Greetings, and welcome to the Digimarc Corporation's Second Quarter 2024 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, George Karamanos. Thank you. You may begin.

Welcome everyone to our Q2 conference call. Riley McCormack, our CEO, and Charles Beck, our CFO, are with me on the call. On the call today, we will provide a business update and discuss Q2 financial results. This will be followed by a question-and-answer forum. We have posted our prepared remarks and our Quarterly Earnings Snapshot 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.

Thank you, George, and hello everyone. I want to begin this call by reiterating the core tenets of our strategy. When we get to the subsequent discussion of Q2, I encourage you to examine our progress with these core tenets in mind. Doing so will help frame the accomplishments we achieved in the quarter, and more importantly, provide context as to where we’re going from here. As our world becomes increasingly digital and companies progress their digital transformation journeys, Digimarc maximizes the ways in which products and multimedia can digitally interact with the various systems that surround them. We excel at the identification and authentication of physical goods and digital assets, often at massive scale, and often where other means of identification or authentication don’t work well – or don’t work at all. Our focus is on converting this large Total Addressable Market into substantial free cash flow by positioning ourselves to deliver high and long-lasting top-line growth at world-class operating margins. This starts with our being easy to begin doing business with and excellent at guiding customers along their Digimarc journey, and is aided by four key tailwinds we have been very intentional to create: One, our incredibly deep and wide moats allow us to offer differentiated products. In turn, our differentiated products enable us to create new markets and disrupt existing ones. Two, the need to identify or authenticate physical goods and digital assets is universal, meaning almost every entity in the world is a potential Digimarc customer. Additionally, because our technology enables us to identify and authenticate things where other solutions don’t work well or don’t work at all, our ecosystem consists of companies incentivized to partner with us rather than posing a competitive risk. Three, there are many use cases that require companies to identify or…

Thank you, Riley, and hello everyone. Financial highlights on a year-over-year basis for the second quarter included: ending ARR increased 44%; commercial subscription revenue increased 39%; subscription gross profit margin was 89%, a 5-percentage point improvement; total expenses only increased 2%; and non-GAAP net loss decreased 14%. We continue to focus on delivering improvement in these financial metrics as they are critical levers in reaching positive free cash flow. Ending ARR increased 44% from $16.7 million at the end of June last year to $23.9 million at the end of June this year. The year-over-year increase in ARR largely reflects the impact of new customer contracts and several important customer upsells, partially offset by customer churn. Total revenue for the quarter was $10.4 million, an increase of $1.6 million or 19% from $8.7 million in Q2 last year, reflecting strong growth in subscription revenue. Subscription revenue, which accounted for 61% of total revenue for the quarter, grew 36% from $4.7 million to $6.4 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 of 39%. Service revenue decreased 1% from $4.1 million to $4.0 million, reflecting slightly lower commercial services. Subscription gross profit margin improved from 84% in Q2 last year to 89% in Q2 this year, representing a 5-percentage point improvement. The significant increase year-over-year reflects both the strong growth in subscription revenue and a favorable mix in subscription revenue to our newer products. Service gross profit margin improved from 51% in Q2 last year to 58% in Q2 this year, reflecting a favorable change in labor mix. We expect to generate mid-50 percent service gross profit margins on a normalized basis, with some fluctuation quarter-to-quarter. Operating expenses for the quarter…

Thanks Charles. In Q2, we made significant progress on multiple fronts, highlighted by meaningful developments in two of our ecosystem-driven opportunities and the rapid progression of an attractive new market opportunity in protecting gift cards from the ever-increasing threats they face. The developments in the ecosystem-driven opportunities give us confidence that we are likely on the precipice of getting these two flywheel spinning. The rapid progression of our opportunity in gift cards is standalone exciting and also served as a cornerstone for a broader suite of offerings to help retailers combat one of their most pressing business challenges, the ever-increasing prevalence and cost of shrink. While we continue to expect our business to be lumpy until we reach a larger scale, the progress we've made in Q2 further demonstrates that as a result of our laser-like focus on the execution of our strategy and the core tenets therein, we are not only on track to unlock the massive TAMs in which we are focused today, but also that new TAMs can rapidly develop. We are positioning ourselves to convert our large total addressable markets into substantial free cash flow by delivering high long-lasting growth at world-class operating margins. Our progress in Q2 gives us even greater confidence in our ability to achieve this goal. Operator, we'll now open the call for questions.

