Q4 2023 Digimarc Corp Earnings Call

Participants

Joel Meyer; Chief Legal Officer; Digimarc Corp

Riley McCormack; President, Chief Executive Officer, Director; Digimarc Corp

Charles Beck; Chief Financial Officer, Executive VIce President, Treasurer; Digimarc Corp

Robin Smith; Analyst; Janney Montgomery Scott

Jeffrey Bernstein; Analyst; Silverberg Bernstein Capital Management, LLC

Presentation

Operator

Greetings and welcome to the Digimarc Corporation fourth-quarter fiscal year 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.

Joel Meyer

Thank you. Welcome to our Q4 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 Q4 2023 and fiscal year 2023 financial results. This will be followed by a question-and-answer form.
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.

Riley McCormack

Thank you, Joel, and hello, everyone. Q4 was another strong quarter for Digimarc. On a year-over-year basis, we accelerated our ARR growth to 71%, accelerated our subscription revenue growth to 37%, and expanded our subscription gross profit margins more than 1,000 basis points to 87.3%.
This performance was a result of our continued execution against our transformation strategy, but it is important to note that our transformation strategy itself continues to evolve as I hope it always will. While the rate of change is attenuating as we move from the radical transformation stage we entered in Q2 2021 to the constant iteration that continuous improvement stage in which we are now, the fact is we can always be better tomorrow, and that will always be our goal.
Constant iteration and continuous improvement could be confusing, if not anchored by a consistent true north. And our true north is beautifully simple. Our goal is to support companies progressing in their digital transformation journey. And to achieve that, we need to be easy to begin doing business with and excellent at guiding customers along their journey.
The initiatives we are pursuing in pursuit of our true north range maturation from just exiting ideation to already launched and in execution and the quality of both the initiatives as well as our execution of those initiatives will take the strength of our future performance. I want to use today's call to talk about four initiatives in greater detail because I believe all four likely to have outsized impacts in our quarterly results for years to come.
The first is the recent launch of our next-generation configuration of our digital watermark, an initiative we've been working on for over two years. Our next-gen digital watermark is a culmination of a lot of incredible work by a lot of incredible people and represents not just a step-change improvement in our digital watermarking technology, but also allows us to knock over a barrier that has historically added friction in our quest to digitize the world's products.
Yes, the latest configuration of our digital watermark delivers dramatic improvement in important areas such as security, adaptability, imperceptibility, and performance. And all of these improvements are important because they all deliver a step-change increase in value to our customers.
But it is the addition of powerful new data access and detection controls that I believe will ultimately be what this new configuration is best known for. Because these controls not only deliver value to our current offerings, they also enable something never before possible. The application of digital watermarking to products and packaging well ahead of adoption of any Digimarc offering.
With these new controls, companies can now embed our digital watermarks well ahead of planned activation, future proofing their products during planned packaging refreshes, regional rollouts, or ahead of future product digitization initiatives. This is not only a new capability of ours. It is something that no other data carrier can provide. It becomes yet another point of differentiation for us in our platform, while simultaneously allowing Digimarc and our partners to rapidly plant seeds we can harvest for years to come.
The second initiative that I believe will have an outsized impact on future quarters is the evolution of our partner strategy to encompass and incentivize partners not yet ready to build their own products and services on top of Illuminate. This is another step towards our being easy began doing business with, in this case, not only for our customers, but also our partners.
Digimarc excels in supporting customers progressing in their digital transformation journey. But the identification or the authentication of physical and digital assets is critical. This superpower is applicable to almost every single industry and brings us in contact with an incredible number of potential partners. These partners in turn possess existing customers, large pipeline of prospects, many salespeople and incredible domain expertise.
