Earnings Call Transcript - DMRC Q2 2025

Operator, Operator

Ladies and gentlemen, greetings, and welcome to the Digimarc Corporation Q2 2025 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, George Karamanos. Please go ahead.

George Karamanos, Host

Thank you very much. Welcome, everyone, to our Q2 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 Q2 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. For those of you dialing in, we have changed the format of our prepared remarks and we'll be simulcasting a presentation that Riley and Charles will walk through today. If you would like to follow along with the slides, I would encourage you to join our webcast as referenced in our earnings press release shared earlier today. 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 Young McCormack, CEO

Thank you, George, and hello, everyone. On this call, we will walk through Digimarc's Q2 performance, highlight our strategic progress across product innovation and commercial execution, including the pending launch of our gift card solution, share updates on our financial metrics such as ARR and cash burn and provide clarity on where we are focused heading into the second half of the year. In Q2, we made significant progress towards launching our gift card solution, generated new ARR from a European packaging customer for a multiyear committed contract that should generate near 7 figures next year and had several upsell ARR wins with existing customers. We delivered our next-generation audio digital watermark to enable accurate compensation for creators and safeguard sensitive data. And we were recognized in Gartner’s Hype Cycle as a key vendor in the emerging TrustOps category alongside the likes of Microsoft and Google and aligned with McKinsey’s identification of digital trust as one of the top technology trends shaping the future. We also completed our corporate reorganization in the second quarter and are seeing significant benefits across the organization as a result. Financially, the reorganization has resulted in a meaningful reduction in operating expenses and cash usage, and we remain on track to deliver positive free cash flow by Q4 2025. Operationally, it has allowed us to increase our focus on the areas most likely to deliver the scalable and repeatable business we must always focus on delivering. I would like to thank all of my teammates for their hard work in effecting this important step in our continued evolution. While not an easy process, we are seeing positive results in our ability to execute on our business. As has been shared previously, our 3 focus areas are retail loss prevention, product authentication and digital authentication. We have several significant ARR generation opportunities in front of us, such as protecting the world's gift cards that exhibit strong demand-pull characteristics with the goal of much quicker time-to-revenue relative to some of our identification use cases. The decision to focus our time and resources on these 3 core areas in the authentication space was supported by deep market research, validated by customer feedback and further confirmed independently by work we commissioned from our consulting partners. With that said, we remain firm believers in our positioning and our ability to execute on the various ecosystem-driven opportunities in the identification space as they eventually become ripe enough to pursue. Our greatest near-term opportunity is retail loss prevention and more specifically, our gift card solution. We made substantial progress during the quarter on commercializing our solutions to address gift card fraud, an ever-increasing existential threat the industry is hyper-focused on solving. We are proud to announce that the first Digimarc-protected gift cards have been received by our first retailer and will appear on shelves next week. While the initial rollout took slightly longer than planned for reasons outside of our control, it includes gift cards for multiple different brands, including some of the largest companies in the world. The interest from these brands reflects the detailed joint success planning we have been undertaking with members of the gift card industry ecosystem, including gift card network companies, gift card manufacturers, card manufacturing equipment providers, label providers, point-of-sale scanner manufacturers and, of course, retailers and brands. This joint success planning positions us to increase long-term revenue velocity as these initial cards hit shelves. We intend to predominantly sell our solution to gift card manufacturers who will apply our technology during their normal printing process before delivering the cards that they currently do today. We have built our go-to-market strategy around trying to solve for 2 often-conflicting goals, providing a revolutionary new solution and minimizing impact on the ecosystem's existing workflow. I think the team has done an incredible job of doing just that. From jointly building threat models that clearly show how our existing solution already reduces fraud and how our road map will drive even greater results to creating a detailed interactive pilot plan that allows for near real-time impact measurement to all the work in between, we've invested the time and resources to set up our solution for success today as well as accelerate the pace of adoption in the future. As we've shared in the past, one of the most powerful facets of this opportunity is that laggards in the adoption of our gift card solution will bear the compounded costs of an increasing percentage of an increasing amount of fraud. We and our partners believe this positions us for a powerful demand-pull dynamic. Moreover, this is a widely held view across the industry and the interest of those not yet included in next week's rollout has continued to increase. In parallel to setting up this initial rollout for maximum success, we've been planning additional rollouts with other industry players as well. While it is hard to be certain ahead of some critical upcoming events, what impact, if any, the slight delay in our initial rollout will have on our 2025 revenue, we have lowered our internal estimate for 2025 gift card revenue. Next week marks a critical milestone and accomplishment in our work to catalyze the gift card industry towards meaningful adoption of our solution, and we believe whatever impact the pilot delay might cause to our 2025 revenue, if any, will be paid back next year and beyond. Turning now to our focus on product authentication, I am thrilled to announce we signed a multiyear committed deal with a large European packaging company that should represent near 7 figures of ARR starting next year and beyond. In addition to providing our customer the ability to resell Digimarc Validate and Digimarc Automate directly, this deal allows our partner to roll out our deploy now, activate later offering on all the packaging they produce, seeding the market for, among other things, potential