DMRC - NASDAQ

Greetings, and welcome to the Digimarc Corporation Q3 2025 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, George Karamanos. You may begin.

Thank you so much. Welcome, everyone, to our Q3 conference call. Riley McCormack, our CEO; and Charles Beck, our CFO, are with me on the call today. On this call, we'll provide a business update and discuss Q3 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, this is a reminder that we are simulcasting a presentation that Riley and Charles will walk through today. If you would like to follow along with the slide, 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.

Thank you, George, and hello, everyone. On this call, we will walk through Digimarc's Q3 performance, highlight our strategic progress across product innovation and commercial execution, share updates on our financial metrics such as ARR and cash burn, and provide clarity on where we are focused heading into the last quarter of the year. In Q3, we made significant progress in advancing towards widespread adoption of our gift card solution and closed multiple upsell opportunities in the product authentication space, including our expansion to a sixth country with a global tobacco company. We quickly turned an inbound inquiry from a major pharmaceutical company into a paid pilot for a novel application of our product authentication solution that, depending on pilot results, may have wide applicability not only across other pharmaceutical companies but additional industries as well. We launched a revolutionary new digitized security label solution to help brands upgrade from analog, easy-to-replicate and low value-add holograms. And we made significant progress advancing our digital authentication offerings, while in parallel growing pipeline, setting ourselves up to take full advantage of this nascent and exciting market in 2026 and beyond. We also continue to harvest the benefits of our recently completed corporate reorganization. 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 delivery. 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 and positive non-GAAP net income in Q4 of 2025 even with our recent decision to invest in more resources to accelerate growth in our focus areas of retail loss prevention and digital authentication. 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 a 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 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, as they eventually become ripe enough to actively pursue. Our greatest near-term opportunity is retail loss prevention and more specifically, our gift card solution. On this front, we made substantial progress in our march towards gaining widespread adoption, aided in large part of the industry's hyperfocus on finding a solution to the fraud that is creating an existential threat to their business. The global gift card industry is estimated to represent approximately $1 trillion of stored value, having reached this impressive milestone due to the many benefits these cards provide all stakeholders, most importantly, consumers. Unfortunately, this large market opportunity has not escaped the attention of sophisticated state-sponsored bad actors and industry growth is currently being negatively impacted by the ever more advanced attacks targeting this global currency. Digimarc's 28-year history working with the world central banks to protect the vast majority of banknotes in circulation worldwide, combined with our decade-plus experience at retail front-of-store, ideally positions us to help this industry reaccelerate its growth. In addition to reducing fraud in the many direct and indirect cost of that fraud being borne by brands, retailers and consumers, our solution also -- also allows the entire industry to improve the marketing, merchandising and giftability of gift cards. These 3 elements were critical pillars of the industry's historic growth and all 3 have been negatively impacted by existing security solutions. Along with fraud reduction, the ability for the industry to reinvest in these 3 pillars to yet against supercharge sales is becoming another selling point of our solution. Our solution also allows for reduced packaging waste and improved sustainability, a value proposition that is resonating with some iconic global brands and is compliant with the ever-increasing number of regulations being put in place, most front of mind currently in the U.S. are the Maryland and New Jersey laws. As more industry participants are exposed to our solution, additional benefits become clear, a wonderful byproduct of being the first adaptable, extensible and technology-driven security layer in this dynamic industry. We provide a solution that is more secure than the highest security solutions on the market today while allowing the industry to regain the use of the powerful growth tools they've had to abandon these past few years. Turning now to the results from our initial rollout. The first Digimarc-protected gift cards reached shelfs in August. Major brands participating included Target, Home Depot, Nordstrom and Blackhawk Network multi-retailer cards. The response has been extremely positive and all KPIs have been easily surpassed. These KPIs include multiple metrics measuring the effectiveness of our solution plus our impact on the industry's operational efficiency. 