DMRC - NASDAQ

Ladies and gentlemen, greetings, and welcome to the Digimarc Corporation Second Quarter 2023 Earnings Conference Call. [Operator Instructions] 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.

Thank you. Welcome 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 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 we 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 our actual results to differ materially. Riley will now provide a business update.

Thank you, Joel and hello everyone. Q2 was a strong quarter on many fronts, a testament to our maniacal focus on being easy to begin doing business with and excellent in guiding customers along their product digitization journey. Starting with the Easy to Begin Doing Business With portion of our mantra, I want to highlight a few wins on the direct side of our business. We added two large new customers in the pharmaceutical vertical and are hard at work expanding this flywheel to help this industry combat the massive and massively important issue of counterfeit products. We also closed deals with two separate divisions of the top 25 global CPG for a sandbox version of our platform involving factory automation and are working to pull together the ecosystem partners necessary to provide a quickly scalable and low-touch solution to the hundreds, if not thousands, of other companies that would benefit from the same. Based not just on these two initial wins nor just on our internal research, but very importantly also on our growing pipeline of opportunities as the word gets out, we are confident we have a truly differentiated and high-value factory automation solution that we can’t wait to provide to many others. On the channel side, we added two new VARs, including the large $32 million plus contract we announced a few months ago. We have high expectations that both relationships will grow as we prove Digimarc Illuminate’s value in allowing our borrowers to provide unique and differentiated solutions to their own customers. In addition, the public announcement of our large borrower deal has put us squarely on the security printing industries radar. We are in early conversations with two new prospects, each of which represent a sizable opportunity. This further validates the unique position we enjoy in this space based not just on Illuminate’s capabilities as the world’s best product digitization hyperscaler, but also Digimarc’s hard-earned and well-deserved reputation with this industry gained by over two decades of delivering value to the World Central Banks. In addition to the opportunities opening to us in the security printing space, the day after we issued that press release, we received an invite to a full-day planning session for a proposed deposit return system program in a major country. We are focused on expanding our opportunities in the DRS market as we believe our Illuminate platform provides our VARs and the ability to offer a DRS solution that is easier, more comprehensive and more cost effective in the status quo. As part of the excellence that guiding customers along the product digitization journey portion of our mantra, we signed multiyear extensions with 6 important customers in Q2, 5 of which resulted in a meaningful increase in annual recurring revenue, a testament to the power of our technology and our team. Four of these renewals were direct customers and the other two are VARs. In addition to these contract renewals, we also had two customers whose contracts were structured under the legacy pay-as-you-go model, significantly ramp up their usage in Q2, including a top 5 global CPG that is also a key supplier to Walmart. All of the above help contribute to strong results in the two key financial metrics by which we have to assess. While Charles will elaborate more in a moment, I want to highlight subscription revenue was up 44% year-over-year and 59% when adjusting for the end of life of piracy intelligence. In addition to strong subscription revenue growth, subscription gross margin expanded 400 basis points sequentially to a near best-in-class 84% with further expansion ahead as we continue to remove costs from our platform and add high incremental margin subscription revenue. Before I turn the call over to Charles, I want to take this opportunity to answer a question I know is front of mind for many of our investors. Yes, our technology does have a significant role to play as the world grapples with both the opportunities and the dangers of generative AI. And as we have been busy preparing our soon-to-launch offering, informed by all the learnings and knowledge that comes from being the pioneer and widely recognized Vanguard of Digital Watermarking, it has been wonderful to see some of the world’s largest companies and governments conclude the same. We also applaud the various governments in Gen AI companies who are moving to act of this conclusion, including most recently, the 7 leading AI companies who convened at the request of the White House and voluntarily committed to take specific steps. The world seems to be coalescing around the view that safely and securely unlocking the transformational power of Gen AI will require addressing its biggest dangers head on. A view we not only share but one we are uniquely positioned and excited to help achieve and no bigger problems need solving in the world of Gen AI and how to ensure the authenticity of digital media and how to provide for the safety and fairness of input to the models themselves. We believe there is an obvious need for a single robust, secure and easy to adopt solution that can accomplish both while also adding additional value to stakeholders in the world of Gen AI and beyond and are anxious to begin telling that story more broadly. But today, I want to focus more specifically on each of these two potentially show-stopping problems in turn. Regarding the need to ensure the authenticity of digital media in a world where digital asset creation is easy, fast and cheap, while the current proposal of tagging all Gen AI-created output is a solid first step, if for no other reason that it shows that the Gen AI companies