Our new Center of Expertise or COE program allows us to build a mutually beneficial relationship by combining the strengths we both bring to bear while also allowing us to benefit as we support our shared customers and progressing their digital transformation journey. The COE program is new, but the early results have been promising.
Taking a step back, just like our products themselves, our initiatives should also be accretive in the case of the two just mentioned, they indeed are. While the interest in our COE program was strong ahead of the announcement of our next generation configuration of our digital watermark, post that announcement, the interest is notably increased while all the improvements delivered by our latest digital Watermark are resonating. It is the new data access and detection controls that have really spurred partner interest as they understand these controls not only help them ensure their customers. Products and packaging are future-proofed, but also allow them to share in our success. And those customers activate those watermarks by subscribing to a Digimarc offering.
Third initiative, I'd like to discuss was when we announced just a few days ago in pursuit of being easy, began doing business with, we have opened a fifth avenue to market for Digimarc recycle under this new avenue to market, Digimarc will license Digimarc recycled to qualified partners who would then lead the regional or country wide rollout of our powerful offering to address the packaging plastic packaging pollution crisis. To be clear, our other four avenues are still open. This is not a replacement, but an augmentation of the options available. And like I imagine, many of our successful initiatives will be this new avenue market was informed by conversations we had with multiple stakeholders who added their feedback to improve our final offering while sharing their excitement about its potential to open their markets. This new avenue excites us as well because it has potential to not just the time to revenue, but also time to broad adoption. And when it comes to Digimarc recycle are interesting. Our interest in shortening time to adoption comes not just from the opportunity. Digimarc recycled presents us as a business, but also the opportunity that widespread adoption of Digimarc recycled presents us as a planet.
Finally, as discussed at an investor conference last month, we are putting the finishing touches on some major updates to Digimarc Engage being easy to begin doing business with an excellent guiding customers along the journey sometimes entails providing the market something they've never had the ability to do before new capabilities that lead to a better end customer experience while also revealing data that has never been it's never before been available for the revealing, our upgraded Digimarc Engage will not only provide new functionality for physical products. It will also take the industry-leading capabilities of Digimarc engage into the digital domain. Moreover, it will allow for a seamless experience between these two domains, something that is not possible with any other consumer engagement offering. We are excited to share more on this very, very soon.
The results of our initiatives don't just show up in our quarterly results. They also allow our participation in important conversations focused on driving the world forward as the pioneer and global leader in digital watermarking, we welcome the world's understanding of the power of this technology and believe it is our responsibility to lead our almost 30 years of experience and expertise to conversations in which digital watermarking is a topic.
Throughout the fourth quarter, we participated in the series of meetings in Washington, D.C. with leaders from both the executive and legislative branches.
On the critical topic of AI security, we were afforded this opportunity given our expertise and proven track record of protecting some of the world's most recognized brands in critical assets. In November, we were invited to participate in one of the Saturday. I Insight forums hosted by Centrum Senate Majority Leader, Chuck Schumer, and Senators Todd Young, Martin Heinrich and microns. It was there that I testified to the need of trustworthy digital watermarks in the fight from online authenticity. Given the advent of artificial intelligence, we remain steadfast in our belief that among the many benefits G&A, I will bring perhaps the most powerful book, perhaps the most powerful will be catalyzing the safer, fairer and more transparent Internet. We all deserve. In addition to our work inside the Beltway, Digimarc was appointed co-chair of the Sea to be a working group on digital watermarking, once again, establishing our credibility and leadership and the authenticity ecosystem, a position we look forward to maintaining whether it be individual events or ongoing engagements to things ever becoming clearer to more and more stakeholders, digital watermarking, the technology of unlimited potential and Digimarc is the company best positioned to bring that technology to the world.
I will now turn the call over to Charles to discuss our financial results.