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 cost of an increasing percentage of an ever-increasing amount of fraud. We and our partners believe this positions us for powerful demand pull dynamic. The detailed results of our initial role have been widely shared within the industry, and we expect multiple major retailers to start selling Digimarc-protected gift cards within the next 2 quarters, carrying an expanded number of closed-loop brands as well as initial open-loop cards. As a reminder, closed-loop cards are gift cards that can only be redeemed at specific retailers. Open-loop cards are issued by the credit card companies and can be redeemed at any location where that credit card is accepted. As a reminder, 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 as 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. We are currently in commercial discussions with 8 gift card manufacturers as well as 1 additional direct customer. These discussions are being shaped, as they always are, by our desire to be an excellent partner to the industry and thus balance, a, the dynamic that laggards in adoption will bear compounding cost of fraud and b, the immediacy of a much broader rollout. Our plan is to ensure we contract for enough 2026 committed annual capacity so we can incredibly address burgeoning industry concerns about whether there will be adequate capacity to avoid the potential for involuntary laggards and then quickly move from commercial discussions to working with our initial partner or partners to flawlessly execute on the expected impending ramp of Digimarc-protected gift card production. The time lines to deliver this large ramp are very tight, and therefore, our goal is to quickly move to the contracting stage and to only contract with a small subset of these 8 printers right now, as we believe with the right partners, we can strike the optimal balance between our 2 goals. Turning now to our product authentication solutions. We closed multiple upsell deals with existing Digimarc Validate customers, reflecting both increased contract value and the expansion of our solution to new geographies and new brands, including the expansion of our solution in the sixth country with a global tobacco company with operations in approximately 175 more. As we've repeatedly stated, when we solve our customers' most challenging problems, we expect to be an upsell and cross-sell company for a very long time. We also closed a paid pilot with a major pharmaceutical company that approached us with a pressing problem they've been unable to solve using other means. I am proud of how quickly and how deeply the team diligenced the problem, allowing them to find a potential solution using existing Validate capabilities. I'm equally as excited for us to successfully execute on the pilot because if we can indeed solve this problem, our solution should be widely applicable across the entire pharma vertical and other verticals as well. Finally, we also launched a revolutionary new digitized security label solution to help brands upgrade from analog, easy-to-replicate and low value-add holograms. This label can be authenticated by consumers and field agents with mobile phones and other devices, providing deterministic B2B or B2C authentication with analytics all in one place. Touching now on our digital authentication solutions. As mentioned on our last 3 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 as opposed to making decisions that might lead to short-term revenue but would come at the cost of our ultimate potential scale. Not only did we exceed our annual target in the first 6 months of the year as we shared last year, but we are now in a position to harvest the fruits of this decision in 2026 and beyond. The twin catalyst of the relentless advance of AI models and agents and the rapid progression of content credentials have 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 expect this space to continue its recent noteworthy growth and evolution. While some of the nascent digital use cases might be served, at least in the interim with good enough offerings, what has become apparent to us in the last few months is that the aforementioned twin catalysts are opening the market for use cases where good enough just simply will not do. Our technology, our history, our credibility, our expertise, our experience and our first-to-market with and co-leadership of the digital watermarking component of the C2PA standard are all coalescing to ensure we are well positioned to serve this ever-growing wave. We pioneered this space. This is quite literally what we were born to do, and the market is finally here. After deep analysis across 3 vectors, market demand, our technological differentiation and buyer synergy, we have narrowed our focus in the digital authentication space to 4 use cases, multiple flavors of leak detection, internal compliance, piracy prevention and royalty monitoring. Our pipelines of both opportunities and partners are growing prior to widespread marketing efforts and we are now resourcing this area with the expectation it will be a significant contributor to our 2026 growth and beyond. We are confident in the opportunities provided in our 3 key 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 could fail fast, iterate and win often and allow these massive but not yet quite ripe for the picking opportunities to provide the potential for another layer of tomorrow's growth. I will now turn the call over to Charles to discuss our financial results.

