanks.

Riley McCormack (President and CEO)

Good. Yeah. So this is a new go-to-market, as I said, perfected, perhaps is the term to use, along with some interested parties. So the partners could range from NGOs. They could range to governments. They could range to systems integrators. And less than $1 per capita is a total price that our partner would pay to roll out Digimarc Recycle in a region or a country. So looking at a country's population, the price to our partner who would be in charge of orchestration of the rollout in the country or region would be less than $1 per person in that country or region.

Robin Knipp (VP)

Just as a follow-up, have you seen any traction with this pricing model yet?

Riley McCormack (President and CEO)

We just launched it a couple of days ago, right? So a little bit early. But I will say yeah. But I did say in the script, though, right, is that this is not the first people have heard about it. It's the first we started talking about it. So we are optimistic, and we are excited. And as you know, Robin, our excitement about Digimarc Recycle, yes, of course, what it means for our business. But also, we think this is a proven, powerful technology to address perhaps one of the top three problems this planet faces. So we want to see it get adopted as residents of this planet.

Robin Knipp (VP)

Understood. Thanks. And thanks again for the great quarter.

Riley McCormack (President and CEO)

Thanks, Robin.

Operator (participant)

Next question comes from Jeff Bernstein with Silverberg Bernstein. Please go ahead.

Jeff Bernstein (Portfolio Manager)

Hi. Good afternoon. So Riley, you mentioned the new Digimarc watermark technology and the improvements there and imperceptibility being one of them. And can you just talk a little bit more about that? I remember quite a number of years ago, there was discussion by some of the consumer packaged goods guys about some of their very iconic artwork and whether they really wanted to embed watermark on that artwork, etc. So just talk to us a little bit about kind of the history of the perceptibility of the watermark and what the improvements are like.

Riley McCormack (President and CEO)

Yeah. Thanks, Jeff. So perceptibility is impacted by two things: size of payload and then also the colors used to embed the watermark. And both of those, we made incredible improvements on. I don't know if you've seen any of this stuff, for example, that we've rolled out for Recycle. These are some of the most iconic brands' packaging that I think we would have all looked at five years ago and been like, "This is going to be really, really hard to watermark." And it's there, and you can't see it. So we're constantly looking at ways to knock down barriers. The new configuration of the watermark plays a part of that. So does an update to our tools that allows for broader use of chrominance and luminance keys or inputs, all focused on driving down the perceptibility.

And even ahead of this new watermark, I think we've made great strides as stuff on the shelf would say. I guess the fact you can't see it on the shelf maybe is the best proof of that. But it's always a focus. How can we knock down barriers?

Jeff Bernstein (Portfolio Manager)

That's great. Then out there in the media, there is some discussion of a Sprite bottle, I think, in Europe that was completely laser engraved, so had no shrink-wrap label around the bottle and had a data carrier on it laser engraved. They didn't specify what kind it was. And I guess it's possible to do digital watermarking as well as QR codes or anything else that way. But just talk about where we are on that laser engraving. And I think there may even be some other technologies that can be brought to bear there. Again, that was something that I know was not completely proven out as of a couple of years ago.

Riley McCormack (President and CEO)

Yeah. Yeah. So on the Sprite bottle, I believe that was a limited market test. Would love to see the world move to label this, again, both as an opportunity for us as a business but also for what it would mean for the planet. We've done studies before my time here, but I recall that there were studies that show digital watermarks actually read better than QR codes in 3D in embedding. There's just more. I'm going to be laughed at by my technical team after this call. But there's more angles for which the light to digital watermarks with QR codes. So they do read better. The downside, of course, is you do need an app today to read a watermark. So I think there are definitely applications for consumer engagement where watermarks are great. I still think QR code is normally better.