are serious about taking action, it won’t solve the problem of how to ensure the authenticity of digital media for the following four reasons. First, unless every Gen AI company applies digital watermarks to its output, which is an impossibility for many reasons, simply tagging the Gen AI created content of some, will do as little to prove authenticities if it were done by none. Intuitively, no one would suggest the system we have built alongside the World Central Banks to help protect the authenticity of currency should rely on every potential counterfeiter current and future, putting the word fake on their counterfeit currency. The same logic applies here. Second, a solution that rests solely on digital watermarking Gen AI output assumes there are only nefarious or frivolous uses of Gen AI, an assumption with which we, along with many others disagree, an incredible amount of legitimate content is already being produced with the help of Gen AI and the value creation potential of Gen AI is still in its infancy. Similar to how the output of copy editors improved with the advent of spellcheck, the work that professional creatives will improve by incorporating Gen AI. Gen AI is a generational productivity tool that should and will be used by legitimate creators of digital assets and what truly matters is whether a digital asset was created by the source one believes it was, not the method of tools using its creation. Third, authentic content used in an authentic context is often worse than just lacking certainty by the digital assets native authenticity because this scenario provides a false sense of comfort. Context about when and why authentic content was created and used matters, and it matters a great deal, to with an authentic image of a medicine that appears in an inauthentic place such as the website of a non-authorized or otherwise illegitimate reseller, but without a doubt, increasing odds, the consumer mistakenly purchases a potentially dangerous item. Content and context are 2 sides of its same authenticity claim. And finally, many Gen AI engines rely on open source technology, which essentially gives anyone the keys to inspect, understand and potentially even edit lines of codes, including those lines involving security. There is a reason why network security companies don’t build their business around open source technology, and the same logic applies when it comes to a system test with ensuring authenticity of digital assets. For these reasons, simply watermarking Gen AI created output will not adequately ensure the authenticity of digital content. Moreover, there’s another crucial issue that must be addressed. The world also needs safe and fair filtering of the content that trains these engines. Several groups have an immediate need for these safeguards. First are the companies and creatives who have spent an incredible amount of talent, time, money and effort to create their digital assets. This is exactly why copyright law exists in countries around the world. Without an automated safe and fair input filter, these assets have simply become free input to the trading of Gen AI engines without the copyright owners having a say. That isn’t fair and in many cases, it isn’t legal. Second are the Gen AI companies themselves. They need a solution that allows them to comply with copyright law or they risk the exponentially growing avalanche of lawsuits overwhelming their legal teams as well as their balance sheets and the only alternative being considered, unilaterally restricting the input needed to train their engines will deprive the world of the productivity gains, their useful and powerful technology will bring. In addition, the Gen AI companies also face a second still in its infancy at the range of existential risk, namely model collapse because without an automated way to filter the quality of input along multiple different vectors, the models will suffer ever decreasing quality of output until the assent to worthless. The universal Law of GIGO, garbage in and garbage out, applies in the world of Gen AI too. And finally, beyond these two game over risks, the current processes being applied to Gen AI model training could be made much more efficient in multiple ways with a robust automated input filter that also allowed for identification were applied. And third is a group much larger than the first two combined, the group comprised of 8 billion people, were all stakeholders in stopping our memories, such as the pictures of our children from being used and monetized without our knowledge, let alone our permission. One of the statements coming out of the White House on this topic a few weeks ago was the highest standards must be upheld to ensure that Gen AI innovation doesn’t come at the expense of Americans rights and safety. Extend that statement to all country citizens, and we wholeheartedly agree. A system that allows for an extensible and adaptable – adopt out a filter benefits all, and we are excited to soon offer the world a single system that will allow for that. Instilling confidence in content authenticity and a whole lot more. In some, some of the brightest minds in the world, spanning both the public and private sectors have instinctually understood that, yes, our technology has a role to play in what will likely prove to be the most powerful technology advancements since the Internet itself. And importantly, they’ve shown a willingness to act to address the problems that must be addressed to unleash this power. We applaud them and are excited to build upon the foundation they have set due to our legacy experience and unrivaled expertise in digital watermarking, we have a meaningful role to play in solving the problems at hand. Digimarc will deliver a solution that provides for authenticity, security, safety and protection of rights, a system that benefits all. As we finish up the work we have been doing ahead of the launch, we are thankful for the positive reception we are already receiving with some incredibly important stakeholders and are excited to unveil more soon. I will now turn the call over to Charles to discuss our financial results.

