Earnings Call Transcript - DMRC Q2 2021

Operator, Operator

Good afternoon and thank you for participating in today's conference call. Now I will turn the call over to Chief Legal Officer, Mr. Bob Chamness. Sir, please proceed.

Bob Chamness, Chief Legal Officer

Welcome to our Q2 Conference Call. Riley McCormack, our CEO; Charles Beck, our CFO; and Tim Price, our Chief Revenue Officer are with me. On the call today, we will provide a review of Q2 financial results and an update on the business, 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. Charles will now comment on our Q2 financial results.

Charles Beck, CFO

Thank you, Bob and good afternoon, everyone. Revenue for the second quarter was $6.3 million, down 3% from $6.5 million in Q2 last year. Service revenue decreased 3% from $3.9 million to $3.8 million, reflecting lower government services due to timing of program work with the central banks, partially offset by higher commercial services related to Holy Grail 2.0 projects. Subscription revenue decreased 5% from $2.6 million to $2.5 million, reflecting lower revenue from digital media customers. Revenue from government customers was $3.8 million, down 5% from $4 million in Q2 last year, reflecting the timing of program work with the central banks. For the 2021 fiscal year, we still expect revenue from the central banks to grow modestly from fiscal 2020. Revenue from commercial customers was $2.5 million, essentially flat with Q2 last year. Commercial services were higher due to new Holy Grail 2.0 project work, offset by lower commercial subscriptions from digital media customers. Total commercial bookings were $2.3 million, up 13% from $2.1 million in Q2 last year. The increase in bookings reflected new bookings in several areas of the business. During the quarter, we signed our first major contract associated with the Holy Grail 2.0 program. The project is centered around Phase II semi-industrial test, which is the next step in the Holy Grail 2.0 roadmap. The contract is expected to contribute nearly $1 million of bookings and revenues during 2021. Due to the timing and structure of this contract, there were no bookings recognized in the second quarter. As we promised on the last earnings call, we have again included a table within the script that shows relevant booking and revenue details under both our prior and new market segments. Gross margin for the quarter was 67%, consistent with Q2 last year. Service margins improved 1% while subscription margins declined 1%. The operating expenses for the quarter were $19.7 million, compared to $11.9 million in Q2 last year. The increase is almost entirely related to non-recurring costs of $7.5 million incurred during the quarter, associated with the separation agreement we entered into in April with our former CEO, as well as severance costs incurred for organizational changes we made in June. The $7.5 million is comprised of $5 million of non-cash stock-based compensation expense and $2.5 million of cash-related expenses, most of which will be paid out over a two-year period. Excluding these non-recurring costs, operating expenses increased 2% to $12.2 million, reflecting higher consulting and legal costs, partially offset by lower recurring compensation costs. We anticipate operating expenses for the third quarter will range from $12.1 million to $12.6 million. Net loss for Q2 was $15.4 million or $0.94 per common share versus a net loss of $7.5 million or $0.62 per common share in Q2 last year. Excluding the $7.5 million of non-recurring costs I referenced earlier, the net loss was $7.9 million or $0.48 per common share. We ended the quarter with $61.1 million in cash and investments. We used $9.6 million of cash and investments during the quarter, which included $2.4 million of cash to repurchase shares and satisfaction of required tax withholding on the stock awards associated with the separation agreement with our former CEO. Our application for forgiveness of the $5 million Paycheck Protection Program loan is still in process of being reviewed by the Small Business Administration. We do not have any visibility on when they may complete their review. For further discussion of our financial results and risks and prospects for our business, please see our Form 10-Q that we expect to file shortly. Riley and Tim will now provide a business update.