Now, 3D might be the one that proves digital watermarking is the best for that. In terms of our work with lasers, the conversations are pursuing there. We talked about CoEs earlier in the call. There's a couple of potential CoEs that are actually laser-based. It is just another great way to lay down our signal, whether it be ink, whether it be lasers, whether it be molds. It's the beautiful thing digital watermarks. there's a lot of ways to embed them. And I agree. I think lasers is a very interesting area in a lot of different ways.

Jeff Bernstein (Portfolio Manager)

Gotcha. And then last question was, in the past, there was an issue about and there's been some discussion in the media about reading without having an app on your phone. And I think there was an issue about Apple iOS embedding reading and not embedding reading versus everyone else. Can you just talk about where we are now on app-less reading?

Riley McCormack (President and CEO)

Yeah. So nothing to talk about publicly here. One of the things if you think about we've alluded there's a lot of benefits by uniting the digital and physical worlds, right? And for Digimarc Validate, the detection in Digimarc Validate, if we were on device, would be a wonderful way to get watermark detection on devices for physical goods as well. But nothing to update on that front, Jeff.

Jeff Bernstein (Portfolio Manager)

All right. Thanks very much.

Riley McCormack (President and CEO)

Of course. Thanks.

Operator (participant)

Once again, if you would like to ask a question, please press star one on your telephone keypad. Next question comes from Matt Collard with PCB Advisory. Please go ahead.

Matt Collard (Managing Partner)

Hey, Riley. Hey, Charles. Congrats on the quarter. I just wanted to ask if there's an update you can give us on anything on the digital watermark registry that was hinted at, I don't know, maybe early Q4?

Riley McCormack (President and CEO)

Yeah. Nothing to update specifically on that. One of the wonderful parts of entering this conversation is the number of people who realize we would be a great addition to their tech stack, and maybe there's a partnership opportunity there. So we are still progressing what we're doing. There's also a couple of people who have incredible registries focused on different end markets, different footprints, different levels of security in terms of government-grade versus non-government-grade. And we'll figure out the best path to market, right? Do we partner? Do we build our own? Do we do both? So nothing to announce yet, Matt.

Matt Collard (Managing Partner)

Okay. Fair enough. And I guess my follow-up to that, if I may, congrats on your leadership in C2PA with Adobe on the working group. That's obviously well-earned and impressive. And I understand you're early in your work. But could you give us or me a little bit of, I guess, if you can, what the landscape might look like post those standards being developed? Is there going to be who's going to be ultimately responsible for the management and oversight of those standards? Is that something C2PA would evolve into, or another regulatory gatekeeper or industry-driven?

Riley McCormack (President and CEO)

Yeah. I think the effort's now already to get the standard up. And then it would probably be something that they would maintain compliance with that standard. Joel, I don't know if you have any thoughts on that you want to add.

Joel Meyer (EVP, Chief Legal Officer, Compliance Officer, and Corporate Secretary)

No, I think that's right. It's early. The C2PA will set the standard specification, but it's a little early as to how much detail they'll put into that standard in terms of specifying a technology or guidepost for implementation of digital watermark. the key is that digital watermark is going to be used to link the content to the authentication and provenance information. So that's the first part of the standard that'll be set. And the implementation of the watermarking technology will be figured out later.

Matt Collard (Managing Partner)

Would you envision an oversight body in that, Joel, I guess, as a follow-up?

Joel Meyer (EVP, Chief Legal Officer, Compliance Officer, and Corporate Secretary)

Yes. I think C2PA will continue to be that standard-setting organization that will oversee that.

Matt Collard (Managing Partner)

Fair enough. Thanks. I'll jump back into the queue. Appreciate the response.

Riley McCormack (President and CEO)

Thanks, Matt.

Operator (participant)

We've come to the end of our Q&A session. I would like to turn the call over to Riley McCormack for closing remarks.

Riley McCormack (President and CEO)

Thank you, Stacy. Thank you, everybody, for your time this afternoon. I hope you have a great rest of your day. Thanks.

Operator (participant)

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.