George Karamanos; Executive Vice President, Chief Legal Officer, Compliance Officer, Corporate Secretary; Digimarc Corp
Riley McCormack; President, Chief Executive Officer, Director; Digimarc Corp
Charles Beck; Chief Financial Officer, Executive Vice President, Treasurer; Digimarc Corp
Joshua Reilly; Senior Analyst; Needham & Company LLC
Jeff Van Rhee; Analyst; Craig Hallum
Operator
Greetings, and welcome to the Digimarc Q1 2025 earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce George Karamanos. Please go ahead.
George Karamanos
Thank you. Welcome to our Q1 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 Q1 2025 financial results. This will be followed by a question-and-answer forum.
We've 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, George, and hello, everyone. As discussed on our last earnings call, we have narrowed our immediate focus to three specific opportunity sets: retail loss prevention, physical authentication, and digital authentication. In parallel, we have also ensured that we are positioned to benefit from our historical programs in other areas, either directly or through our valued partners. This tightening of focus was made possible by our recent technological and market advancements in the authentication space.
As a reminder, we discussed those advancements in greater details on our last two earnings calls. It is a testament to the power of our team and our technology that we've been able to grow annual recurring revenue are almost five times over these last four years, as we've been zeroing in on areas of deep product market fit. Most companies oscillate around flat until they reach that critical milestone.
We've accomplished this while applying the rigor and focus required to speed time to deep product market fit. Since the middle of 2021, we have exited businesses and deemphasized offerings and business practices that didn't make strategic sense while also moving away from pursuing nonscalable services revenue.
Adjusting for the end-of-life of our piracy Intelligence business, we have more than tripled commercial subscription revenue since Q2 2021. We have also expanded our subscription gross margin almost 1,000 basis points, no longer licensing our IP to potential competitors. This decision was a headwind to both revenue and margins as IP licensing carries 100% gross margin rate. It was also unquestionably the right thing to do to ensure our long-term success.
More exciting than where we have been, however, is where we are going. On that front, I want to take a moment to reiterate what we shared on our last call. While we continue to expect lumpiness as we show our patient basis, we believe we are on the cost of sustainable free cash flow generation for the first time in over 12 years. Moreover, beyond just achieving this important milestone, we expect to deliver significant top line growth and free cash flow generation in 2026 and beyond.
Turning now to an update on our business. Our Q1 results came in above our internal plan. These results demonstrate that it is indeed possible to deliver on our much tighter focus areas while still positioning ourselves to potentially benefit from our historical work outside these specific areas. Starting with our work in retail loss prevention, we expect the first gift cards protected with our solution will appear on shelves within the next month.
This is a critical milestone in our work to catalyze the industry towards meaningful adoption this year. Moreover, while the market sizing we have shared for our gift card solution only contemplates the US market, we're beginning to work with partners to map out the opportunity in multiple other large geographies. The driver behind narrowing our go-to-market focus is the incredible power that comes from such focus, especially when trying to orchestrate a rollout is large, and on as tight a timeline as we expect this gift card rollout will be.
As discussed in greater detail on our last call, the other retail loss prevention use case that we expect to contribute to 2025 ARR is our solution addressing price lookup or PLU fraud. On this front, our initial customer will be a featured guest on the May 29 episode of the influential Omni Talk podcast to talk about the power of our solution. This level of customer advocacy is both powerful and appreciated.
Turning now to our physical authentication solutions. We expect to shortly sign a fifth deal with the Digimarc validate customer I referenced on our last call. Recall, the first deal they signed with us was -- the first deal was signed in Q3 2024. Our learnings from this engagement and how we can replicate it are as valuable to us as the mid-six-figure revenue it represents.
We have also formed a partnership with a fellow supplier to one of our loyalty and reward customers. We both agree with the shared customer that our solutions pair well together. As a reminder, our low (technical difficulty) board offering involves the application of serialized QR codes and Digimarc illuminate analytics to modernize and secure loyalty and reward programs, not the creation of the underlying programs themselves.