Thank you, Riley, and hello, everyone. Before I dive deeper into our Q2 financial results, there are some financial highlights that are important to emphasize. We closed $8.8 million in first year commercial bookings, up more than 300% year-over-year. We delivered 59% year-over-year subscription revenue growth from current products. We achieved 84% subscription and gross profit margin, and we significantly reduced our operating expenses and cash burn from last year. I highlight these areas as they are critical drivers as we work hard to get the business to profitability. Now on to the details. First year commercial bookings were $8.8 million during the second quarter, a 4x increase when compared to the $2.2 million booked in Q2 last year. As Riley mentioned, one source of this growth was upsells to existing customers. These upsells are important to mention as we have some very large customers and in most cases, we are in the earlier stages of account penetration, meaning we have a lot of runway to materially grow the revenue from these existing customers. These opportunities for revenue growth can come from adding new products and/or expanding usage of existing products. While not unexpected, it was an encouraging sign to see these customers not only renew their contracts, but to do so at higher levels of commitment. It’s also important to highlight that many of these deals contributing to bookings this quarter were multiyear commitments. Because we only report first year bookings, the true impact of a multiyear contract is not captured. To further this point, if we signed a 3-year committed contract, for instance, only the first year’s annual fees would ever be reflected in our reporting bookings number. Years 2 and 3 would never show up. The impact of that contract, however, is committed revenue for the next 3 years. I showed this context because bookings would have been much higher this quarter if we included the total contract value for multiyear deals. Total revenue for the quarter was $8.7 million, an increase of $1 million or 13% from $7.7 million in Q2 last year. Excluding revenue from our end-of-life piracy Intelligence product, revenue increased $1.3 million or 17% year-over-year. As a reminder, Q2 last year was the last quarter of meaningful Piracy Intelligence revenue, and so this optical headwind to year-over-year growth is now gone. Subscription revenue, which accounted for 54% of total revenue for the quarter grew 44% from $3.2 million to $4.7 million. Our subscription revenue growth rate was 59% or $1.7 million when excluding Piracy Intelligence. Again, this headwind goes away – this headwind goes away starting in Q3. Service revenue declined 10% from $4.5 million to $4.1 million, reflecting the impact of Holy Grail Recycling project work in Q2 last year of $700,000. The excluding this non-recurring project work, service revenue increased $300,000 or 8%, reflecting the impact of the larger annual budget from the central banks for project work this year. We still expect our currency business to deliver double-digit growth this year. Subscription gross profit margin improved from 73% in Q2 last year to 84% in Q2 this year. The large increase in margins year-over-year reflects two positive trends we foreshadowed on our Q4 earnings call that would start to occur this year and continue into next year and beyond. First, a more favorable mix of subscription revenue to our newer products, which carry higher gross profit margins on average than our legacy products. Second, our product infrastructure costs are declining even with increased usage by customers on our platform. We expect these trends to continue, resulting in further expansion over time to our subscription gross profit margins. This is an important development to know given our focus as a company on growing subscription revenue. Service gross profit margin decreased from 61% in Q2 last year to 51% in Q2 this year. The decrease reflects the impact of project work we realized from Holy Grail Recycling projects in Q2 last year and some higher costs in Q2 this year, which are not expected to repeat. We anticipate service gross profit margin to be in the mid-50s on average going forward with some fluctuation quarter-to-quarter depending on labor mix. Operating expenses for the quarter were $16.1 million compared to $18.9 million in Q2 last year. The large decrease in operating expenses reflects the impact of the reduction in force this past February, along with other cost-saving initiatives implemented in Q1 this year. Non-GAAP operating expenses for the quarter were $12.9 million compared to $15 million in Q2 last year. Net loss per share for the quarter was $0.53 versus $0.75 in Q2 last year. Non-GAAP net loss per share, which excludes non-cash and non-recurring items, was $0.29 versus $0.47 in Q2 last year. We ended the quarter with $34.5 million in cash and investments. We used $8.5 million of cash and investments during the quarter compared to $14.7 million in Q2 last year. Our cash usage for the quarter, while much lower than last year, reflecting higher revenues and lower costs, was negatively impacted by unfavorable timing of customer seats. It was also much higher than we anticipate in our quarterly results going forward. For the second half of 2023, we expect our total cash usage for the 6-month period to be noticeably less than the amount of cash we used in the last 3 months alone. As we have stated before, we continue to be focused on building a sustainable business capable of extremely high cash flow generation. 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’ll now turn the call back over to Riley for final remarks.

