Digimarc Corp Q1 FY2025 Earnings Call

Greetings and welcome to the Digimarc Q1 2025 Earnings Conference Call. This conference is being recorded. I am now pleased to introduce George Karamanos. Please proceed. Thank you. 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 2025 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.

Thank you, George, and hello everyone. As discussed on our last earnings call, we have narrowed our immediate focus to three specific opportunity sets: retail loss prevention, physical authentication, and digital authentication. In parallel, we have also ensured that we are positioned to benefit from our historical programs in other areas, either directly or through our valued partners. This tightening of focus was made possible by our recent technological and market advancements in the authentication space. As a reminder, we discussed those advancements in greater detail on our last two earnings calls. It is a testament to the power of our team and our technology that we have been able to grow annual recurring revenue or ARR almost 5x over these last 4 years as we have been zeroing in on areas of deep product-market fit. Most companies oscillate around flat until they reach that critical milestone. We have accomplished this while applying the rigor and focus required to speed time to deep product-market fit. Since the middle of 2021, we have exited businesses and deemphasized offerings and business practices that didn’t make strategic sense while also moving away from pursuing non-scalable services revenue. Adjusting for the end of life of our Piracy Intelligence business, we have more than tripled commercial subscription revenue since Q2 2021. We have also expanded our subscription gross margin almost 1,000 basis points despite no longer licensing our IP to potential competitors. This decision was a headwind to both revenue and margins as IP licensing carries a 100% gross margin rate. It was also unquestionably the right thing to do to ensure our long-term success. More exciting than where we have been, however, is where we are going. On that front, I want to take a moment to reiterate what we shared on our last call. While we continue to expect lumpiness as we shift our focus to our core authentication use cases, we believe we are on the cusp of sustainable free cash flow generation for the first time in over 12 years. Moreover, beyond achieving this important milestone, we expect to deliver significant top line growth and free cash flow generation in 2026 and beyond. Turning now to an update on our business, our Q1 results came in above our internal plan. These results demonstrate that it is indeed possible to deliver in our much tighter focus areas while still positioning ourselves to potentially benefit from our historical work outside these specific areas. Starting with our work in retail loss prevention, we expect the first gift cards protected with our solution will appear on shelves within the next month. This is a critical milestone in our work to catalyze the industry towards meaningful adoption this year. Moreover, while the market sizing that we have shared for our gift card solution only contemplates the U.S. market, we are beginning to work with partners to map out the opportunity in multiple other large geographies. The driver behind narrowing our go-to-market focus is the incredible power that comes from such focus, especially when trying to orchestrate a roll-out as large and on as tight a timeline as we expect this gift card rollout will be. As discussed in greater detail on our last call, the other retail loss prevention use case that we expect to contribute to 2025 ARR is our solution addressing price look-up, or PLU, fraud. On this front, our initial customer will be a featured guest on the May 29th episode of the influential Omni Talk podcast to talk about the power of our solution. This level of customer advocacy is both powerful and appreciated. Turning now to our physical authentication solutions, we expect to shortly sign a fifth deal with the Digimarc Validate customer I referenced on our last call. Recall the first deal was signed in Q3 2024. Our learnings from this engagement and how we can replicate it are as valuable to us as the mid 6-figure revenue it represents. We have also formed a partnership with a fellow supplier to one of our loyalty and reward customers. We both agree with this shared customer that our solutions pair well together. As a reminder, our loyalty reward offering involves the application of serialized QR codes and Digimarc Illuminate analytics to modernize and secure loyalty and reward programs, not the creation of the underlying programs themselves. This new partner has already introduced us to four of their more than 1,000 customers. We look forward to strengthening this new partnership one happy customer at a time. Touching now on our digital authentication solutions, as mentioned on our last call, we had chosen to be very conservative about this area's contribution to 2025 ARR. We made this decision to ensure that we were focused on optimizing our work in this area for the long-term. As it turns out, it is likely this area will exceed the conservative assumptions for this fiscal year. Not only do we expect to grow the relationship with the Fortune 100 customer we discussed on the last call, we are also beginning conversations with others interested in a similar solution to help fight unauthorized leaks and/or the improper usage of sensitive and valuable digital assets. Still, my message remains consistent, we will make decisions optimized for the long-term, not the short-term, in this area and across our entire business. Moving now to how we have positioned ourselves to benefit from other opportunities outside of our three current areas of focus. Last week, we were excited to share the news of being selected by Unilever to be their digital link vendor of choice. We also recently won a deal with another large CPG for this same use case. With the twin tailwinds of Digital Product Passport and Sunrise 2027, carving out early wins in this space sets us up to help companies with their need for upcoming compliance, whether that be directly or through our valued print/pack partners. We were also excited to share the announcement from The Alliance to End Plastic Waste and AIM that now is the time to scale commercial adoption of Digimarc Recycle. We agree, and our initial win in Belgium, as well as our support for other opportunities this group is progressing, positions us squarely under that tree as this much-needed future unfolds. Finally, with regards to our work of identifying digital assets in the era of Gen AI, we expect to be able to soon announce a win with an important division of the United States government. When it comes to providing the safer, fairer, and more transparent internet we all deserve, this win is an important beachhead as this future unfolds. It should also act as an important point of validation as we focus on opening the digital authentication market that is currently a commercial focus. I will now turn the call over to Charles to discuss our financial results.

