Digimarc Corp (DMRC) Q4 2022 Earnings Call Transcript

Digimarc Corp (NASDAQ:DMRC) Q4 2022 Earnings Conference Call March 1, 2023 5:00 PM ET

Company Participants

Joel Meyer - EVP, Chief Legal Officer, Compliance Officer & Corporate Secretary

Riley McCormack - CEO, President & Director

Charles Beck - EVP, CFO & Treasurer

Conference Call Participants

James Ricchiuti - Needham & Company

Operator

Greetings, and welcome to the Digimarc Fourth Quarter and Fiscal Year 2022 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, Joel. You may begin.

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 and fiscal 2022 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.

Riley McCormack

Thank you, Joel, and good afternoon, everyone. 2022 is a transformative year for our company. In a bit, Charles will review the financial highlights for the year. I want to spend time on the strategic highlights and how they position us in 2023 and beyond.

As you all know, we generate revenue through 2 primary markets: government and commercial. On the government side, we re-signed our contract with the consortium of the World Central banks 2 years before expiry, extending it out through the end of the decade. We take great pride in our work to deter global currency counterfeiting and are excited to continue our work with our long-standing and deeply valued customers, the central banks.

Moreover, this program is a wonderful testament to the power of our technology, our scalability and our trustworthiness as a partner, not to mention our ability to build and support a massive mission-critical, multinational and multi-stakeholder system, similar to what we are doing in recycling. On the commercial side, we closed on our acquisition of Everything, launched our first products, announced our first major value-added reseller or VAR, repeatedly and publicly proved our ability to make a real impact on the global plastic problem and signed a multiyear deal with Walmart for an exciting new use case, further strengthening our relationship with the world's largest retailer.

We have combined our digital watermarking and product cloud capabilities to form the Digimarc illuminate platform, and on top of that platform have built 4 products: Digimarc Engage, Digimarc Validate, Digimarc recycle and Digimarc retail experience. We also continue to progress product candidates along the rigorous process that all must endure to become launch products, including intense market research to ensure they address large and growing problems and that eliminates functionality upon which all of our products are built, provide significant technological differentiation. We prioritize product candidates that have forcing functions, network effects or other powerful drivers of adoption.

We have multiple promising product candidates we are currently progressing. Our goal is to digitize our world's products. To accomplish this, we must be easy to begin doing business with and excellent at guiding customers along their Digimarc journey. These simple truths drive everything we do. On the channel sales side, by licensing Digimarc illuminate to a growing number of VARs, we not only gain quickly scalable and high-margin revenues as our buyers go to market with their own products and services built upon our world-leading product digitization platform, we also increased the amount of items that are digitized using our technology.

This creates ever-increasing number of upsell and cross-sell opportunities for both us and our virus. On the direct sales side, by building a growing number of our own accretive products by building a growing number of our own accretive products upon the Illuminate platform, we are not only ensuring the customer is able to solve the problem that brought them to us today, but also providing them a frictionless path to solve the problems they want to solve tomorrow.

Moreover, because our products are accretive, which means that the stand-alone value they provide is increased by the adoption of additional Digimarc products, this frictionless path forward not just solves new problems, it compounds returns from all products, existing and new. We are building the product digitization market 1 product and 1 bar at a time, solving discrete problems while watching with growing excitement as visionary companies and industry observers begin to understand that by adopting multiple products built on a single platform, our customers can solve for today's and tomorrow's discrete problems while positioning themselves to finally achieve true digital transformation as their products are no longer stranded in the analog world.

This is what we mean by being easy to begin doing business with and excellent guiding customers along their Digimarc journey. This is why we are indifferent as to where our customers decide to begin their Digimarc journey. And this is how we'll digitize the world's products and in so doing, build a new market we are uniquely positioned to lead due to our one-of-a-kind means of identifying an item our digital watermark and the world's most scalable product cloud.

A perfect example of this is a comment recently made to us by 1 of the world's largest CPGs, a current Engage customer they are looking to dramatically increase their adoption of this product. While they know they can get lower pricing from companies that can provide some of the consumer engagement functionality we are currently providing them, it isn't just our superior functionality that is keeping them moving forward on their Digimarc journey.

It's their realization that their journey will include Digimarc recycle and potentially another Digimarc product in the not-too-distant future. Having all their products on the same platform will provide them accretive value that no stitching together point solutions if they were even available would be able to replicate. This is the power of what we built in 2022. This is what gives us excitement for 2023 and beyond.