future Digimarc Recycle deals. Just last week, I had dinner with the CEO of this valued customer, and he shared his plans for utilizing our partnership to drive messaging at an upcoming conference, stating that he believes our partnership will enable his company to stand out amongst their peers and drive new business their way. More immediately, he wants to arrange an opportunity for us to spend time with a sister company that he believes is interested in pursuing a similar relationship with us. Nothing is more powerful in driving to a scalable and repeatable business than delighting existing customers, and our focus is, as it always is, on continuing to win our customers' business every day. We also signed upsell deals with 3 of our existing Digimarc Validate customers, reflecting both increased contract value and the expansion of our solution to new geographies and new brands. As we have repeatedly stated, when we solve our customers' most challenging problems, we expect to be an upsell and cross-sell company for a long time. While still early in that journey, the results are proving this thesis correct. Brands faced rampant counterfeiting and IP theft and our secure and scalable covert and connected solutions provide far superior results compared to competing analog solutions such as tags, codes, inks and labels. Touching now on our digital authentication solutions. As mentioned on our last 2 calls, we chose to be conservative about this area's contribution to 2025 ARR. We made this decision to help ensure we remain focused on optimizing our work in this area for the long term. We have already exceeded these conservative assumptions. As announced in a recent press release, we recently delivered a next-generation audio digital watermark architected to address the unprecedented challenges rights holders, content creators, companies and governments face with the explosion of digital and AI-generated content and capabilities. We recently signed a new deal with SourceAudio to embed our audio watermarks into production music for TV and commercials in order to monitor royalty rights across over 150 national channels and 100 local stations. Additionally, we have multiple deals in the pipeline as a result of our new offering, including technical testing with an AI company looking to both comply with EU regulation as well as automate internal authentication. Our next-generation offering has also caught the attention of an important industry group that is searching for solutions to an unmet need arising from the emergence of AI. We look forward to proving our value to this gatekeeper and unlocking the opportunities on the other side. Q2 also saw us grow the relationship with the Fortune 100 customer we mentioned on the last call, signing a low 6-figure deal that we believe could grow close to 7 figures starting in year 2 and beyond. In addition to our belief, this customer presents a future upsell opportunity, they have offered to be a reference account to other prospects in the future. Additionally, the implementation of our solution is being led by one of the world's largest system integrators. Success with our shared mutual customers should open future doors for us to partner with this industry giant to deter insider threats and safeguard sensitive data for additional customers across industries and sectors worldwide. The twin catalyst of the relentless advance of AI models and agents and the rapid progression of content credentials has created a wave of awareness and urgency for a robust, scalable, secure, and imperceptible perpetual and deterministic solution to address the many trust and authenticity problems growing in the digital world. We anticipate that this area will continue to experience significant growth and transformation. While some of the emerging digital applications may currently be adequately addressed by existing solutions, it has become clear to us over the past few months that the two key drivers we mentioned are creating opportunities for applications where merely satisfactory solutions will not suffice. Our technology, track record, credibility, expertise, experience, and our leadership in the digital watermarking aspect of the C2PA standard all combine to position us well to address this increasing demand. We were pioneers in this field. This truly aligns with our core mission, and the market has finally arrived. Although our focus over the near term will be on our 3 core focus areas, we continue to believe in our positioning and ability to execute in other areas when those markets are ripe for addressing. Before I turn the call over to Charles, I want to address the development that will have a negative future impact on our near-term top line results. We are currently in contract renegotiations with a large retailer customer of a legacy solution, which will most likely result in a reduction of up to $3 million in annual revenue. As these conversations are very recent and currently ongoing, we are not able to estimate the exact impact at this time. This development also reinforces our decision to focus on our 3 authentication markets and building the trust layer for the modern world. Solving urgent problems provides stronger protection from changes in customers' strategic focus than some of our legacy solutions did. Moreover, this retailer is an important gift card vendor, and our focus is on maximizing future revenue opportunities for our gift card solution, not on trying to maximize revenue from a use case we haven't sold in many years. We believe we continue to have an excellent relationship with this customer and that there is much to accomplish with them over the coming years. We are excited to continue to help them win. We are also energized by moving Digimarc into a future where we're not overly reliant on any one customer and can move more quickly with the market. We are confident in the opportunities provided in our key 3 focus areas and are excited by the results our increased focus are already beginning to deliver. Ecosystem-based sales are great because of their size, but the sales cycles can be slow, expensive and multiple constituencies must adopt before meaningful ROI is unlocked. Our strategic shift allows for the building of a scalable and repeatable business where we can fail fast, iterate and win often. Even with the expected top line impact of this contract renegotiation, we still anticipate being free cash flow positive in Q4. Reorganizing our company to focus on our authentication use cases was a difficult but necessary decision, and we appreciate our investors' patience as we navigate this transition, which we are more confident than ever is the best strategy for the company and will create the best outcome for investors. Even if timing around meaningful revenue generation from our new products were to slip 1 to 2 quarters, we believe the company is well positioned to win and reach significant scale. I will now turn the call over to Charles to discuss our financial results.