Thank you, Riley, and hello, everyone. Ending ARR for Q3 was $15.8 million compared to $18.7 million for Q3 last year. The decrease reflects $3.5 million from the DRS contract that lapsed in Q2 this year. Excluding this headwind, ARR grew $600,000 year-over-year. That growth, however, was largely muted by higher other customer churn and are choosing to be strategically price aggressive on products outside of our focus areas. As I've stated previously, we expected these impacts as we sharpened our go-to-market focus. We believe the churn is now largely behind us, except for the renegotiation of the retailer contract we mentioned last quarter, which will reduce ARR by $3.1 million in the fourth quarter. Despite this headwind, we expect ARR to trough in Q4 and to reaccelerate thereafter into 2026, largely from increasing penetration of our gift card solution and growth in digital authentication. Total revenue was $7.6 million, a decrease of $1.8 million or 19% from $9.4 million in Q3 last year. Subscription revenue, which accounted for 60% of total revenue for the quarter, decreased 13% from $5.3 million to $4.6 million. The decrease largely reflects the impact of the expired DRS contract I referenced on the prior slide. Service revenue decreased 27% from $4.2 million to $3.1 million, reflecting lower government service revenue from the central banks as expected, given the lower 2025 program budget we have discussed on prior earnings calls, and no revenue from HolyGrail recycling products in Q3 of this year as those projects concluded earlier this year. Subscription gross profit margin was 86% for the quarter, flat with Q3 last year. On the last earnings call, I shared that we expected to see a downward blip in our subscription margins for anticipated costs we would incur to migrate our customers from legacy platforms to Digimarc Illuminate. Due to some incredible work from our team, we actually saw an immediate reduction in our costs, with subscription costs decreasing 13% year-over-year. We expect to generate additional savings as we continue our work. Service gross profit margin was 57% for the quarter, down 4 points from 61% in Q3 last year. The decrease was due to a more favorable mix of revenue and cost last year. As a reminder, we expect service gross profit margin to typically be in the mid-50s. Operating expenses were $12.8 million for the quarter, down $4.5 million or 26% from $17.3 million in Q3 last year. The large reduction in costs reflects lower compensation costs due to the reorganization in Q1 this year and lower other cash costs from our streamlining efforts. We still expect even more cost savings in Q4 from our streamlining efforts as not all the benefits were fully realized in Q3. Non-GAAP expenses, which exclude noncash and nonrecurring items were $8.6 million for the quarter, down $5.5 million or 39% from $14.1 million in Q3 last year. Again, the decrease is due to the impact of the reorganization and streamlining efforts. Net loss per share for the quarter was $0.38 versus $0.50 in Q3 last year. Non-GAAP net loss per share for the quarter was $0.10 versus $0.28 in Q3 last year. We remain on track to generate positive non-GAAP net income in Q4 even with our recent decision to invest in more resources to accelerate growth in our focus areas of retail loss prevention and digital authentication. Regarding cash flow, we ended the quarter with $12.6 million in cash and short-term investments. Free cash flow usage was down considerably from $7.3 million in Q3 last year to $3.1 million in Q3 this year, a decrease of $4.2 million or 58%. The decrease largely reflects a significant reduction in our total expenses. Looking forward, we remain on track to deliver positive free cash flow in Q4 despite our recent decision to invest in more resources to accelerate growth in our focus areas, again, of retail loss prevention and digital authentication. Looking further ahead, we expect to rebuild our cash balance via operating cash flow throughout 2026. 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.

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. Operator, we'll now open the call for questions.

[Operator Instructions] Our first question comes from the line of Jeff Bernstein with Silverberg Bernstein.

Just a couple of unrelated questions. One, can you just give an update now on HolyGrail? What's happening there now?

Yes. So Jeff, it's in our slide. We gave an update on what we're doing and not just HolyGrail, right, across all recycling opportunities. So as we announced a couple of quarters ago, Belgium is getting going and there's conversations in Germany. And actually, we included a link in our deck. You can click on some more details on both of these.

Okay. And so these are still -- Belgium is a full country pilot essentially, right?

Yes. Jeff, if you go to the website, you can see all of this. It's on flexibles, but yes, it's across all of Belgium.