Riley McCormack, CEO

Thanks, Charles. As I mentioned last quarter, across the whole company, we are questioning every assumption and being patient to come up with the right answers. Good enough and this is the way it has always been done are no longer answers we need to accept. Nothing has shaken our belief in the following very simple facts. 2022 and beyond will be much better if we take the time to do things right today, acting with the wonderful freedom to plan, not react. As this is our number one priority and where we as a management team and we as a company are spending most of our time. I want to use the bulk of this call discussing what exactly that means. I fully appreciate there are some investors who might find this boring, but there are no shortcuts to repeatable and scalable. Moreover, every call we do for the next decade will bear the results of how we're organizing ourselves today. For those investors who get that results are a function of input and process, I'm happy to provide this color. Not only is it by far the most important thing we're doing right now, but its impact will affect our shared investment for years to come. Before I get to that, I want to make clear that we still believe that as we are building and getting ready to drop the Space-X engine into the race car, our existing engine is going to deliver strong results for 2021. We fully realize our first half bookings do not reflect that fact. All I will say on this – all I will say on that is the year as I had done. While we are much more focused on 2022 and beyond, it does not mean that we are not focused on 2021 at all, stay tuned. I mentioned in the last call I was going to have Tim Price, our CRO; and Kelly Haggerty our CPO on today's call to give you all some color on how they are building our 2022 and beyond engine. As you might have noticed during Bob's introductory remarks, Tim is indeed with us today and in a minute I'm going to turn the call over to him so he can give you an update on our go-to-market build. Kelly, however, is no longer at the company. He has resigned for personal reasons. I got to know Kelly from the Board and then was fortunate enough to overlap with him for a brief period of time when I became CEO. I think the world of Kelly as a professional. However, I think even more highly of him as a person and wish him all the best going forward. He has been available as a part-time consultant, as we finish up our CPO search, and his input has been invaluable. I also want to give a big shout out to the entire product team for making fantastic progress in getting us to where we need to be. All of your hardest, smartest teamwork is noted and appreciated. We also executed a reorganization toward the end of June, breaking down silos and streamlining our company, removing non-aerodynamic quarters from our race car. Marketing has been combined with sales and already we are seeing the wonderful synergies that come from having a single go-to-market team. We moved our professional services group, as well as our education and training team to research, thus platinum making the tip of the spear by uniting these three key components in one functional group. We moved our infrastructure partner relationships to product, uniting in one place the natural build by partner decision that product needs to be driving. When we find our CPO, engineering will be reporting to him or her. Product and engineering don't exist one without the other. And for this company to be truly scalable, they need to have a direct line without any side dash. That fact will not be clearly codified. And then finally, as you all saw in yesterday's press release, Mignon Senuta has joined the executive team as VP ESG Engagement and Corporate Communications. She will be driving our ESG strategy from the executive level, ensuring our commitment to ESG is not a passing fancy, but core to our very DNA. She will also be in charge of all stakeholder engagement and corporate communications, including among other stakeholder relations, Investor Relations. In addition to the reorganization, we also reexamined all aspects of our sustainability initiative, as if it were day one. Holding an offsite to make sure our actions were driven by the careful mapping of all the stakeholders and the strongest influencers. During this two-day intensive process, we came to the obvious conclusion that there are many wonderful benefits our technology is capable of providing the world in addition to the one front of mind for most of you, improving plastic sortation. While we continue to make great progress on plastic sortation, both from a technology as well as a business perspective, our confidence has increased from already high levels that we are indeed the solution to this global problem. What the upside showed us is we are capable of doing so much more while at the same time, we're capable of doing so much normal at the same time also improving plastic sortation. And thus, we are now embarking on doing that so much more. Importantly, these additional benefits are directly related to, and additive to our existing work in plastic sortation. We are not reinventing the wheel, but strengthening the wheel to provide additional benefits. The new path we are charging in sustainability isn't the result of a loss of focus, but instead the exact opposite. By increasing our focus and asking ourselves the question, we are asking company-wide, what if, why not? We are augmenting the solution we will provide and that's the value we will add. We've also embarked upon a new methodology for meetings and 360 communications, laser-focused on getting to and then maintaining company-wide clarity on where we are going and how we are getting there. Tech is fast. Techs are winning. Thus, tech requires being nimble and being nimble requires company-wide cross-functional clarity. Declined amounts we will climb this is table stakes and we are anting up. Finally, we will be having our first-ever annual product strategy meeting in September, where product will tell us not based on sales or RSS feeds, but on the real research and the result of data, they are now finally empowered to provide, where they believe we should be spending our most precious resource, engineering time. As an executive team, we will then place those bets. As a side note, you might have noticed we have stopped using the tagline the barcode of everything. While we will eventually get to everything, if we don't start with some things, we will be the code of nothing. I want to be clear, the height of the mountain we will climb has not changed in the slightest; if anything it has grown taller. What has changed, however, is by tackling the climate changes, we will not only ascend the mountain in a more scalable, higher-margin way, but perhaps as importantly, we will be much faster in putting real distance between us and base camp. And so with the conclusion of the annual product strategy process, while I don't want to understate the work it will always take to climb to the levels we are targeting, the new engine will be dropped in the race car and they can focus less on transformation and more on execution. We will be able to begin to harvest the fruits of years of world-class, world-changing work, finally unleashed by our taking the time to reimagine everything and plan our path not react to distractions. I want to turn the call over to Tim now, who will discuss the work he and his team are doing on our go-to-market strategy.

