Greetings, and welcome to the Digimarc Corporation Third 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. Thank you. You may begin..

Thank you. Welcome to our Q3 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 Q3 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 will archive this webcast there. Before we begin, let me remind everyone that today’s discussion contains forward-looking statements that have risks and uncertainties.

Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. Riley will now provide a business update..

a safe, fair, trusted, and authentic internet. And Digimarc Validate is ideally positioned to be a foundational element of such a future. On the government front, we have been engaging with leadership at the highest levels to discuss the need for tools to support the protection and authentication of digital assets in the Gen AI era.

We have met with senior leaders at the White House, Executive Agencies and Departments, and in Congress, and in these bipartisan meetings our history, proven technology, and ability to work across images and audio, especially on-device, is helping drive awareness of what’s possible.

We have been asked by multiple groups to help educate and inform the conversation, commitments, and coming regulation, and our ideas have been well received.

We expect to continue participating in discussions at the highest levels to shape the future of artificial intelligence and the broader digital ecosystem and we feel confident that Digimarc Validate has an important role to play in effectively protecting the rights of content creators and owners while also building the foundation of true digital asset authentication.

On the standards body front, we are a member and heavily involved in the Coalition for Content Provenance and Authenticity, otherwise known as C2PA.

For those of you not familiar with C2PA, it is a group of industry leaders working to address the prevalence of misleading information online through the development of technical standards for certifying the source and history or provenance of media content.

We are appreciative of all the hard, smart work this group has been doing and thrilled they understand digital watermarking has a role to play in proving the authenticity of digital content. I know there have been some questions around C2PA’s Content Credentials and if this is competitive to Validate, and the answer is no.

In fact, Digimarc will be supporting Content Credentials as part of our upcoming registry, because while industry standards are necessary, they are not by themselves sufficient. Standards need companies to support them for there to be meaningful adoption, and we recognize we have an important role to play.

Content Credentials are an elegant means of organizing and recording metadata, but the risk to metadata is that it can be altered and is removed by common workflows such as editing software and social networks, rendering it useless for the purposes of intellectual property protection and authentication in such scenarios.

Just like in the physical world, our digital watermarks will act as a unique, necessary, and immutable bridge between the data and the object, allowing the content owner to control their digital asset’s story. On top of this governmental and standards body engagement, of course, we are building our Digimarc Validate business.

Digimarc Validate provides value to content creators and their consumers as well as owners of detection points running the gamut of Gen AI engines, e-commerce sites, network security companies and device vendors.

We are engaging with prospects and partners across the full spectrum of size, and we intend to make it as difficult to counterfeit content and identity in the digital world as we have currency in the real world.

In addition to the massive opportunity ahead of us, and the fact we are uniquely qualified and positioned to address it, there are two perhaps non-obvious important points worth highlighting about our entrée into the digital domain.

The first is that our ability to bridge both the physical and digital domains is a key differentiator of our platform, our products, and our digital watermarks, and nowhere is that becoming as obvious as with Digimarc Validate.

And secondly, as I know at least a few investors have noticed from visiting our website, the expansion of Digimarc Validate to the digital domain allows us to open a fully digital sales motion.

In terms of our mantra of being easy to begin doing business with and excellent at guiding customers along their product digitization journey, this web-based sales motion has opened a new door to “easy.” Thus, the expansion of Digimarc Validate to the digital domain has not only dramatically increased our overall total addressable market, it has also increased our opportunities in the physical domain, while adding width and depth to the moats surrounding all our offerings.

I will now turn the call over to Charles to discuss our financial results..

Thank you Riley, and hello everyone. Before I dig deeper into our Q3 financial results, I wanted to share some financial highlights from the third quarter. We ended the quarter with $19.6 million of annual recurring revenue or ARR, representing 54% growth year-over-year. I will talk more about this important performance metric in a minute.

We achieved 85.5% subscription gross profit margin; we reduced our operating expenses year-over-year by 17%; and our free cash flow usage was only $400,000 for the quarter. I highlight these areas as they are all critical drivers towards reaching profitability. Now onto the details.

As we mentioned on previous earnings calls, we have been working to select a new reporting metric to replace first year commercial bookings that would provide a better indicator of our progress in growing our high-margin commercial subscription business.

As Riley already mentioned, we have decided on annual recurring revenue as it’s a key performance metric we are now using to run our business. We intend to report ending ARR each quarter with comparative periods so you can measure our progress.