Thank you, Riley, and hello everyone. Ending ARR for Q1 was $20 million compared to $23.9 million for Q1 last year. Excluding the $5.8 million commercial contract that lapsed last year, we grew ending ARR by $1.9 million, representing year-on-year growth of 11%. I want to remind everyone that on the last earnings call I mentioned the potential for an increase in customer churn and that we would be strategically price aggressive on a handful of renewals outside our current focus areas. This occurred in Q1 and we expect it to continue into Q2 as we tighten our go-to-market focus. As Riley referenced earlier, we are above our internal plan for ARR after the first quarter. Total revenue was $9.4 million, a decrease of $600,000 or 6% from $9.9 million in Q1 last year. Subscription revenue, which accounted for 57% of total revenue for the quarter, decreased 8% from $5.8 million to $5.3 million. The decrease reflects no revenue recognized on the expired commercial contract I just referenced versus $1.1 million of revenue recognized in Q1 last year. Excluding the impact of the expired contract, subscription revenue would have increased $600,000 or 13%, reflecting revenue recognized on new contracts and upsells on existing customers. Service revenue decreased 3% from $4.2 million to $4.1 million, reflecting lower government service revenue from the central banks, partially offset by higher commercial service revenue from HolyGrail recycling projects. As I stated on the previous earnings call, we expect government service revenue in 2025 to be 12% to 14% lower than 2024, but also to be spread more evenly in 2025 than in 2024. Actual results were in line with our budget as government service revenue was down 17%, reflecting both a lower annual program budget and a smoother distribution of services in 2025. Regarding the HolyGrail recycling projects, we have now substantially completed the services related to Phase 3. We do not anticipate any future services as the industry shifts its focus to commercial rollout. Subscription gross profit margin excluding amortization expense was 86% for the quarter, down 1 percentage point from Q1 last year, reflecting the impact of lower subscription revenue. We anticipate that subscription gross profit margins may be lower the next couple of quarters as we continue to consolidate our legacy platforms, but after the migration, we expect subscription gross margins to recover and even increase over time as our Illuminate platform should be more efficient than our legacy platforms. Service gross profit margin was 65% for the quarter, up 9 percentage points from Q1 last year, reflecting a favorable service labor mix that we do not expect to continue at this elevated level. As a reminder, we expect to generate mid-50% service gross profit margins on a normalized basis, with some fluctuation quarter-to-quarter. Operating expenses were $18.2 million for the quarter, up 6% from $17.1 million in Q1 last year. The increase in operating expenses primarily reflects $3.2 million of one-time cash severance costs incurred in Q1 related to the reorganization we announced in late February and $900,000 of higher professional services costs, partially offset by lower stock compensation expenses of $1.5 million and lower headcount costs of $1.4 million. Due to the timing of the reorganization, the headcount cost savings in Q1 were around $1 million, but going forward we expect the savings to be over $4 million a quarter. Non-GAAP operating expenses, which exclude non-cash and non-recurring items, were $16.5 million for the quarter, up 19% from $13.8 million in Q1 last year. The increase in non-GAAP operating expenses primarily reflects $3.2 million of one-time cash severance costs incurred in Q1 related to the reorganization and $900,000 of higher professional services costs, partially offset by lower headcount costs of $1.4 million. As a reminder, we do not exclude cash severance costs in our non-GAAP results. Net loss per share for the quarter was $0.55 versus $0.50 in Q1 last year. Non-GAAP net loss per share for the quarter was $0.40 versus $0.27 in Q1 last year. Excluding the one-time severance costs of $3.2 million, net loss per share and non-GAAP net loss per share would have been $0.40 and $0.25, respectively, both an improvement over Q1. Now turning to cash flow, we ended the quarter with $21.6 million in cash and short-term investments. Free cash flow usage was down considerably from $8.6 million in Q1 last year to $5.6 million in Q1 this year. Further, the $5.6 million of free cash flow usage included $2.1 million in one-time severance related costs paid during the first quarter. Excluding the one-time severance costs paid, free cash flow usage would have been $3.5 million. Looking ahead, we now expect to see higher cash flow usage in Q2 than we originally expected due to significantly higher legal and public relations costs as a result of an external matter that arose near the end of March. Currently these costs are running upwards of $0.5 million per month, before accounting for the risk they introduce to important ongoing customer and partner conversations. Assuming a cessation of this external matter, after Q2 we expect normalized cash flow usage to continue to decrease, with the goal of becoming free cash flow positive by Q4 this year. 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.