Tim Price, CRO

Thank you, Riley and hello everybody. Over the past four, five months, we have embarked upon a journey of change, most notably an intense focus on process, methodology and culture, all of which are essential ingredients for success. In this case, success equals predictable results and the ability to scale. Per Riley's earlier comments, we have been thoughtful in our approach, taking time to plan and exercising patience to get the right answers. Swapping out the engine mid-race is difficult, but I know we are up to the challenge. We must be very calculated in our approach. We want to perfect the new engine, while making sure we get every last mile out of the current one. We are driving our internal sales and marketing systems to a whole new level. Our systems support our processes, yielding sales enabling functionality. On top of our systems and processes, we have implemented a sales methodology, which is actually a company-wide methodology called Miller Heiman strategic selling that now supports how we address and process our sales engagements. This is for both new and existing customers. It is a common framework and language we all use to speak efficiently, enabling and transparent. I wanted to take a moment to call out some key progress that we have made over the past five months, progress that will get us predictable results and give us the ability to scale, progress that will deliver success. The first thing we've got has created two core teams within sales, sales enablement and sales execution. This has given us greater focus and will allow us to iterate and grow faster. Our sales enablement team consists of sales engineering, subject matter experts, customer success, and sales development reps. Our sales execution team is comprised of our quota-carrying team members and is broken into three core teams: our enterprise sales team, channel sales team, and digital media sales. Digital media sales is a new group leveraging what we used to refer to as our media business, which includes our digital images, digital documents, and piracy intelligence product lines. Besides having real unexploited revenue generation promise as a standalone, this is also a strong cross-sell opportunity builder for our enterprise sales team. The next thing we have done is we've moved from a global sales quota and commission to individual quotas and commission. This will drive greater individual team member accountability and more predictable results. Next, we have implemented a forecast Friday call to track all sales opportunities and it is attended by a cross-functional team including executives. This leads to increased visibility and accountability. Next, we have been holding quarterly business reviews, or QBRs, with each sales rep to go over their accounts and prospects to help foresee and remove blockers and deliver predictable revenue. Sales and marketing teams have both been trained in Miller Heiman strategic selling methodology, and large account management processing training will occur in Q4 of this year at our annual global sales and marketing meeting. In addition, we have trained and certified our sales engineering team in demo to win, a world-class demo and presentation skills training module. Working with product and finance, we are currently working with product and finance on new pricing models, and no discounting. Our goal state, which is a goal state for great companies, is to be easy to buy from and easy to sell for. Our pricing must make sense and simultaneously maximize our value add. Next, we are interviewing agencies for enhanced messaging, positioning, and go-to-market assistance. We need loud and proud messaging for our vision, solutions, and products. Lastly, we are fully reimagining the National Retail Federation Show in January 2022, including speaking engagements, more clarity around our core messaging, and much more focus on customer and partner events and meetings. We have made great progress in a short time, but we are focused even more on where we are going. We are putting the finishing touches on a really fast engine and excited to produce the results. As we like to say, let's win. Thank you and I will now turn the call back over to Riley.