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from Joshua Reilly with Needham.

All right. Great. Thanks for taking my questions and nice job on developing some of these product opportunities here in the last couple of quarters. Maybe just starting off on net new ARR, can you just give us some additional details on maybe what type of customer churn in the quarter? Did you consider them core to the business? And maybe how the center of expertise program for partners impacted net new ARR in the quarter?

Yes. Thanks for the question. The -- most of the churn was specifically related to transition of our COE program. So, as Riley stated in the prepared remarks, we don't expect to see any more customers moving in the CoE program. So, we expect that most of that is behind us at this point.

Yes. Josh maybe if I can double-click on that just quickly. Our traditional part in the bar program, there were two types of partners we had in there. We had the big partners who were technologically capable and really wanted to use Illuminate to build their own products and services on top of. And then we had a bunch of partners that maybe unless they choose to build the things wanted access to our technology because they have a ton of customers who they wanted to sell our existing products. And then we have a third class, our partners that would have fallen into that second category, but didn't want to sign up for the bar. So, we still have partners that we consider under our bar model. These are the bigger customers who want to build things on top of Illuminate. We've been -- our focus has been on the second group is getting to a bigger group of potential partners. And that's what the CoE program allows and the reason it allows us is lower upfront costs, right? They're getting at the pure CoE, that is free. It's our entry gear. But it's -- we're not trying to monetize the relationship as much. We are in direct relationship with a partner. We are trying to both have skin in the game so we can go after their customers and help their customers solve a ton of problems. So, that's what I meant when the transition has low with our ARR. Our CoE deals are going to be less than our traditional bar deals on day one. But they are set up to be focused more on the massive pipeline from the end customers that we can service together. And that's why I said over time it's going to lead to a lot higher ARR and it's also more focused because they're selling our products or they're reselling our products, so they're bringing us leads for our products as opposed to them building their own things on top of it. Does that answer your question a little bit?

That's very helpful I think and provide some nice clarity on what's going on there. Maybe moving on here. If you look at some of the legislation that's progressing in Europe and Canada around plastic recycling, can you just give us any updates you have in terms of time lines? Any change in expectations you have on how the projects will progress relative to kind of maybe public statements you've made previously? And maybe just any other relevant information that investors should be aware of with the current recycling opportunity.

And I'll definitely point you back to the prepared remarks where it said the first partner in our new go-to-market motion. We -- they've told us they expect to sign a deal in the second half of this year to start the European country which is huge. We're also expanding the number of partners. We're in conversation with both not just a number of customers, but other countries. And we expect to have a whole another wave of additional potential partners that we're getting introductions to from a very powerful and wonderful partner of ours. So that's on the opening up Digimarc Recycle markets which is where our focus is. Holy Grail work continues. And if you refer to the quarterly earnings snapshot you'll see that -- there's some revenue coming in the back half of this year from the Holy Grail work which is important. It's continued proof-of-concept never seen 170 organizations do a very public POC on a single company software like Holy Grail is it's wonderful in so many different ways. Now on the regulation there's a tighter regulation -- this is depending on who you talk to top three problems are global basis right is that we only have one planet and we got to solve for the plastic recycling issue. So kind of regulation our -- we don't want to wait for regulation to be the driver. Regulations are a wonderful tailwind. People can see the writing on the wall and see what's coming down from regulation. So I think it gives an urgency to the conversation but we don't want to rely on that. We want to drive our own urgency. And so that's what we're really focused on in these conversations for this new go-to market this partnership model on Digimarc Recycle.

Got it. That's helpful. And then you highlighted in the prepared remarks that in Q2 you demonstrated with your largest commercial customer the ability to carry a heavy load in a multi signal future. I know that you're limited with what you can discuss with this but can you just discuss or maybe from a high level explain what you were referring to maybe with this particular statement?

Yes. I would point to the two developments that I -- I mean that fact is powerful right and interesting. But what's really important is the two developments that come from that fact. First and most immediately, we believe this customer understands the more items in their store including items produced by the national brands, the more profound the improvement in what they're trying to do will be. And then secondly, the an interesting value of our owning more of a technology stack on the razor component -- on using more Illuminate capabilities to build up the points of detection. Outside of reiterating some work for what I said on the call I said I can't provide any additional details, except I do want to stress two things. It's difficult to overstate the importance of these developments. These are important, important developments and we look forward to be able to talk about it more soon.