We calculate ARR using the annual recurring fees stated in our sales contracts, thus mirroring the underlying economic value of these contracts. Also, ARR only includes recurring subscription fees from commercial contracts. Government contracts, service fees and non-recurring subscription fees are excluded from our reported ARR.

The reason for this is, the most important growth driver we are all focused on is recurring commercial subscription revenue. We have included a table within the earnings script that reports our ARR at the end of each of the last eight quarters for comparative purposes.

In addition to focusing on growing our high-margin commercial subscription business, we are also focusing on making sure the payment terms in our sales contracts are consistent with traditional SaaS terms, which results in the collection of annual payments up front.

I call this out because it is yet another benefit of our transition to becoming a product and platform company and allows our ARR growth to have a more immediate impact on improving cash burn. Ending ARR for the quarter was $19.6 million representing net ARR growth of $6.9 million or 54% year-over-year.

Total revenue for the quarter was $9 million, an increase of $1.2 million or 15% from $7.8 million in Q3 last year. Subscription revenue, which accounted for 53% of total revenue for the quarter, grew 18% from $4.1 million to $4.8 million.

The increase reflects subscription revenue recognized on new customer contracts signed this year as well as upsells this year on existing customer contracts. Service revenue increased 12% from $3.7 million to $4.2 million.

The increase reflects a larger annual budget from the central banks for project work in 2023 than 2022, which includes both higher billing rates and project hours. Subscription gross profit margin improved from 75% in Q3 last year to over 85% in Q3 this year.

The large increase year-over-year reflects two positive trends we’ve highlighted previously, both a favorable mix of subscription revenue to our newer products and lower product infrastructure costs. We expect these trends to continue resulting in further expansion over time to our subscription gross profit margins.

Service gross profit margin decreased from 57% in Q3 last year to 54% in Q3 this year. The decrease reflects a more favorable labor mix last year than this year. We continue to expect 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 $16.4 million compared to $19.7 million in Q3 last year, a decrease of 17%. The large decrease in operating costs largely reflects lower headcount, partially offset by annual compensation adjustments, and lower contractor and consulting costs.

Additionally, Q3 last year included $1.4 million of severance costs for organizational changes. Non-GAAP operating expenses, which excludes non-cash and non-recurring items, were $13.2 million for the quarter, down 15%, compared to $15.5 million in Q3 last year. Net loss per share for the quarter was $0.53 versus $0.76 in Q3 last year.

Non-GAAP net loss per share was also considerably lower for the quarter at $0.29 versus $0.47 in Q3 last year. We ended the quarter with $33.3 million in cash and investments. Free cash flow usage was $400,000 for the quarter, compared to $11.4 million used in Q3 last year. We used an additional $800,000 of cash in Q3 for share repurchases.

Q3 shows the power of my earlier comments about our focus not just on growing our subscription business but also on the payment terms of that business. And while we expect Q4 free cash flow usage to be higher than the $400,000 we used in Q3, it will be significantly lower than prior quarterly trends.

Last quarter, I mentioned we expected our free cash flow usage for the final six months of 2023 to be notably less than the $7.9 million we used in Q2 alone. We are reiterating that statement today. For further discussion of our financial results, and risks and prospects for our business, please see our Form 10-Q that will be filed with the SEC.

I will now turn the call back over to Riley for final remarks..

Thanks Charles. We are seeing momentum across all areas of our business, and are hard at work continuing to increase that momentum as we create a market we are uniquely positioned to lead for years to come, a market that at scale has the opportunity to be as large if not larger than the other legs of the digital transformation stool.

With our recent expansion of Digimarc Validate into the digital domain, that opportunity has become significantly larger. And because we are unique in being able to bridge both the physical and digital worlds, not only has our TAM become larger, but our moats have become wider.

As those of you with whom I have spoken with over the years know, I think there’s a really easy way to identify once-in-a-generation investment opportunities before they become obvious to the rest of the world. It’s simply a matter of TAM, moats, and execution.

As just mentioned, our massive TAM has become that much more massive, and our incredibly wide moats have become that much wider. In addition, as our financial results in the last few quarters combined with our comments about Q4 show, we’re executing. We appreciate your interest as we continue to progress this generational opportunity.

Diego, we’ll now open the call up for questions..

Thank you. [Operator Instructions] Our first question comes from James Ricchiuti with Needham & Company. Please state your question..

Hi. Thank you. Good afternoon. By the way, thanks for the additional information on ARR. The question I have is just with respect to the subscription revenue that you’re seeing.