Charles Beck, CFO

Thank you, Riley, and hello, everyone. Ending ARR for Q2 was $15.9 million compared to $23.9 million for Q2 last year. The decrease reflects both the $5.8 million retailer contract that lapsed last year and $3.5 million from the DRS contract that lapsed in Q2 this year. Excluding these 2 headwinds, ending ARR grew $1.3 million year-over-year. That growth, however, was largely muted by higher other customer churn and our choosing to be strategically price aggressive on products outside of our focus areas, both of which had outsized impacts in the first half of 2025. As I stated on the last earnings call, we expected these impacts as we sharpened our go-to-market focus, and it is important to note that our ending ARR is in line with our original 2025 internal budget. Total revenue was $8 million, a decrease of $2.4 million or 23% from $10.4 million in Q2 last year. Subscription revenue, which accounted for 58% of total revenue for the quarter decreased 28% from $6.4 million to $4.6 million. The decrease reflects the impact of 2 expired contracts I just referenced. Service revenue decreased 15% from $4 million to $3.4 million, reflecting lower government service revenue from the Central Banks. The decrease is generally in line with our expectation of a 12% to 14% decrease in program work for fiscal 2025 that we shared on the previous earnings call. Subscription gross profit margin, excluding amortization expense, was 85% for the quarter, down 4 percentage points from Q2 last year, reflecting the impact of lower subscription revenue. We anticipate that subscription gross profit margins may be lower next quarter as we work to consolidate our legacy platforms. After the migrations are completed, we expect subscription gross margins to not only fully recover but to increase beyond current levels as we benefit from the efficiencies of the Illuminate platform. Service gross profit margin was 59% for the quarter, essentially flat with Q2 last year. Operating expenses were $13.1 million for the quarter, down $3.7 million or 22% from $16.8 million in Q2 last year. Included in operating expenses this quarter was $600,000 of legal expenses largely related to an external shareholder matter. We do not expect these legal expenses to continue. Excluding these legal expenses, operating expenses were $4.3 million or 26% lower than Q2 last year. The large reduction in costs reflects lower compensation costs due to the reorganization in Q1 this year. As we look forward, we expect to continue to see a reduction in our run rate of expenses as not all the benefits from our streamlining efforts, especially in the non-compensation cost areas were fully realized yet in our Q2 results. Non-GAAP operating expenses, which excludes noncash and nonrecurring items, were $8.9 million for the quarter, down $5.2 million or 37% from $14 million in Q2 last year. Again, the decrease is due to the impact of the reorganization and streamlining efforts, partially offset by $600,000 of higher legal expenses. Net loss per share for the quarter was $0.38 versus $0.43 in Q2 last year, while non-GAAP net loss per share for the quarter was $0.11 versus $0.23 in Q2 last year. Our internal plan for 2025 at the start of the year was to be non-GAAP profitable and free cash flow by no later than Q4. Even adjusting our plan to account for the risks to revenue Riley discussed earlier, namely the large customer contract renegotiation and the timing of significant gift card revenue recognition, we still believe it is likely we will achieve these targets in Q4. Regarding cash flow, we ended the quarter with $16.1 million in cash and short-term investments. Free cash flow usage was down considerably from $6.9 million in Q2 last year to $5 million in Q2 this year. Excluding $900,000 of previously accrued severance costs from Q1, which were paid in Q2 and $300,000 of the $600,000 of higher legal costs that were paid during the quarter, free cash flow usage would have been only $3.8 million for the quarter. Free cash flow was also negatively impacted by the timing of customer receipts in Q2, which we expect will reverse in the second half of 2025. As I noted earlier, we still have not fully realized all the cash cost savings from our reorganization and streamlining efforts put in place earlier this year, which are estimated to total $22 million on an annualized basis. As those savings start to be fully realized and with forecasted revenue growth, we expect Q3 cash flow usage to be much lower than Q2, even when factoring in the payment of the remaining $300,000 in legal cost referenced above, and we believe we are likely to deliver positive free cash flow in Q4. 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.