Looking ahead, I want to provide an update on 2 of our products, the two I refer to as our top-down drivers of product digitization because of their ability to quickly advance the market we are building. The first is retail experience, which we recently soft launched about which more is available on our website. While we are excited for a broader launch, it is in our best interest to work with the industry on this product's rollout. The potential downside of top-down drivers of product digitization is that the very fact they are top-down means we don't always control all aspects of that product's launch. The upside, of course, is that there are top-down drivers encouraging adoption.

I would note that a lack of broad publicity about this launch does not mean that there is not ongoing activity, not a real intent from interested parties to drive adoption to modernize the retail experience, an experience where watermarks have moved from nice to have to need to have. As stated on our last call, the serviceable addressable market for retail experience is enough to take us well into profitability by itself.

The second is recycle. While the same top-down driver give and take that applies to retail experience applies here as well, the 2 big differences with recycle are we've been actively advancing recycle for almost a year and we are active on multiple continents and with multiple important stakeholders. We believe the per country TAM for Digimarc recycle is onto the 8 figures and plan to soon publish recycle pricing on our website to provide requested transparency to multiple important stakeholders.

Our activity in 2 countries for Canada is publicly known. A few weeks ago, the industry gathered in France friends to learn more about the opportunity to make France the European pilot market for Digimarc recycle. A large CPG announced at its public gathering, they are committed to being part of this pilot market at scale, and we are in discussions with multiple other brands and retailers about joining them. The group has had aggressive targets for both the scope and timing of initial adoption, and we stand by ready to assist them in their quest to make a real impact on plastics recycling.

We are all aware the world is watching. Stay tuned. Moving to Canada. In Q4, we announced the results of our work with the circular plastics task force. What I found most impressive about this group's efforts is that they are proving how quickly a small, nimble, dedicated and motivated group can move to make a real difference to a large and growing problem and our wonderful partnership with them continues to deepen. Here again, we expect to have more to say soon.

Our work in Canada is also informing our work in other countries that are further behind both France and Canada, but where we hope to apply the learnings we are getting in Canada to close time and gap.

Before I turn the call over to Charles, I want to talk about our path to profitability. We know that to deliver upon the immense value inherent in what we are building, we need to build a financially sustainable business that can deliver what we fully expect to be able to deliver. This includes making sure we are always investing with great responsibility across all areas of our business. We recently made the very difficult decision to streamline certain areas and reorganize in others and in so doing parted ways with some wonderful people and talented teammates. This action was neither a reflection of our prospects or the performance of any impact to team made. Instead, it was a reflection of our knowing that in order to change the world, we must have a durable business.

The actions we recently took not only have a big impact in reducing our current cash burn but importantly take us a big step forward on our path to profitability, something that based on the size of the markets immediately ahead of us, coupled with the world-class contribution margins we enjoy is squarely in both our focus and line of sight. I will now turn the call over to Charles to discuss our financial results.

Charles Beck

Thank you, Riley, and hello, everyone. As we reflect back on 2022, there were a number of strategically important accomplishments to note, as Riley just highlighted, and there were also some important financial developments during the year I want to highlight before I dive into Q4 numbers. First, we delivered 85% year-over-year growth in first year commercial bookings with bookings of $19.1 million in 2022. As a reminder, the commercial market is our largest area of focus given the enormous opportunities we are uniquely positioned to address.

If you exclude our piracy Intelligence product, which we have now completely sunset, our commercial bookings growth was even higher at 160% year-over-year. Second, we delivered 32% growth in subscription revenue year-over-year, with subscription revenue of $15.2 million in 2022. For the first time in a decade, subscription revenue accounted for over half of our total revenue, which is notable given the sale of our software subscription products is not only our most important product focus, but also our most profitable. We earned roughly 80% incremental margins on our software products right now with the potential to increase that to more than 90% at scale. If you exclude piracy Intelligence, our subscription revenue growth was even higher at 77%.

Third, while service revenue was flat year-over-year at $15 million, we expect service revenue to be higher in 2023. As a reminder, the majority of our service revenue comes from software development services we provide to the central banks. With the early extension of our contract with the Central Banks, which now runs through the end of 2029, we expect services revenue from that contract, which was $12.9 million in 2022 to be up over 10% in 2023.

Now as promised, I'll dive deeper into our Q4 results. First year commercial bookings were $10 million during the fourth quarter compared to $2.6 million in Q4 last year. Booking in Q4 last year included $1.3 million from piracy Intelligence. As I referenced earlier, our piracy Intelligence product has now been completely sunset so that there will be no future bookings or revenues. Excluding piracy Intelligence, first year commercial bookings increased $8.7 million or 680%. First year commercial bookings in Q4 included the remaining $7.3 million of minimum fees due from the new Walmart contract we signed in Q3 as during Q4, these fees became noncancelable and payable within the next 12 months.