Charles Beck

Thank you, Randy, and good afternoon, everyone. building on the positive financial trends we delivered in the third quarter. We saw continued progress in our financial performance during the fourth quarter in several key areas. Ending ARR grew to $22.3 million, representing a 71% year-over-year growth subscription revenue increased 37% year-over-year. Subscription gross profit margin reached 87.3%, a 1,000 basis point improvement. Operating expenses decreased 2% from Q4 last year. Non-gaap net non-GAAP net loss decreased $2.5 million or 31%, and free cash flow usage improved $2.2 million or 29%. Our healthy there is they are all critical drivers toward reaching positive free cash flow. Arr increased 71% from 13 million at the end of 2022 to $22.3 million at the end of 2023. The increase in AR are largely reflects the impact of new customer contracts and to a lesser extent, several important customer upsells during the year. As a reminder, we believe ARR is the best leading indicator for future commercial subscription revenue growth. Subscription revenue will lag ARR growth as subscription revenue is recognized ratably over the contract term versus ARR was recognized upfront upon entering into a contract.
Total revenue for the quarter was $9.3 million, an increase of $2.1 million or 29% from $7.2 million in Q4 last year, reflecting strong growth in both subscription and commercial work and service revenue. Subscription revenue, which accounted for 60% of total revenue for the quarter grew 37% from 4.1 million to $5.6 million. The increase reflects subscription revenue recognized on new customer contracts as well as upsells on existing customer contracts.
Commercial subscription revenue grew at an even higher rate at 40%. Service revenue increased 18% from 3.1 million to $3.7 million. The increase primarily reflects a larger annual budget from the central banks for project work in 2023 than in 2022. Subscription gross profit margin improved from 77% in Q4 last year to over 87% in Q4 2023. The large increase year-over-year reflects a favorable mix in subscription revenue to our newer products, which have higher gross profit margins than our legacy products. This bodes well for continued expansion of our subscription gross profit margins as we both migrate existing customers to our newer products and we sign up new customers. Service gross profit margin was flat at 56% in Q4. For both years, 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 $16.8 million compared to $17.1 million in Q4 last year, a decrease of 2%. Despite the impact of annual compensation adjustments for our employees, we were able to reduce our operating expenses year-over-year as we continue to focus on ways to maximize our productivity and efficiency as an organization.
Non-gaap operating expenses, which excludes noncash and nonrecurring items, was $13.4 million for the quarter, down 6% compared to the $14.3 million in Q4 last year. Net loss per share for the quarter was $0.52 versus $0.62 in Q4 last year. And non-GAAP net loss per share was also considerably lower for the quarter at $0.28 versus $0.41 in Q4 last year. We ended the year with 27.2 million in cash and investments. Free cash flow usage was $5.6 million for the quarter compared to $7.8 million used in Q4 last year, we used an additional 700,000 of cash in Q4 for share repurchases. Our free cash flow usage was down considerably in the second half of 2023 as compared to the first half of the year, largely reflecting the impact of growing our ARR. And as promised, free cash flow usage was noticeably less in the second half of 2023 as compared to Q2. Given cash flows can fluctuate quarter to quarter, depending on the timing of cash inflows and outflows, we continue to believe that a good proxy for a normalized level of free cash flow is using non-GAAP loss and adding capital expenditures. While the trend in free cash flow is significantly improved over the past few quarters, and we expect it to continue to improve. We do expect Q1 2024 to be higher than Q4 2023 due to year-end related expenses, including annual incentive payments, as I'm sure you are all aware by now, we entered into a registered direct stock transaction over the weekend, whereby we raised $32.5 million of gross cash proceeds by selling 929,000 shares of our common stock at a price of $35 per share. The price represented only a 2.5% discount to the last trade. This transaction not only topped off our balance sheet and expanded our roster of both long term and value added shareholders, a special thank you to Rishi and the team at Alton capital for the introduction to the new shareholders, their efforts in bringing this deal together and their continued partnership after completing this transaction.
We also decided to terminate our at-the-market or ATM stock program that we had established back in 2019. The ATM program will be terminated effective March first, 2024 for the fiscal year, we made considerable progress in the underlying fundamentals of our business. Subscription revenue increased 25% from last year and 33%. If you include the impact of our retired piracy intelligence product, while commercial subscription revenue grew at an even higher rate at 38%. Excluding Paris intelligence, subscription gross profit margin averaged 84.3% for the year, a 1,000 basis point improvement over last year. And operating expenses decreased $8.8 million or 11%, despite the headwinds from inflation as a result of accelerating our subscription revenue growth, expanding our subscription gross profit margins and lowering our operating expenses. Non-gaap loss decreased $12.1 million or 31% for the year and free cash flow usage was more than cut in half, decreasing from $45.9 million in 2022 to $22.7 million in 2023 took a giant step in 2023 to move the Company down the path to cash flow positive. We still have work to do, but we will remain maniacally focused on continuing to grow ARR, expanding our gross profit margins and effectively managing our expenses to shorten that path.
For further discussion of our financial results and risks and prospects for our business, please see our Form 10 K that will be filed with the SEC later this week.
I'll now turn the call back over to Randy for final remarks.