This new partner has already introduced us to 4 of their more than 1,000 customers. We look forward to strengthening this new partnership, one happy customer at a time. Touching now on our digital authentication solutions. As mentioned on our last call, we had chosen to be very conservative about this area's contribution to 2025 ARR. We made this decision to ensure that we are focused on optimizing our work in this area for the long term.
As it turns out, it is likely this area will exceed the conservative assumptions for this fiscal year. Not only do we expect to grow the relationship with the Fortune 100 customer we discussed in the last call, we are also beginning conversations with others interested in the similar solution to help fight unauthorized leaks and are the improper usage of sensitive and valuable digital assets.
Still my message remains consistent. We will make decisions optimized for the long term, not the short term, in this area and across our entire business.
Moving now to how we have positioned ourselves to benefit from other opportunities outside of our three current areas of focus. Last week, we were excited to share the news of being selected by Unilever to be their digital link vendor of choice. We also recently want to deal with another large CPG for the same use case.
With the twin tailwinds of digital product Passport and Sunrise 2027, carving our early wins in this space sets us up to help companies with their need for upcoming compliance, whether that be directly or through our value print pack partners.
We were also excited to share the announcement of the Alliance and Plastic Waste and AIM that now is the time to scale commercial adoption of Digimarc Recycle. We agree and our initial win in Belgium as well as our support for other opportunities this group is progressing, positions us squarely under that tree as this much needed future unfolds.
Finally, with regards to our work of identifying digital assets in the era of Gen AI, we expect to be able to soon announce a win with an important division of the United States government. When it comes to providing the safer, fair, and more transparent Internet we all deserve this win is an important beachhead as this future unfolds. It should also act as an important point of validation as we focus on opening the digital authentication market that is currently a commercial focus.
I will now turn the call over to Charles to discuss our financial results.
Charles Beck
Thank you, Riley, and hello, everyone. Ending ARR for Q1 was $20 million compared to $23.9 million for Q1 last year. Excluding the $5.8 million commercial contract that lapsed last year, we grew ending ARR $1.9 million, representing year-on-year growth of 11%. I want to remind everyone that on the last earnings call, I mentioned the potential for an increase in customer churn and that we would be strategically price aggressive on a handful of renewals outside our current focus areas.
This occurred in Q1, and we expect it to continue into Q2 as we tighten our go-to-market focus. As Riley referenced earlier, we are above our internal plan for ARR after the first quarter. Total revenue was $9.4 million, a decrease of $600,000 or 6% from $9.9 million in Q1 last year. Subscription revenue, which accounted for 57% of total revenue for the quarter decreased 8% from $5.8 million to $5.3 million.
The decrease reflects no revenue recognized on the expired commercial contract I just referenced, versus $1.1 million of revenue recognized in Q1 last year. Excluding the impact of the expired contract, subscription revenue would have increased $600,000 or 13%, reflecting revenue recognized on new contracts and upsell on existing customers.
Service revenue decreased 3% from $4.2 million to $4.1 million, reflecting lower government service revenue from the Central Banks partially offset by higher commercial service revenue from Holy Grail recycling projects.
As I stated on the previous earnings call, we expect government service revenue in 2025 to be 12% to 14% lower than 2024, but also to be spread more evenly in 2025 than 2024. Actual results were in line with our budget as government service revenue was down 17%, reflecting both the lower annual program budget and a smoother distribution of services in 2025.
Regarding the Holy Grail recycling projects, we have now substantially completed the services related to Phase III. We do not anticipate any future services as the industry shifts its focus to commercial rollout. Subscription gross profit margin, excluding amortization expense, was 86% for the quarter, down 1 percentage point from Q1 last year, reflecting the impact of lower subscription revenue.
We anticipate that subscription gross profit margins may be lower in the next couple of quarters as we continue to consolidate our legacy platforms. But after the migration, we expect subscription gross margins to recover and even increase over time as our Illuminate platform should be more efficient than our legacy platforms.