Understood. And just one quick financial question for me. As you're looking at the operating expense growth for the balance of the year I think aside from the adjustment that grew total expenses grew 2% year-over-year which is great. How should we think about any increased hiring or expenses coming into the model for the second half of the year? Thanks, guys

Yes. Josh, we don't necessarily give guidance but directionally I can just talk. We don't expect you to ramp up expenses significantly at all. And quite frankly generally expenses are a little bit higher in the first half of the year than they are in the second half of the year just given some of the year end compliance and things that we had in Q1. So we wouldn't expect to see material growth in expenses. Now obviously at a much higher scale of revenue. There will be some additive expenses. But as I touched on in my prepared remarks this business we believe has tremendous operational leverage and you can start to see that where we're able to grow revenue at 39% in our expense were pretty low. So we can't say that the expenses will grow but they shouldn't have to grow at a significant amount even to reach a much higher scale.

Awesome. Thanks, guys.

Thanks, Josh.

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

Great. Thanks. A couple for me guys. Maybe first just can you quantify on the ARR what was the actual dollar impact of that churn to customer?

Yeah. So, Jeff, we're not providing any other metrics around ARR at this point. And you know, ARR is really our true north as a business providing other metrics at this point in time, just given our scale, could be misleading, and therefore, we're not going to provide them at this juncture. We can't wait to be at the scale, where we're providing more of those metrics, like gross adds and churn, and things like that. But at this point, we're not prepared to do that.

Okay. Maybe I'll try -- on the multiyear validate deal that you had can you talk more about that you said it was a COE source deal. What's the size of the deal? What's the use case? Just a little more clarity there?

Yeah, it's around -- it's low six figures per year ARR. It's a producer of products, who has tried other ways to authenticate and stock both SaaS as well as their version of their products and realize that we have a pretty good solution. So there's nothing -- well, I guess there is actually to me this is -- this COE partner it's a valued customer of theirs, right? So it's always great to start with a COE partner's platinum customer. It shows that relationship is just off to a good start, they're putting us in front of their customer. We've got to perform, right? We're not just trying to solve users problem. We're trying to make our partners look good, and help them get more comfort in us and really build that partnership. But there's nothing, I would say, unusual or we love all of our deals, right? So it's nothing, it wasn't an exciting deal but there's nothing new about it. It's just our when it came through the COE program, which is a pretty quick turnaround. We launched the partner in Q2 and signed our first partner sourced deal in the same quarter.

Yeah. Got it. That's helpful. And then I guess just lastly as it relates to the commercial customer that you referenced. What happened? I mean, I know, you can't get into specifics of that account and kind of what they're doing with your product. But I mean, clearly, they've had your product in hand for a long, long time. They've looked at it. And it seems highly intuitive that the more product that's marked the more effective your platform is. And I guess, just my first reaction to reading that or hearing that was what took so long that they're finally now just getting that realization?

Yeah. I guess, if you're looking at that from the original 2019 deals, I haven't benchmarked it versus the deal we signed a couple of years ago, right? This is a different use case. It's next-gen, in-store operations. And I know, we talked a little bit about this on our fireside chat. It's ultimately up to the customer, when we're licensing our platform, right? It's up to the customer to really decide, how best they want to build it. That was the second key development, Jeff, I was referencing here is they're understanding that the more that, they use the capabilities of Illuminate is a huge unlock. And then the -- if you go back to the 2019 deal. Our focus across this company is on solving, the problems front of mind for our customers. And when you look at the retail industry, there is far and away two things on the front of their mind. Loss prevention, especially post COVID, but just it's in general, but it's getting worse. You're seeing big retailers taking out self-checkout right or putting more stuff behind locks. That is becoming real as the retail space. And really, it's skyrocket is one of their top concerns and the other one is next-generation operations, right? The retail industry is for the most part, they've had improvement, but it's kind of the same process for the last couple of decades. If we can build solutions that can address, where the industry is going versus, where they are it's a huge unlock. If our solutions can not only add value to their existing processes, but also future proof in for the future ones, Jeff, those are wonderful conversations to be had with these people.