Thanks, Charles. Q2 was a strong quarter. On both the direct and channel front, we were successful in not just being easy to begin doing business with, but also excellent at guiding customers along their product digitization journey. As promised at the end of last quarter’s call and continues today, we are seeing momentum across all areas of our business, and that strength is showing up in our income statement and the two key financial metrics by which we obsess with 59% year-over-year subscription revenue growth from current products and a sequential addition of another 400 basis points of subscription gross margin to a near best-in-class 84%. But however, strong Q2 was, what continues to excite us most is where we are going because as we are beginning to show the results of our transformation to unlock the unparalleled hour of our world-leading product digitization hyperscaler, we are also on the cusp of extending that opportunity more fully to the digital world, a domain in which the combination of our past and present, will add to our delivery of a generational future. Ryan will now open the call for questions.

Thank you. [Operator Instructions] Our first question comes from the line of Jim Ricchiuti with Needham & Company. Please go ahead.

Hi, good afternoon. This is actually Chris Grenga on for Jim. Thank you for taking the questions. You mentioned that you expect cash usage to be lower in the back half than in Q2. Could you frame for us some of the factors that you expect to drive that result? And maybe speak to the weights of those factors in driving that result and your visibility there?

Yes. It’s a culmination of timing of customer receipts. We have some large customer receipts coming on, but also growing revenues. As we talked about on the last call, the $32 million contract has three projects to it and they start in different phases. As that continues to ramp, that will both drive revenue as well as additional cash. But some of it is also just related to the timing of cash payments, including the large contract that we have with Walmart that we signed last year.

Yes. And Chris, we grew revenue – we grew 59% year-over-year in Q2. We expanded gross margin by 1,100 basis points. That’s an incredibly strong tailwind for cash flow – for a reduction in cash burn. Those two big trends growing our top line and expanding the gross margin.

Got it. Thank you very much. And could you elaborate a bit on the Sandbox version of the factory automation? What – I guess what that entails for those customers and what they were doing before in the absence of a program like that? And yes, just elaborate on the nature of that product?

Yes, I would love to. And Chris, if you wait about five weeks or so, there will be a lot more out publicly about this. This is really, really exciting stuff. I just want to front run really strong joint comps plan that is being put together. But as on the specific use case and who the customer is, stay tuned. One of the important things, and I referenced, it’s a Sandbox version of our platform, right. So historically, we have gone to market with products and then we have gone to market with our full platform. And what we are finding is, and we are exploring and we are constantly learning. We are constantly opening up new opportunities. We are constantly learning new things. There is a market also for a Sandbox version of our platform. So Illuminate for x, in this case, Illuminate for factory automation. And so what the buyer enables as they get some flexibility from buying the platform components itself, but not paying the cost or for a lot of components of the platform they don’t need. So, it’s a really exciting go-to-market development that seems to have real legs here. So, without getting specifically into what this customer is doing and where they see the value and who the customer is, that will all be out publicly in about five weeks or six weeks. But more importantly, I think the idea here is we potentially could be opening up a third avenue to go to market. We got our products. We got our platform, and then we have Illuminate for x being in this case, factory automation, but there is a couple of other Illuminate for x we are exploring as well.

Got it. That’s very helpful. Thanks. And one more, if I may, I appreciate all the color on the Generative AI vision. Do you anticipate targeting customers that are existing customers that are moving into using Generative AI more in their operations, or would you anticipate that this would be targeting a new set of customers for the business?

Well, first of all, I would say I don’t know if not now in six months, everybody is going to be using Generative AI. So, I don’t know if there is a difference of customers who are not. I would say, again here, we are going to be out and where we have a very detailed comps plan and launch for upcoming product that we will be talking about more. But if you listen to what we are saying, there is benefits to all, right. So, watermarking digital assets to provide authenticity and at the same time there is so much value in Gen AI and itself solving the two problems of authenticity of digital assets as well as safe and fair input for the training models. But it’s beyond solving those two problems in the Gen AI world, and it’s beyond even the Gen AI world. So, stay tuned for more on that, but huge opportunity. And we are again, one that we are uniquely positioned to provide simply because of our background in digital watermark and our relationships, our expertise. It’s pretty exciting stuff.

Great. Appreciate the color. Thanks very much.

Thank you.

Thank you. Our next question comes from the line of Jeff Bernstein with Silverberg Bernstein Capital. Please go ahead.