Riley Young McCormack, CEO

Thank you, Charles. In the wake of the relentless acceleration of AI models and agents, a vacuum of trust and authenticity is being created. Trust is fast becoming the only currency that matters, and the future will belong to companies that make that currency scalable. We believe Digimarc is ideally positioned to lead that charge. We are focused on delivering a future where humans and intelligent systems alike can verify what's real, protect what matters and move forward with confidence. We are focused on filling the ever-expanding vacuum by positioning ourselves to deliver trust in every interaction, spanning both the physical and digital worlds. We are building the trust layer for the modern world, a layer that is needed now more than ever and is forming a massive opportunity we were created to deliver. I would like to conclude this call by once again thanking my amazing teammates. Reorganizing our business to increase our focus has been extremely challenging, but absolutely necessary to achieve the results we know we must deliver, fast, profitable and durable growth. I believe we are positioned to win and are on the precipice of scalable and repeatable in our commercial business. I'm excited to share our progress, especially in the quarters to come. Operator, we'll now open the call for questions.

Operator, Operator

Our first question comes from Jeff Van Rhee with Craig-Hallum Capital Group.

Jeffrey Van Rhee, Analyst

Great. So a couple for me. Charles, you mentioned the run rate expenses have come down. What is the GAAP OpEx run rate at the end of the quarter?

Charles Beck, CFO

The non-GAAP operating expense run rate?

Jeffrey Van Rhee, Analyst

Yes, GAAP or non-GAAP. At the end of Q2, you said it came down quite a bit. I'm just trying to figure out how far you are...

Charles Beck, CFO

Yes. For non-GAAP. Yes. So we were at $8.9 million of non-GAAP operating expenses for the quarter. We expect that that's going to continue to come down some as we start to realize the full benefit of all of our streamlining efforts.

Jeffrey Van Rhee, Analyst

And I guess what I was saying is, I know it was $8.9 million for the quarter. Based on the cuts you've made, how much lower than that $8.9 million quarterly rate is your run rate right now?

Charles Beck, CFO

Yes. I'm not going to give exact guidance, but there's still a significant amount of savings that we can generate in Q3 and Q4.

Riley Young McCormack, CEO

Yes, Jeff, just to clarify, there is still more to come from non-headcount savings even when considering our current monthly or weekly run rate.

Jeffrey Van Rhee, Analyst

Got it. That's helpful. Regarding the Central Bank business, do you have any visibility into next year? I believe you mentioned expecting a decline of 10% to 15%. That's what we've observed. When do you typically get an indication of what next year is projected to look like?

Charles Beck, CFO

Yes, Jeff, we do have usually a full year of visibility. But again, we wouldn't provide guidance unless we expect material changes in our business. So we generally have at least 12 to 18 months of kind of forward-looking visibility because they commit to a statement of work basically a year in advance. So we have fairly good visibility there.

Jeffrey Van Rhee, Analyst

Okay. I mean, historically, it had been kind of flattish. You can't share if it's kind of flattish or it continues this roughly 10% decline?