Thank you, Charles. We are excited to continue to execute against the strategy we laid out on the last call. Recent technological and market achievements have allowed us the opportunity to tighten our focus to an even greater level, and we seized that opportunity, knowing that the combination of focus, this team, and this technology is a powerful force. While early, Q1 results demonstrate that it is possible to deliver in our much tighter focus areas while positioning ourselves to potentially benefit from our historical work outside these specific areas. We remain excited about what lies ahead. Joe, we will now open the call for questions.

Thank you. The first question comes from Joshua Riley with Needham. Please proceed.

Thank you for taking my questions. To start with the gift card opportunity, could you clarify your expectations for revenue and annual recurring revenue in relation to the gift card opportunities for 2025? Should we view this year as more about development, with a greater financial impact expected in 2026 and 2027? Additionally, what feedback have you received from the ecosystem regarding how your solution is distinct from what has traditionally been offered?

Sure. Hey, Josh, thanks for the question. So on the revenue impact, as we mentioned on the last call, we expect gift cards to be a significant driver of our 2025 ARR growth. We are focused on catalyzing adoption this calendar year, which I mentioned again in this call. And in fact, this deadline was one of the drivers behind our decision to tighten our focus even further than we've done in the past. This is part of what we talked about last call about why we are getting so focused, is deadlines and milestones that we want to hit in order to make it a significant driver of 2025 ARR. I think it's a great segue into your second question, which what is the reception like? It's astounding. It truly is. I know that some people went to a trade show in September of last year, which was six months ago. Things have only progressed since then. This is a real issue, this is an existential issue this industry faces. Mid to high teens growth last year, flat this year expectations. Obviously, that's not a great trend for this industry. It is a trillion-dollar global industry that is being attacked, and we think we have a novel solution, and we've been doing this for 26 years, helping protect other currency, fiat currency. We think we can do the exact same thing in gift cards, and it’s wonderful to see the reception we are getting from the industry. This is something that, as we've mentioned before, has a lot of characteristics of our ecosystem-driven opportunities, but none of the actual requirements of this being ecosystem adoption. So it's unlike anything we've seen, and it's pretty exciting. That's why we've been talking about it. That's part of our decision behind the reorganization and focusing on authentication; this is a big driver of that.

Understood. Got it. And then as you look at a couple of those price sensitive renewals that you highlighted in the shareholder letter, are those actually having an impact on ARR growth here in Q1 and Q2 that is enough to actually call out? Are you just kind of highlighting those deals to point out a couple of trends in the industry?

We were highlighting trends in the industry. As you know, Josh, we don't break down ARR in any detail. There's no material movements from those, but I think that's what Riley was highlighting. This is a general trend.

Got it.

I think as we get more price aggressive back on continuing deals, it did have some impact on Q1 and likely will in Q2, but not material enough what we are calling out, because we don't break down ARR in any sort of specific pluses and minuses.

Yes, Josh, it's an example of us investing in the future, right? These are not areas that we need necessarily monetized right now. Maybe they are areas that are a little bit more competitive. We want to plant our flag so we can come back to them. They are obviously outside of the authentication use cases, so we want to plant our flag, and so we are willing to get a little more price aggressive with the, again, making sure that if we decide to come back and focus on the area we are there and also potentially tighten the screws on some people, some competitors that rely on these areas more than we do.

Understood. That's super helpful. Okay. And then last question for me is, as we kind of think about the deal with Belgium, it's hard for us to get transparency into what's going on from the element of the governments over there and everything, all the different moving parts. Is there any initial proof points you can highlight now that this has been going for a couple quarters in terms of points of success or timeline achievement that we should be considering?

It hasn't been active for a few quarters, just a couple of months perhaps. I believe we announced or signed it shortly after our last call, which was around two months ago. I want to clarify that regarding your question about adoption and potential upside, there is indeed potential for growth from this engagement as the initiative progresses. The initial annual recurring revenue is not the only outcome we anticipate as this project develops. However, it's only been a couple of months since the original signing.