Total revenue for the quarter was $7.2 million, an increase of $100,000 or 1% from $7.1 million in Q4 last year. Subscription revenue, which represented 57% of total revenue in Q4, grew 13% in the quarter from $3.6 million to $4.1 million. There are multiple factors offsetting one another that impact the overall positive trend in subscription revenue. Adding the revenue was the impact of new deals signed during 2022, including the new Walmart contract in Q3 and the addition of subscription revenue from the Everything acquisition. These additions were offset by $1.6 million of subscription revenue from piracy Intelligence recognized in Q4 last year, which included the $1 million sale of noncore patents versus there being no revenue in Q4 of this year.

Excluding Piracy Intelligence, subscription revenue increased $2.1 million or 105%. Service revenue was $3.1 million in the quarter compared to $3.5 million in Q4 last year and was higher than our internal forecast. The year-over-year decline is due to recognition of significant project work last year related to Holy Grail 2.0 while services with the central banks were marginally higher year-over-year. As a reminder to those modeling our business, our Central Bank business tends to be seasonal. And thus, for the last several years, our Q4 service revenue has been down sequentially from Q3.

Gross profit margin for the quarter was 53% compared to 70% in Q4 last year. The decrease in margin reflects $1.1 million or 15 percentage points of amortization expense recorded on acquired intangible assets recognized in the acquisition accounting for Everything. Excluding amortization, subscription margins were 77% and service margins were 56%. Non-GAAP gross profit margin, which excludes amortization expense as well as stock-based compensation expense, was 72% for the quarter compared to 74% in Q4 last year. The slight decrease in gross margin was driven by lower subscription gross margins year-over-year, which in turn was largely related to product mix, as legacy Everything subscription business carried a lower gross margin than the legacy Digimarc subscription business.

As we work to combine these 2 amazing technologies into 1 seamless platform, we have identified ways to improve our product margins and expect the combination of cost outs and revenue growth to drive our subscription margins north of 80% in 2023, higher than they were pre acquisition. Operating expenses for the quarter were $17.1 million compared to $13.2 million in Q4 last year. The increase reflects $3.1 million of operating expenses from Everything post acquisition. Excluding the impact of everything, operating expenses were $900,000 higher, which included $1.2 million of higher compensation costs for annual compensation adjustments and higher headcount of which $200,000 was noncash stock compensation expense.

Additionally, we recorded $300,000 in noncash lease impairment charges. The higher compensation costs and lease impairment charges were partially offset by lower other expenses. The lease impairment charges related to adjusting our assumptions regarding the timing of subleasing our prior corporate office in Oregon, as well as our decision to abandon our office lease in London.

Non-GAAP operating expenses for the quarter were $14.3 million compared to $10.3 million in Q4 last year. The increase reflects $2.6 million of non-GAAP operating expenses from everything post acquisition. Excluding the impact of Everything, non-GAAP operating expenses were $1.3 million higher year-over-year which included $1 million higher cash compensation costs.

On February 16, we announced a restructuring plan focused on streamlining our operations, removing redundancies and improving our operating margins. While our level of optimism regarding our future business prospects only continues to grow, these reductions were the right thing to do to optimize the business for long-term sustainable success. The plan involved a reduction in our workforce of approximately 17%. We estimate the plan will result in onetime cash charges of approximately $1.5 million and noncash charges of approximately $600,000 for accelerated stock compensation expense. We expect that most of these charges will be incurred and the plan will be substantially complete in the first quarter.

The plan should result in approximately $7.4 million in annual cash savings and approximately $700,000 in stock compensation expense. We are also looking at other non-headcount-related areas of the business where we can streamline our operations and reduce our costs. Offsetting some of these savings, though, is the impact of annual compensation adjustments for our employees and generally higher prices for third-party products and services due to inflationary pressures.

Net loss per common share for the quarter was $0.62 versus $0.50 in Q4 last year. Non-GAAP net loss per common share, which excludes noncash and nonrecurring items, was $0.41 versus $0.30 in Q4 last year. We ended the year with $52.5 million in cash and investments. We used $3.8 million of cash investments during the quarter compared to $10.9 million in Q4 last year. During Q4, we opportunistically raised $4.7 million of net proceeds under our at-the-market program to bolster the balance sheet. We sold 222,000 shares at an average price of $22.42.