Yeah. Got it. And maybe, sorry, this will be my last. On the gift card, because that's very interesting. I don't know, if I came out of nowhere, but certainly showed off quickly. The materiality of it you're describing it and the pace at which it showed up. You talked about all these attack factors on gift cards. Can you just give us a 20-second education on a little more of the opportunity around gift cards? And then, I don't know any sense on timing? Yeah, I realize, it's just a swag, but how quickly can these result in ARR?

So, in terms of the attacks, there's multiple vectors of attacks, they roll into a couple of big top level one's, right? One is trading so getting a gift card that you believe has money on it, but the money has already been stolen and the second one is social engineering. Those are the two main vectors, but there's a bunch of other vectors and there's a bunch of sub attacks, within those vectors. But it's basically, they're buying a gift card that you should have had value on it, and it doesn't when you get it, or else social engineering and attacking, again, most of these social engineering attacks go after the elderly or -- so those are the two big problems become an issue not just for the industry as a whole. And the only thing this -- the gift card industry is massive. Globally in terms of the total amount of money that is stored on these cards and it's growing in incredibly digitized market. The only thing growing faster is these attacks because this industry has tried a lot of older analog type technologies that you've just proven not to be up for the challenge of a really dedicated group of thieves because of the – pot of gold at the end of the rainbow. So – it's tough to get into exactly how we're solving all the problems. This is a tough – again we identify and authenticate them. The identified, we'd love to talk about it authenticating part of – we don't want to get too far into what we're doing but we have multiple different solutions, multiple different implementations as I mentioned. And then it's sort of timing state too but there is – we don't know what we don't know. As I mentioned, the pace at which this is evolving and the engagement is unlike anything I've ever seen it is remarkable. The goal on this call was to introduce the idea just so you all have awareness of it because like I said at the beginning, our competency of a solution and the materiality to our business if we're, right stationed.

Fair enough. Thank you.

Thanks, Jeff.

Our next question comes from Jeff Bernstein with Silverberg Bernstein.

Hi, guys. Thanks for letting me ask the question. I just wanted to get an update on the California legislation and whether you think that might actually get voted through I guess their Senate this summer? And then I guess there's some different legislation that's starting to percolate for the US government as well relating to AI deepsense

Yes. So on a AB-3211, I mean we're just absolutely thrilled to be part of this conversation, not only because we can make a real impact to a really pressing problem but also because it just – it speaks to our recognized leadership in digital watermarking, right, they approached us to as experts. And probably goes without saying, but I'll say it, we're widely in favor not only because we know of that the implementation of the solutions and it's not just digital watermarking. This is a very comprehensive build, 3211 will work and the technology behind it which is a lot of digital watermarking based stuff. Well of course, that we know will work. Trying to predict how legislation moves through any processes is probably beyond my ability to do. I can tell you right now this is an update. It's currently in the Senate Appropriations Committee and Federal [ph] expense File, which is where I forget the hurdle but any bill that had above a certain very low bar for financial impact, that’s Federal expense file and we're waiting for progress out of that. We provide direct feedback on the content. We've testified on this. And we're just as anxious awaiting progress as you are Jeff.

Got you. And then on the federal level, are they also kind of going to the same path in terms of digital watermarking and other technologies that will be in there?

Yes. At the federal level, there's a lot of different bills talking about this. If you recall, we were at the AI Insight forums. We were also a founding member of the NIST, which is National Institute for Standards and Technology. We're a founding member of their AI initiatives group. So we're supporting at the federal level as well. What's remarkable is how quickly 3211 is moving. California has a history of leading but not just the country but the world in big important things. So – we love all. And again, this is not just a problem facing the US right? This is a global problem. So we're supportive and we're trying to do all we can to help educate governments and regulatory bodies globally because this is a big problem. And I think the outcome of this is wonderful. We believe this and truly deliver the safer fair or more authenticate Internet we've all deserved since the internet was created.

It would be great to get the 15th largest country signed up. So looking forward to that.

Thanks. Thank you, Jeff.

Thank you. There are no further questions at this time. And I would like to turn the call back to Riley McCormack for closing remarks.

Well, thank you everybody for joining us this afternoon. I hope you have a great rest of your day.

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