Yes. Got you. Okay. All right. And then you mentioned the impact in Q4 of the retailer contract renegotiation. Does that mean that there's still some revenue there or there's still something going on there or is it just that the contract lapsed and there's the impact in Q4?

Yes. We still have a relationship. It's still a value customer. We're not going to talk about any customers by name or details, but I would point you, Jeff, to what I shared in the last call in my prepared remarks and an update Charlie provided today, but they're absolutely still a customer, and have wonderful opportunities with them across loss prevention specifically in the gift card space.

Got you. So -- but that prior particular contract is over, not being renewed?

Correct. We have a contract renegotiated that led to large downturn. So yes. But we still have other contracts open with them, Jeff.

Right. Understand. Understand. No, that's perfect. And then just interested in your thoughts around the -- I guess, it was AB 853 in the final version or whatever, but the California AI-related law that got passed that had some digital watermarking language in it. And what, if anything, it means? Or is it sort of really a long-term kind of opportunity?

Yes. Unfortunately, this one did not have digital watermarking language in it. They talked about a couple of requirements that might play on this space. Our belief is a couple of things, and this hasn't changed, is that, first of all, there is not a single system of trust and authenticity in the world that is based on, I guess, fakes or synthetic content being marked as such, right? It's always an opt-in because that's where the value comes if it is removed. So one, I would -- our belief has always been that, yes, it might be important to label certain things as AI-generated. But really what's important is giving human beings the ability to optionally to not mandate, right, respect privates to mark their items as authentic. That's how systems of trust and authenticity work. And then two, without having a permanent tether, right? So what this law is talking about is metadata. And metadata right now -- until Internet is completely re-architected, which I don't think is going to happen in the next couple of hundred years, metadata is stripped out. So excited to see governments take action in terms of a step in the right direction. I don't -- our belief is this doesn't go anywhere near far enough and the previous bill from last year would have addressed all of these concerns, and we'll see how this plays out. But I would also point you to, Jeff, when we talk about our digital space, right, you'll notice that providence and authenticity is not necessarily an area we're focused on right now. That's for a couple of reasons. This might be an area where good enough for the time being is good enough, but more importantly, regulations are not quick catalysts for revenue. So even when a regulation were to take place and -- look, we've seen this in your first question about recycling, right? PPWR passed a couple of years ago, it still takes the time. So we're not looking for regulation to drive business. I think regulation is a nice sort of cleanup, maybe to get the last 10% or 20% of the market. But we're focused on selling things that actually people are really interested to purchase themselves because of an immediate ROI, not because some government says something because some other government is going to say something else.

[Operator Instructions] Your next question comes from the line of Jeff Van Rhee with Craig-Hallum Capital Group.

This is Vijay Homan on for Jeff Van Rhee. Just kind of a quick one. You've got the first few retailers using Digimarc-protected cards. Just kind of curious how that's going to ramp? Is that about winning more partners, adding more of their retailers, adding geographies? Just kind of what will be the drivers of that ramp? And what are the steps that are going to take you from A to B?

Yes. Great question, and the answer is all of the above, right? So our focus in the industry and our partners' focus is on lighting up more and more retailers, lighting up more and more brands for those cards to flow through those retailers both in the U.S. and other countries in North America and countries around the globe and also cards that aren't necessarily sold through these existing channels today. So the answer is all of the above. What we've talked about with our initial rollout was the results, and that's giving the confidence -- the industry the confidence to take this in a broader direction across multiple different vectors.

Okay. Got it. And then just one more. You kind of -- you made some executive changes to the sales org obviously with Tom Benton leaving. If you could just walk us through some of the go-to-market changes that have come out of that and kind of some of the additional steps you foresee taking?

Yes, I'm not sure what you're saying in terms of what's the go-to-market. Can you ask the question maybe more directly where you're trying to get at?

No, I was just curious if there's any updates there. Just anything kind of that's changed now that the personnel is different.

No, nothing has changed. We still have the full rev team and marketing team moving forward with their jobs.