Riley McCormack, CEO

Thanks, Tim. As a company, we've been focused on running the existing engine as hard as it can be run, something that will be important over the next couple of quarters as we fully get the new engine up to speed. And I want to be very clear here that doesn't mean there isn't some amazing prospects for real company-changing opportunities in our existing engine. As I said on the last call, we are going to make this hot swap in such a way that if we didn't just tell you how you're going to do it, you wouldn't have known that it happened. Tim and his team, in collaboration with the entire Digimarc team have done an amazing job of keeping the lights on while the whole organization has been planning how exactly it is we are going to shoot the lights out. But I do want to highlight something that has just been incredible to see. In great tech companies, there's always a natural contention between maximizing today's results and setting oneself up to make tomorrow that much better; harvest some now or harvest more later. And saying something I don't imagine I'll never say again, I strongly believe the most impressive thing about this quarter from a sales perspective is the deals we didn't close. Deals are for a variety of reasons, including not having our tech exactly where we want it either for us or for our customers we put on pause. Delaying short-term gratification for the long-term win takes courage. It takes a belief in the roadmap and a belief in the team, a belief in where we are going and who will get us there. That is exactly what our sales organization did this quarter. And so I want to use this very public forum to deliver a very personal message to our entire sales organization. I know it's tough to nail on the two-yard line and not score that touchdown. Your actions are appreciated. I'm so thankful for how you didn't for one second think about anything but team. You made a confident decision on prioritizing team, and more importantly, trusting your teammates. I hope each fully and completely know that the belief will pay off for us many times over in the coming quarters. As I started off this call by saying the planning we are now close to finishing up might strike some as boring. And like all of you, I can't wait until we are spending these calls discussing the real progress we are making in the market not internally. But all of the above, in addition to a lot of other important initiatives and accomplishments, too numerous to mention on this call, are the foundation upon which all of our future progress will be built. As an executive team, we stressed the organization because there was a lot to do would be open-ended instructions to take all the time necessary but not one second more and it responded wonderfully. I want to thank all my teammates for being such amazing dual trackers, focused not only on the win and an if, but also on the here's how. We are setting up the foundation for our next many years. And while of course we'll always be tweaking and optimizing the engine, we are close to putting away the blueprints and starting our test runs. We're building something really special here at this company, something that we all realize outsiders will only believe when we start demolishing lab records. As always, judge us on the results. One last thing before we open the call up for questions, I do want to alert everyone we'll be filing a Form S-3 with the SEC shortly to register the shares TCM strategic partners bought last September. This is a normal process that will allow these shares to be freely tradable once the one-year lock has passed. The truth is, however, I have zero intent of selling a single share anytime soon or much more importantly, anywhere near these levels. There's just too much good yet to come. Like our two previous calls, we'll be taking questions from anyone interested in asking one. Operator?

Operator, Operator

Thank you. Our first question is from Jeff Van Rhee with Greg Hallum Capital.

Riley McCormack, CEO

Hey, Jeff.

Aaron Spychalla, Analyst

This is actually Aaron on for Jeff. Yeah. Thanks for taking my question. First question I have. So you alluded to becoming the barcode of something looking at other avenues besides plastic sortation. Just interested in a little more color there where you're seeing progress anything top of mind a couple of areas if you can give any more color?