Riley McCormack

Thank you, Charles. Q4 was another strong quarter for Digimarc made possible by the progress we've made on multiple important initiatives we have been pursuing since we began our transformation in Q2 2021 while we are through the most radical part of our transformation, we will always be focused on what's next guided by our simple mantra of being easy, began doing business with an excellent guiding customers along their journey. I believe the four initiatives we shared today are likely to become inputs to future strong quarterly reports, and it is important to note here just a sampling of the things on which we are hard at work every day. I share my teammates excitement about where we are going, as well as our urgency to get their urgency that comes from knowing there is a massive marketing, massive market waiting for us to unlock it and that we are in a unique position to do just that strong results are wonderful. And as we've said consistently over the last 2.5 years, we expect you to judge us nothing on nothing but our results, but they are only made possible by never settling for the status quo and by always planting the seeds for future growth. The only constant at least Digimarc is improvement. And I don't I don't expect that will ever change combination of this team and this tech is squarely squarely powerful mix. And as a team, we are excited by what the future holds.
Stacy will now open up the call for questions.

Question and Answer Session

Operator

Thank you. And we will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. By confirmation tone will indicate your line is in the question queue, you may press star two. If you would like to remove your question from Kian For participants using speaker equipment it may be necessary to pick up your handset before pressing the star keys. One moment, please while we poll for questions.
Yes, once again, that's star one. If you would like to quick question. First question comes from Robin Smith with Janney Montgomery Scott. Please go ahead.

Robin Smith

Thanks for taking the question on rally. Could you elaborate a little bit on the $1 less than $1 per capita, what that means and who that is going to be applying to.

Riley McCormack

Yes. So thanks, Robert, for the question. Ivan Babin. Well, thanks, good. Yes, so this is a new go to market. As I said, perfected, perhaps we've used the term to use along with some interested parties. So the partners could range from NGOs. They could range from the government, think about Range systems integrators and the less than $1 per capita is a total price that our partner would pay to rollout Digimarc recycle in a region or a country. So we're looking at a country's population. The price to our partner would be in charge of orchestration of a rollout in the country or region will be less than $1 per person in that country or region.

Robin Smith

So just as a follow-up, have you seen any traction with this pricing model yet?

Riley McCormack

We just launched it a couple of days ago, right? So I kind of learn a little bit early, but I will say, yes, I did say that and I and I did say in the script though, right is it is this is not the first people have heard about as far as we started talking about it. And so here we are optimistic and we are excited and as you know, Robin, our excitement about Digimarc directly, yes, of course what it means for our business. But also we think this is a proven, powerful technology to address perhaps one of the top three problems this planet faces. So we want to see it get adopted for her as residents of this planet.

Robin Smith

Understood.
Thanks. And thanks, Ken, for the year.
For the great quarter.

Riley McCormack

Thanks, Robin.

Operator

Next question comes from Jeff Bernstein. Silverberg. Please go ahead.

Jeffrey Bernstein

Hi, good afternoon. So at Riley, you mentioned the new Digimarc Watermark technology and the improvements there and Intercept ability being one of them.
And can you just talk a little bit more about that? I remember, you know, quite a number of years ago there was discussion by some of the consumer packaged goods guys about some of their very iconic artwork and whether they really wanted to embed watermark on that artwork, et cetera. So just talk to us a little bit about kind of the history of the Percepta ability of the watermark and what the improvements are like?

Riley McCormack

Yes. Thanks, Jeff. So Precept ability is impacted by two things, size of payload and then also the colors used to embed the watermark. And both of those, we made incredible improvements on. I don't know if you've seen any of this stuff, for example, that we've rolled out for recycle. These are some of the most iconic brands packaging that I think we would have all looked at five years ago. And that is going to be really, really hard to watermark and it's there and you can't see it. So we're constantly looking at ways to knock down barriers, the new configuration of the Watermark plays a part of that. So it is an update to our tools that allows for broader use of prominence and Luminent's as keys or inputs all focused on driving down that process stability and even ahead of this new watermark, I think we've made great strides stuff on the shelf with the I guess the fact you can't see it on the shelf maybe is the best proof of that, but it's always a focus. How can we knock down barriers?

Jeffrey Bernstein

And that's great. And then on out there in the media, there's a some discussion of a Sprite bottles, I think in Europe that was completely laser engraved, so had no shrink wrapped, you know, label around the bottle and and us a data carrier on it laser engraved, it didn't specify what kind it was. And I guess it's possible to do both on digital watermarking as well as QR codes or or anything else that way, but just talk about where we are on that laser engraving. And I think there may even be some other technologies that can be brought to bear there. And again, that was something that I know was not completely proven out as of a couple of years ago.