Is there -- you see more activity from upsells on existing -- with existing customers, or with new customers?.

The impacts definitely come from both, but it’s been more from new customers. We’ve had a couple of handfuls of really nice upsells that we highlighted on the last call this year, but the majority of the new revenue’s coming from new contracts..

Okay. Got it. And then maybe a little bit of color on the -- if you can, on the expected deal you alluded to with a company that’s presumably tied to this rollout in France.

I’m wondering, what’s driving this? Is this an existing customer, someone you’ve been talking to?.

I’m sorry. Jim, you broke up.

Are you asking the customer we alluded to being close to signing in France?.

Yes, I am. Thank you..

Yes. So it’s a new customer. It’s a new logo. It’s an incredibly impressive logo. And the point I was trying to make in that part of the call was this wasn’t even a company that was listed in that initial press release, which I forget exactly, came out a couple of weeks ago, some time in that period of time.

So I think their interest is in helping make a difference in the environment in France. And I think, to your point, I was going to add -- if I could add on to what Charles was saying is, Jim, we had this conversation in the past of we expect to be enough in cross-sell opportunity for decades. And so it’s important to get those new logos.

We view them as future upsell and cross-sells. And that’s how we view Recycle, right, is that one of the wonderful things about how we’ve architected our platform and our products is very accretive. So, we don’t care where somebody starts their product digitization journey.

Our goal is to guide them and be excellent guides at continuing their product digitization journey..

Got it. Final question. And I’ll jump back in queue. Early days, I know, with Validate, but I’m just wondering what kind of traction do you anticipate from this over the next year..

It’s hard to quantify it at this point. I can tell you we’re having -- I chose the words very carefully of saying we’re having conversations across the full gamut. We are talking to some very large, both on the content creator and content owner side as well as on the nodes side, on the detection point side, we are talking to the biggest of the big.

We also expect that this will be a web sale opportunity, too, and so we have some smaller opportunities we’re progressing as well..

[Operator Instructions] Our next question comes from Jeff Van Rhee with Craig-Hallum Capital..

Riley, just back to the France opportunity, I mean maybe just spend a minute or two more.

At a very basic level, what -- how do you envision that rolling out? What kind of signings, what kind of pace of signings, what kind of vendors, use case? Just kind of what do you anticipate over -- I mean, you can be as precise as you like, but just how does France play out and really start moving the needle on revenue? How do you sort of over-under? When does it really start to make a difference?.

Yes. The wonderful thing about France is it’s the first Digimarc Recycle country we’ve opened. So I don’t have -- I’d like to stick with what we know as opposed to what we think. I can tell you that when you asked who the customers are, they’re going to be the brands in retail, so people putting plastic packaging into the French market. So we’ll see.

We’ll keep you all updated as we know more. But we’re -- and what is exciting about it is the initial interest are from the big companies. You saw a couple of the logos that were listed in the press release. That’s the size of company we’re talking to..

You had the large win a couple of quarters ago and in there, you had some security printing customers in particular.

How are those going? And any other follow-ons similar to those working through the pipe?.

Yes. So, there is follow-on in the pipe, absolutely. When you said how is that going -- that was what I referenced, if you remember that customer who signed up or is using Illuminate to build three products. One of them is a deposit return scheme.

And as I mentioned in the prepared remarks, I was in-country maybe about a month ago, a few weeks ago, maybe about a month ago, and initial production of their logo is rolling out, being produced on very high volume, very iconic products. So, it’s going well..

And then just lastly, maybe open-ended because I know you said you tried to address your comments on the call for questions people are asking, but maybe just describe what’s in the pipeline, what are you seeing, and how has that evolved in the last six months, if it wasn’t already touched on..

You’re talking about -- you mean product mix, or are you talking -- could you be a little more specific?.

Deals that are late stage in the pipeline now versus six months ago..

You mean how does it relate to where it was six months ago?.

Yes..

It’s growing. I mean, I think you can look at our ARR growth, right? We grew ARR 54%. And so, there’s -- and if you listen to -- if you look at what I said, we expect ARR growth to be greater in Q4 on a year-over-year basis than it was in Q3..

Thank you. There are no further questions at this time. I’ll hand the floor back to Riley McCormack for closing remarks..

Well, thank you, Diego, and thank you, everybody, for joining us today. We hope you have a great rest of your day..

Thank you. And with that, we conclude today’s conference call. All parties may disconnect. Have a great evening..