Riley McCormack, CEO

Absolutely, after APS, Aaron, we'll be happy to share that with you. So APS is the annual product strategy. So historically, we have been trying to figure out exactly how best to use our technology based on where customers have been taking us. That is changing. We are a product company. We're becoming a solutions company. We need to let product do the time to perform that research, collect the data and tell us where we need to be going. So obviously, I mean like it's a little bit of spoiler yes, sustainability will be one of those product lines. But stay tuned, after APS, we'll be more than happy to share with you guys exactly where we are going from a product perspective. And in addition, as Tim alluded to also encourage you to come to NRF you'll see a lot more there.

Aaron Spychalla, Analyst

Fair enough, fair enough. Another question for me. Just curious on any updates on the retail side of things, specifically around the relationship with Walmart? Any color you can provide there?

Riley McCormack, CEO

Obviously, we're not going to talk about any customer in particular. But as I said in the last call, Walmart is a wonderful forward-looking company. If you look at the overall level where they want to go and what we can provide there's a lot of overlap. If there is any major retailer that we would want to be close to Walmart is that retailer. So we're excited to continue to develop that relationship.

Aaron Spychalla, Analyst

Good deal. And then one more for me, if it's okay. Just curious you mentioned the bookings aren't where you want them to be at the midpoint here, but so there's a lot of room left in the year. Just curious what it takes to get to that triple-digit booking growth that we talked about previously what do you see happening to get us there?

Riley McCormack, CEO

Close deals.

Aaron Spychalla, Analyst

Fair enough, easy enough. All right. Cool. Thank. That's it for me.

Riley McCormack, CEO

Thanks, Aaron.

Operator, Operator

Our next question is from Jeff Bernstein with Cowen.

Riley McCormack, CEO

Hey, Jeff.

Jeff Bernstein, Analyst

Just wondering if you have an update at all on laser serialization and whether that looks like you're going to be able to do that?

Riley McCormack, CEO

We can definitely achieve it; there's no doubt about our capability. The real question is where it fits into our product roadmap. Stay tuned for APS. To emphasize the point, the quickest way to expand our base camp and create a significant distance in bookings is through focus. We can handle anything that isn't made by hand or by nature; the question is where we begin. This decision should be informed by research, not customer requests driving a shift in our engineering priorities. I believe there’s nothing we can’t tackle, at least nothing we’ve encountered so far, except for things made by nature or by hand. There are many ways to improve our coding, and laser ablation is just one of them. We will keep you updated on whether this will be a key focus area for us after APS.

Jeff Bernstein, Analyst

Got you. Okay. And then the potential for the significant bookings growth this year was in part driven by sort of fallout from COVID and supply chain weaknesses that potential customers had. And I think produced some applications that you even felt were worthy of Digimarc going after. Has that kind of continued? Are you actually getting some ideas from customers that you think are going to survive the APS filter, or could you just give us a little bit of color on that?

Riley McCormack, CEO

So a big part of the APS filter what product does is voice of customer, right? So we might be 230 smartest people in the world. But if we just stop our ideation with us, we're going to fail. So there's a lot of research. When I talk about research not research internally to Digimarc, it's research with the world. We're 230 people. There are 7.6 billion people we got to sell to. So that voice customer is a huge part of the product. Product market obviously product driving APS.

Jeff Bernstein, Analyst

And then lastly, just a quick update. Japan grocery seem to be starting to move forward a little bit. Just wondering what the update is there? And if you can say anything also about how Netto is progressing?

Riley McCormack, CEO

Yeah. So we don't like to talk about individual customers obviously, right that's their business and talk about the great way to anchor our customers talk about their own business. So I mean, Netto is doing great. They're a great customer of ours. We'll leave it at that. I don't know the Japanese grocer, I don't know if there's a grocery reference you made. I'm not familiar with us having talked about that.

Jeff Bernstein, Analyst

No, not by name generally. I believe there was a lead customer involved. I'm aware you have a relationship with a significant packaging player there and I'm curious about how that is progressing.