Riley McCormack

Yes, yes. So on the Sprite bottles, I believe that was a limited market test would love to see the world move to label this again, both as an opportunity for us as a business, but also for what it would mean for the planet. There is we've done studies is before my time here, but I recall that there were studies that show that digital watermarks actually read better than QR codes in 3D in embedding. There's just more. I'm going to be laughed at by my technical team after this call, but there's more angles to which the light, the light, the catch digital watermarks we've chartered. So they do read better on the downside, of course, is you do need an app today to re-do watermark. So I think there are definitely applications for consumer engagement where watermarks are great. I still think QR code is normally better. Now 3D might be the one that proves that digital watermarking is the best for that in terms of our work with lasers, the conversations are pursuing there. We talked about COEs earlier in the call. There's a couple of potential COEs that are actually laser-based. It is just another great way to lay down our signal, whether it be ink, whether it be lasers, whether it be molds is the beautiful thing about digital watermarks. There's a lot of ways to embed them. And I agree I think lasers is a very interesting area in a lot of different ways.

Jeffrey Bernstein

Got you. And then last question was in the past there was an issue about and there's been some discussion in the media about your reading without having an app on your phone. And I think there was an issue about Apple IOS embedding reading and not embedding reading versus you know, everyone else. Can you just talk about where we are now on Atlas reading?

Riley McCormack

Yes. So nothing to talk about publicly here. I mean, one of the things, if you think about our we've alluded there's a lot of benefits by uniting the digital and physical worlds, right? And for Digimarc validate the detection and Digimarc validate if we were on device would be a wonderful way to get a watermark detection on devices for physical goods as well. But nothing to update.

Jeffrey Bernstein

I'm not trying to check, but thanks very much.

Operator

First, thanks, but again, if you would like to ask a question, please press star one on your telephone keypad. Next question comes from that cohort with PPB. advisory. Please go ahead.

At Riley. Charles, congrats on the quarter. And I just wanted to ask if there's an update you can give us on the anything on the, say, digital Watermark registry that was hinted at, I don't know, maybe early fourth quarter.

Riley McCormack

Yes. Nothing to update specifically on that on one of the wonderful and part of entering this conversation is that number of people who realize we would be a great addition to their tech stack and maybe there's a partnership opportunity there. And so we are still progressing what we're doing. There is also a couple of people who have incredible registries focused on different end markets, different footprints, different levels of security in terms of government grade versus non-government grade. And we'll figure out the best path to market, right? Do we partner? How do we build our own? Do we do both significantly, not yet.

Okay. Fair enough. And I guess my follow-up to that, if I may. I'm congrats on your leadership and C. two PA. with Adobe on the working group that's obviously well earned and an impressive. And I understand you're early in your work but could you give us or me a little bit of, I guess if you can, what the landscape might look like and post those standards being developed, is there going to be who's going to be ultimately responsible for the management oversight of those standards? Is that something CTPA. would evolve into or another regulatory gatekeeper industry driven?

Riley McCormack

Yes, I think the efforts now are to get the standard up and then it would probably be some that they would maintain compliance with that said, or Joe, I don't know if you have any thoughts on that you want to add?

Joel Meyer

No, I think that's right. It's early. The C to B A. will set the standard specification, but it's a little early as to how much detail we'll put into that stand in terms of specifying a technology or guide posts for implementation of the digital watermark. The key is that the digital watermarking is going to be used to link the content to the authentication and provenance information. So that's the first part of the standard that will be set and the implementation of the watermarking technology will be figured out later.

Would you envision an oversight body in that, Joel, I guess, follow-up. Yes, I think CTPA. will continue to be that that standard-setting organization will oversee that.
Fair enough.

Jeffrey Bernstein

Thanks.

I'll jump back into the queue.

Operator

Appreciate the response that we've come to the end of our Q&A session. I would like to turn the call over to Riley McCormick for closing remarks.

Riley McCormack

Thank you, Stacy, and thank you, everybody, for your time this afternoon. I hope you have a great rest of your day fixed This concludes today's teleconference.

Operator

You may disconnect your lines at this time, and thank you for your participation.