Charles Beck, CFO

What I said is if we expected a material difference, and that's something that we would disclose.

Jeffrey Van Rhee, Analyst

The European customer that you mentioned...

Charles Beck, CFO

You could assume that means it's not going to be materially different from 2025.

Jeffrey Van Rhee, Analyst

Okay. The European customer that you mentioned in the quarter, nice ARR value to that. Was that signed in the quarter? And did that impact the reported ARR?

Riley Young McCormack, CEO

Yes, I was at the close...Sorry, go ahead, Charles.

Charles Beck, CFO

Yes, I was going to say, yes, it was effective during Q2 and is included in ARR. Although that contract, as Riley referenced, is expected to grow in multiple years. So only the first year is reflected in ARR at this point in time. So there's some potential built-in basically upsell in future years under that contract.

Operator, Operator

Our next question comes from Jeff Bernstein with Silverberg Bernstein Capital. Riley Young McCormack, CEO: Yes, I was at the close... Sorry, go ahead, Charles. Charles Beck, CFO: Yes, I was going to say, yes, it was effective during Q2 and is included in ARR. Although that contract, as Riley referenced, is expected to grow in multiple years. So only the first year is reflected in ARR at this point in time. So there's some potential built-in basically upsell in future years under that contract.

Jeffrey Milton K. Bernstein, Analyst

Regarding the gift card business, you mentioned various stakeholders and supply chain elements involved in launching the first cards. Can you summarize the number of card vendors you collaborate with? Will you need to revisit many of these elements for each vendor, or has most of that work already been completed? It appears that you are already engaging with several brands for the retailer you mentioned. Could you elaborate on how all of this works?

Riley Young McCormack, CEO

I'm not sure I exactly understand the question. Jeff, are you asking how many brands we're working with, how many retailers? Maybe you can repeat the question.

Jeffrey Milton K. Bernstein, Analyst

No. I'm asking if it's just the gift card companies. Are there four, and do we need to get three more? Do you have to retouch all scanners, brands, and retailers? Or do we just have to win over three gift card companies? Please provide a complete breakdown of how this all works.

Riley Young McCormack, CEO

How much time do you have? I’ll provide a brief overview. Jeff, you’ve asked the right question. We primarily market through gift card manufacturers, specifically printers. This is a relatively concentrated industry with only a handful globally; you can think of the 80-20 rule. Most of our customers will be from this group. There may be one or two companies we approach directly. The team has truly excelled in rolling out our innovative technology. The gift card industry is facing a significant challenge, and they are intensely focused on addressing it, albeit with outdated technologies. This is where we stand out. Our solution is superior and more cost-effective. For the first time, we offer a technological solution, which not only improves things today but also sets a strategic roadmap for the next 20 years as we collaborate with this industry to combat widespread fraud. Rolling out a revolutionary new technology while ensuring the existing workflow remains undisturbed is quite challenging. The team effectively planned the go-to-market strategy, which is why we're collaborating with gift card manufacturers and printers. The printers work with all the brands, helping them create their cards, so they will present our new solution to their customers. A significant part of this industry involves the gift card network, with Blackhawk and InComm being the two major players. They have connections with all the brands and engage in discussions about new security solutions. They also interact with retailers, so when you visit a store and see a display full of gift cards, it likely belongs to either InComm or Blackhawk. They play a crucial role for both the brands and the retailers. Additionally, we definitely need our software operational at the front of these retailers' stores. We have established our presence in most major scanners over the years. There is an upgrade to our software, and part of our solution involves more than just applying technology to gift cards; it also includes detection. This approach is highly scalable since we are a recognized entity that has been utilized in many of these scanners, even if it's not currently activated. There are significant retailers where it is activated, so it's primarily about facilitating the firmware updates. Many of these large retailers regularly update their firmware, and events like this prompt them to do so. The problem at hand is substantial, with estimates in the U.S. alone exceeding $4 billion, and the losses for retailers are significantly greater than that. That's about it, Jeff. I hope that clarifies things.

Jeffrey Milton K. Bernstein, Analyst

That's what I was looking for. That's fine. We can do more offline, but that was generally what I was...

Operator, Operator

Ladies and gentlemen, at this time, there are no further questions. The conference of Digimarc Corporation has now concluded. Thank you for your participation. You may now disconnect your lines. Thank you.