Riley McCormack, CEO

Yes. So we're not going to talk about a customer. All I'll say is, we have a lot of value to add to a lot of different customers. I would say something that maybe I'll turn it over to Tim to talk about the pipeline in Japan, it seems like it's waking up since there's some great opportunities there. But what's really important, Jeff, is closing deals not typeway.

Tim Price, CRO

I would say that to double down on the APS strategy that that's going to be very illuminating and very constructive for our go-to-market there. So I do think that will increase as a result of our APS.

Riley McCormack, CEO

Awesome. Thanks, Tim.

Jeff Bernstein, Analyst

Thank you.

Riley McCormack, CEO

Thanks, Jeff.

Operator, Operator

Your next question is from Robin Knipp with Jamie Montgomery.

Riley McCormack, CEO

Hey, Robin.

Robin Knipp, Analyst

Thanks.

Riley McCormack, CEO

Yeah. Hey, Robin, I don't have to take that. But thank you. I think.

Robin Knipp, Analyst

Take it in a good way. So my question is actually a hard right turn from plastics more towards global packaging, I had the occasion yesterday listening to Phil Stafford and John Dwyer and Westrock talking about the opportunities there and the fact that global packaging is a $450 billion business today and yet five years from now nearly 20% of the packaging is going to be targeting the anti-counterfeit market. Now to me this is a no-brainer for us, but how do we get there?

Riley McCormack, CEO

I'm trying to decide how to answer that question, Rob. First of all, stay tuned for APS. APS is a significant milestone in our future plans as it delivers the product. Generally speaking, aside from any specific product line, I believe you heard from Tim about our approach. Tim will take our product and bring it to market to secure the bookings. That's an interesting insight, Robin.

Robin Knipp, Analyst

So just as a follow-up then when I think about invisible digital watermarks versus the QR code and everybody sees a QR code. They know how the QR code can bring a call to action there. But if they don't even see it in a visual watermark on an object how do we get that same call to action?

Riley McCormack, CEO

So what we talk about for product authentication, or are you talking about just in general for consumer engagement?

Robin Knipp, Analyst

Both actually. And when we're talking about counterfeit deterrents, when we're talking about the pursuit of finding more information about a product, talking about just getting the whole story out there about a digital watermark that's invisible to the naked eye. I think we have to be doing a better job of telling the story.

Riley McCormack, CEO

Who as we? Digimarc?

Robin Knipp, Analyst

Yes sir.

Riley McCormack, CEO

Yes. There are a few ways to address that. We can act as the solutions provider in several capacities. When it comes to product authentication and brand protection, it really depends on the customer’s preference for covert or overt methods. There are various approaches for calls to action; you don’t have to specifically instruct users to scan a QR code. You can simply suggest scanning an image or use QR codes in ways that complement our services. I'm not overly concerned about singular applications, as sometimes a lack of a universal call to action can actually add value. Regarding overall consumer engagement, I have a personal belief that we should be able to derive the truth from products. I don’t think broad consumer engagement is a compelling use case for our technology until it becomes more widespread. There are native readers now, but my viewpoint may not be universally held. The opinions of the 7.6 billion people out there matter more than mine since they are the ones buying our products. I believe that broad QR engagement has potential, and we don't need to claim we have no competition. I believe in cooperative competition, and there may be better solutions for specific needs. That's perfectly acceptable, as there is plenty of market space for us.

Robin Knipp, Analyst

Fair enough. Thanks. Appreciate the time.

Riley McCormack, CEO

And Robin I mean it hit one little script on that. That's also entering a platform right where the beautiful thing is if we architect our products and our solutions correctly if consumer engagement is a nice to have, that's an add-on okay, right? So even takes sustainability, right? So if we're solving real prompt in sustainability and there is a way to get consumer engagement to help at the front of that funnel, okay, right? But stand-alone consumer engagement. I just don't see it. Again, thesis to be verified but we know a lot more when product tells me and tells all of us what the research and what the truth is.