Understood. I think more broadly too, I was just kind of asking is this going to be an example that other countries are watching closely other industry groups in Europe and maybe just touch on that aspect as well.

Yes, as I mentioned in the previous call, I'm happy to revisit this topic. We believe there must be a solution to the plastic pollution crisis. This is a single planet, and while plastic is an incredible material, it becomes problematic when it cannot be recycled or reused, which is a significant issue. There are many top-down drivers, with PPWR being the largest, that will eventually encourage adoption. We have always maintained that our solution not only generates a higher quality and quantity of recyclate but also provides valuable data in an area where most companies lack information. Companies collect a lot of data from when an item is created until it is scanned at the front of the store. However, once a product is purchased and consumed, relevant data is scarce. There is some qualitative and survey data available, but not much quantitative universal data. In the era of Generative AI, having new, clean data to feed into an AI system will transform these industries. Our focus in Belgium is to validate this concept again. As highlighted in AAPW and AEM's press release, everyone agrees that our technology will improve the quality and quantity of recyclate. The challenge is achieving commercial-scale adoption. One aspect we want to enhance is the pay-as-you-go growth initiative in Belgium, particularly emphasizing the value of the data. Since PPWR is a European regulation rather than a global one, it should be adopted worldwide because it's a global issue. While everyone is concentrated on enhancing recyclate quality and quantity, which is vital, we aim to demonstrate the data's value to accelerate adoption. We believe that executing excellently in Belgium will help us prove both value propositions and facilitate adoption on a larger scale.

Understood. Thank you, guys.

Yes. Thanks, Josh.

Thanks, Josh.

And the next question comes from Jeff Van Rhee with Craig-Hallum. Please proceed.

Great. Thanks for taking my questions. I've got a few. First on ARR and the trajectory, can you give us any sense of how you are thinking about ARR trajectory going into the end of the year? I know the prior question was around how do we size this churn and it's really tough to get a sense of the scope of the churn and then ultimately what you think you can do with ARR. So I realize you are not giving formal guidance, you probably don't want to dial it in too narrowly, but any qualitative commentary you are able to share as to how we should think about ARR by year-end?

Yes, Jeff. So I would go back to some of the statements that we made on the last call that provided some kind of inputs to modeling. Obviously, we said our focus is to get to non-GAAP profitability no later than Q4. You can kind of do some quick modeling there and get to that as we go don't give specific guidance. I would also just touch on the fact that Riley just reiterated that we believe the gift card will be a significant driver to 2025 ARR. So just taking some level of market penetration in 2025, I think can give you a sense of magnitude there. But I'd really point you to the model because we don't give specific guidance.

Okay. Yes. Thanks, Charles. And so and I think in terms of gift card pricing while you're on that, can you just give us a refresher? I mean, obviously, you're getting further into these, you're seeing more repeatability of the contracts and getting a better sense of what baseline pricing is going to look like. How should people size the gift card TAM based on how the current contracts are being priced?

Yes, that's great. Nothing has changed in our perspective; we've mentioned several times now that the U.S. market is estimated at $900 million to $1.5 billion. There are three areas for growth. First, we are pricing competitively to capture market share. We aim to not only provide greater efficacy but also lower the Bill of Materials, resulting in potential upside over time. Second, we have an existing product roadmap with new features and capabilities to combat emerging threats. As we continue to release new versions and defenses against various attacks the industry faces, we anticipate growth in this area as well. Finally, the figure I mentioned pertains specifically to the U.S. market. As I indicated earlier in this call, we are already engaged in discussions with our partners regarding expansion into other major markets. This issue is global; it represents a trillion-dollar Gross Merchandise Value worldwide, and it is a challenge that transcends borders. There is no specific reason for this being confined to the U.S.

Yes. Okay. And then last I guess for me on the ARR front, you're narrowing the portfolio from 7, 8, 9, I don't recall the exact number of ranges, but you decided to go after these three focal areas and obviously with reduced R&D and other support for those other products and then obviously in combination with the comments you made around increased churn there. Can you give a crude sense of what percent of ARR right now is from the three go-forward products?

Yes, Jeff, we just don't quantify the composition of ARR in that respect, just like the pluses and minuses of ARR at this point in time.

Okay. I will leave it there. Thank you.

Thanks, Jeff.

Thank you. Ladies and gentlemen, this concludes the question-and-answer session, and this will conclude today's conference. You may disconnect your lines at this time and enjoy the rest of your day.