The ATM program has $1.9 million available for future sales. Although we have no plans to sell any additional stock under the ATM program in Q1 as we assess the opportunities ahead of us. Excluding the net proceeds from the ATM, cash usage would have been $8.5 million. 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. I will now turn the call back over to Riley for final remarks.

Riley McCormack

Thanks, Charles. 2022 set the foundation for the years ahead, and we are excited to continue to build upon that foundation in 2023 and beyond. We are seeing momentum across all areas of our business and our 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, and the other legs of the digital transformation stool. There are trillions of items produced per year, and our goal is to sell multiple Digimarc products into each of them, adding exponentially accretive value as we digitize the world's products. Operator, we will now open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question is from Jim Ricchiuti with Needham & Company.

James Ricchiuti

I'm wondering if you can elaborate of the recycled product comments that you made. Riley, the question -- let me see if I can phrase it this way, maybe you'll be able to help. Would you be surprised if we're into the second half of this year, and there's still this relative lack of publicity that you're alluding to particularly in light of some of the restructuring actions you've announced. I'm wondering if there is still the difficulty of predicting when the timing around when this -- the product gets traction in the market?

Riley McCormack

You're talking about recycle or retail experience?

James Ricchiuti

I'm sorry, the -- not the retail experience product.

Riley McCormack

I don't -- Jim, the one thing I got to say, one of the wonderful things about top-down drivers are top-down drivers. So one of the downsides of that is we're not going to complete control. I wouldn't confuse publicity and a broader talk about -- I wouldn't confuse that with activity or there being a lack of activity or real intent. That's all I'm going to say. This is -- I think we mentioned on our last call that -- the new contract we signed with Walmart is a powerful anchor for this product. I think if you go to our website and look at this product, you'll understand, I'll just leave it that. It's in our best interest to work with the industry at the pace they want to go on all things, including publicity. But again, I would not mistake publicity for activity.

James Ricchiuti

Does the pace at which the retail industry is moving though. Does that have any relation just in light of some of the actions you're taking to ensure that you can get to profitability sooner rather than later. I'm just wondering if there's any connection there may not be I just.

Riley McCormack

Are you saying what -- was there a headcount reduction related to our belief in the inflection of our business?

James Ricchiuti

Timing around it being uncertain.

Riley McCormack

Yes. No, no. I think both Charles and I went out of our way to call that out. I think Charles was phrase number of business confident or increasing confidence, and I said this has nothing to do with either the people impacted or our beliefs in anything. So no, they were not related.

James Ricchiuti

And then just with respect to the recycle, take recycle product. Is there -- you can, I think, talk a little bit more freely about this. Is there -- in your mind, is there a time line as to when this large SAM begins to convert into revenue opportunities. Yes, something along the lines of what you highlighted.

Riley McCormack

Yes. I mean, we -- there's -- in France, we talked about -- there was a public meeting where a large CPG committed to getting going at scale, and we're in conversations with other people. We're still early in 2023. So I would be hopeful that, that happens this year. And then same with Canada, I mentioned, stay tuned shortly there should be some ties out relatively shortly in Canada.

James Ricchiuti

Okay. It does sound like you're expecting a decent amount of news flow over the balance of the year.

Riley McCormack

Absolutely.

Operator

Our next question is from Jeff Van Rhee with Craig Hallum Capital Group.

Unidentified Analyst

This is on for Jeff Van Rhee. First question, just on the workforce reduction, what was the timing on that was that in Q4 here? Or is that layering in, in Q1 just for thinking about whether or not that's already reflected in this quarter's numbers or how much of a quarter of that is reflected in this quarter's numbers?

Charles Beck

It happened mid-February. So we'll have 1.5 months of kind of regular spend in Q1 before the action took place. And then we'll have about $1.5 million of cash costs in Q1 related to this event.

Unidentified Analyst

Okay. And then on -- so on that $7.4 million of annual cash savings, that's all in relation to that workforce reduction? Or is there other pieces and parts?

Charles Beck

That is all related to the workforce reduction.

Unidentified Analyst

Okay. And then on the Walmart new use case that we were talking about last quarter, you talked here on the call about the soft launch of retail experience. I don't know if that was suggesting. That was what the Walmart use case was. But just if you could update us on where we're at with Walmart and then what the current thinking is on when we would hear about what that use case is?

Riley McCormack

So on the latter, that's up to them. What do you mean by updating you on where we are with Walmart? I don't understand the first part of your question.

Unidentified Analyst

I just mean in terms of rollout in terms of usage at Walmart in terms of when we might hear about what the use case is just all of the above? Anything that can be shared about that.