Hi guys. Just a couple of questions for you today. Just back on the factory automation side, is this related to – this is going back quite a while, I think you guys had done some work with Cognex, with machine vision and you had very high relates on machine vision. Is that what we are talking about here?

Yes, absolutely. So, there is – without mentioning the vendors, too, and it’s more than just one camera vendor that has market share and multiple – we talk about developing an ecosystem, right. There is multiple wonderful vendors out there. Cognex, itself obviously is a wonderful vendor. And as you mentioned, the historic partner, Digimarc wonderful. But there is – a lot can be automated in a factory. There is a lot of providing identification and intelligence to items in their factory. So, yes, you are absolutely on the right track. You have mentioned one of our wonderful partners and stay tuned.

Got it. Okay. And then I just want to make sure I understood. When you talk about Sandbox, that’s not a cyber security term as in not connected to the cloud?

Sorry.

Got it. Okay. I just wanted to make sure….

We had no idea and I know it’s a lot easier to make see a word in here would Illuminate for x, meaning Illuminate for a bunch of different things. It’s just taking out – whatever functionality, again, to give a step back. Our Illuminate platform is what we build our own products upon, right. And so we are taking some of the capabilities of Illuminate in our currently four products and say we want a little bit of this capability, a little bit of that capability, we are calling that a product. Sometimes customers want, especially want our full platform. They want every lever and bell and whistle and all the wonderful capabilities within Illuminate. And then sometimes people want to solve for a problem not using one of our predefined products, but using just some of our capabilities. And so that’s what we are talking about Sandbox version is Illuminate for factory automation in this case or Illuminate for – there is a couple of other ones that potentially could be coming.

Understand. Okay. That’s great. And then you mentioned a deposit return program. So, is this a second one in addition to – I think you talked about one on the prior quarter.

Yes. So, our wonderful VAR that we announced that we signed in Q2, and we announced a couple of months ago. As Charles just mentioned, they are building three products currently on top of Illuminate. And one of them is to provide for the authenticity of a DRS system in a specific country. What I referenced on the earnings call is as soon as that press release came out, I think it was literally the next day, we got an invitation to a meeting for a very large country who is working on their own DRS scheme and wanted our insights and talk to us about the value we could have because we believe there is a huge opportunity here in terms of coverage, in terms of cost effectiveness, in terms of ease of implementation. There was – and it’s important stuff. There was an article actually that somebody sent me about a week ago, or 1.5 weeks ago about somebody family making $6 million or something by bringing cans from Arizona and getting the deposit back from California. This is a big problem. And there is ways to solve it. There is ways that existing DRS systems are using to solve it. We got a solution that can extend coverage and do it in a lot more cost-effective way. But – and that’s the one we are going to go through of our VAR. We have one VAR that we – and that’s earlier in Q2 as part of the $32 million deal, and we are looking to expand that network and also to help that VAR to be more successful in other countries.

Got it. And then you mentioned adding one more VAR. Any color on kind of the general area that VAR is in?

Yes, and they are using Illuminate. So, you mean so not what the use case are they going after, what end market they – they are packaging and label company.

Got it. Okay. Alright. And lastly, there was a mention about the product infrastructure costs coming down as customers actually utilized your product more. And it sounds a little counterintuitive to me. Could you just walk us through how that is.

Yes. I mean we are updating the platform capabilities that we have that it will provide for more efficiency from a cost perspective and be able to scale out. So, we are taking some on legacy technology and updating that to a newer platform, which is the Illuminate platform. So, as we transition customers off of our legacy platform onto that, we expect that we will continue to be able to drive the average price down.

That’s great. Thank you. Thanks for the help there.

Thanks Jeff.

Thanks Jeff.

[Operator Instructions] Our next question comes from the line of Robin Knipp with Janney Montgomery Scott. Please go ahead.

Thanks for taking the call. I appreciate it, gentlemen and congrats on a really good quarter. I suspect I know the answer to this question, but I will ask it anyway. Riley, are you able to share with us the collective total of the different contracts that were multiyear deals that we were only reporting on the first year?

Yes. We intentionally aren’t trying to throw out other metrics, but it’s into the seven figures. But I don’t want to get into it. There was a reason why we went away from reporting both total and first because it was confusing, but it was sizable.

Okay. Very good. Thanks. Appreciate it. Nice quarter.

Thanks Robin.

Thanks Robin.

[Operator Instructions] As there are no further questions, I would now hand the conference over to Riley McCormack for closing comments.

Thanks Ryan and thanks everyone. We hope you all have a wonderful rest of your day. Take care.