Riley McCormack

Yes. I'll just repeat what I said in the call, which is it's our best interest to work with the industry on this. So that's up to them. But again, important to make clear that just because you don't know about it doesn't mean there's an activity going. I don't know me that just mean in general, right? I don't think any of our partners are necessarily messaging to all they're taking care of their own business. So when Wall Street finds out about it may be at a very different time than when important other stakeholders find out about.

Unidentified Analyst

Okay. And then just last of all. On the service revenue and the year-over-year decline in Holy Grail. Just maybe talk us through that? What was driving that decline? And then maybe what are the current expectations for Holy Grail moving forward? I know France being the pilot project there, but just any other thoughts on how we should think about that service revenue going into.

Charles Beck

Yes. So this has nothing to do with Holy Grail. I mean there's a lot of the same stakeholders involved, right? But Holy Grail, there was -- it was a Phase III trial and we got service revenue as part of that. That's a lumpy onetime service revenue. We're not -- you heard Charles say, our focus is on subscription. That is where we're going to be at 80% gross margin next year with growth from there, which is incredible in terms of just versus the SaaS universe, right?

So our focus is on subscriptions. But we provided along with some really small licensing revenue to Holy Grail for this pilot that was Holy Grail grilled was services work. So there was just the timing of that different phases, Phase I, Phase II. I don't -- I mean, for a couple of years, there's been Holy Grail services work. But our goal would not be to have a bunch of Holy Grail services where we want to sell Digimarc services. That's the focus.

Operator

[Operator Instructions]. Our next question is from Matt Collard with PCB Advisory [ph].

Unidentified Analyst

Charles. Congrats on a strong year in '22. You introduced in your comments, Riley, about the value-added reseller. And I guess, I just wanted to understand, do we think of that? Or should we think of that as a license at the individual product level in terms of? Or is it the platform level?

Charles Beck

Platform level. So Digimarc Illuminate is our platform. We're using that in 2 ways. We are building our own products on top of that. Those are the 4 products we talked about. We have other product candidates that we're working on. That's what we sell direct, right? But we also believe -- and I think I mentioned this in the call is going to be 2 calls ago, we also are licensing that platform to value-added resellers to build their own products and services on top of it. And it's just like any other hyperscaler type model where the more capacity they use, the more they pay us.

And there's 3 wonderful things about it, I guess. The first is its highly scalable and high-margin revenue, right, as our value-added resellers are out selling whatever products or services they built upon Illuminate, that's them doing all that work and as they need more capacity, they got to license more from us. So that's one. Secondly, it's digitizing more and more of the world's products using our technology. It's a win-win-win. It's a win for us. It's a win for the VARs and it's a win for the end customers. There's cross-sell and upsell between that.

We're building a lot of technology companies that are both platform and product that can get to channel conflicts. We're actually creating a triple win with the way we're going to market. And then the third thing is we are never going to have all the best ideas in the world. And so by letting value-added resellers make use of our platform to come up with other solves, it's wonderful.

Unidentified Analyst

Got it. Okay. All right. And then also, I appreciated the comments because we're obviously excited about some of the potential new product candidates. So I appreciate the insight into the new product candidate process, if you will. I guess the question would be are any of the new product candidates that you're kind of referencing top-down drivers? Or would you consider those also top-down drivers of product digitalization? Or are they more -- I don't want to use the term bolt-on, but I will because I can't think of anything else.

Charles Beck

Yes. You could say accretive products, maybe bolt-on accretive. Yes, they're both. I mean there's a reason -- here's the reality, right? And Matt, we've had this conversation. I'd like to I never -- I want to be careful what I say because there's still uncertainty. And when there's uncertainty, I want to call it out, they're product candidates for a reason because we are not guaranteeing right now, they're going to be some products. If we knew they were going to be products, they would be products, right?

So with that caveat said, absolutely. There's a reason why I talked about how we what we prioritize in the product candidate road map because those are really powerful, right, that having either a top-down driver or a network effect or some other forcing function is an incredible tailwind to have to a product as opposed to your word, bolt-on, as just another product.

So absolutely, there is -- you picked up on it. I think that's -- that's why I talked about how we prioritize some. So there are -- there is a mix in our product candidate pool of both single products, kind of dissolving discrete problems that help us digitize the world's products, one problem at a time. but there's also some top-down forcing function network effect products in there. And when the time is right, when we can talk about it, we'll make sure we talk about them.

Operator

There are no further questions at this time. I'd like to hand the floor back over to Riley McCormack for any closing comments.

Riley McCormack

Well, thank you, everybody. We appreciate your time. Have a great rest of your day.

Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.