Service gross profit margin was 65% for the quarter, up 9 percentage points from Q1 last year, reflecting a favorable service labor mix that we do not expect to continue at this elevated level. As a reminder, we expect to generate mid-50% service gross profit margins on a normalized basis with some fluctuation quarter-to-quarter.
Operating expenses were $18.2 million for the quarter, up 6% from 17.1% in Q1 last year. The increase in operating expenses primarily reflects $3.2 million of onetime cash severance costs incurred in Q1 related to the reorganization we announced in late February, and $900,000 of higher professional services costs. Those partially offset by lower stock compensation expenses of $1.5 million and lower headcount costs of $1.4 million.
Due to the timing of the reorganization, the headcount cost savings in Q1 were around $1 million. But going forward, we expect the savings to be over $4 million a quarter. Non-GAAP operating expenses, which exclude noncash and nonrecurring items, were $16.5 million for the quarter, up 19% from $13.8 million in Q1 last year.
The increase in non-GAAP operating expenses primarily reflects $3.2 million of onetime cash severance costs incurred in Q1 and related to the reorganization and $900,000 of professional services costs, partially offset by lower headcount costs of $1.4 million.
As a reminder, we do not exclude cash severance costs in our non-GAAP results. Net loss per share for the quarter was $0.55 versus $0.50 in Q1 last year. Non-GAAP net loss per share for the quarter was $0.40 versus $0.27 in Q1 last year. Excluding the onetime severance costs of $3.2 million, net loss per share and non-GAAP net loss per share would have been $0.40 and $0.25 respectively, both an improvement over Q1.
Now turning to cash flow. We ended the quarter with $21.6 million in cash and short-term investments. Free cash flow usage was down considerably from $8.6 million in Q1 last year to $5.6 million in Q1 this year. Further, the $5.6 million of free cash flow usage included $2.1 million in onetime severance-related costs paid during the first quarter.
Excluding the onetime severance costs paid, free cash flow usage would have been $3.5 million. Looking ahead, we now expect to see higher cash flow usage in Q2 than we originally expected, due to significantly higher legal and public relations costs as a result of an external matter that arose near the end of March. Currently, these costs are running upwards of $0.5 million per month before accounting for the risk they introduce to important ongoing customer and partner conversations.
Assuming the cessation of this external matter, after Q2, we expect normalized cash flow usage to continue to decrease with the goal of becoming free cash flow positive by Q4 this year. 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.
Riley McCormack
Thank you, Charles. We are excited to continue to execute against the strategy we laid out in the last call. Recent technological and market achievements have allowed us the opportunity to tighten our focus to an even greater level and we seize that opportunity, knowing that the combination of focus, this team and this technology is a powerful force.
While early, Q1 results demonstrate that it is possible to deliver in our much tighter focus areas, while positioning ourselves to potentially benefit from our historical work outside these specific areas, we remain excited about what lies ahead.
Joe, we will now open the call up for questions.
Operator
(Operator Instructions) Joshua Reilly, Needham.
Joshua Reilly
Maybe just starting off on the gift card opportunity. I guess maybe it would be helpful to kind of level set for people. How are you thinking about the potential for revenue and ARR to actually hit the model in 2025 from the gift card opportunities? Or maybe is the better way to think about it, like another year -- this is a year of development and maybe that's got more of a financial impact in '26 and '27.
And then second, on gift cards, what is the feedback from the ecosystem on how your solution is differentiated versus what has historically been used? And maybe you could just kind of touch on that a bit there as well.
Riley McCormack
Sure Josh, thanks for the question. So on the revenue impact, as we mentioned on the last call, we expect gift cards to be a significant driver of our 2025 ARR growth. We're focused on catalyzing adoption this calendar year, which I mentioned again on this call. And in fact, this deadline was one of the drivers behind our decision to tighten our focus even further than we've done in the past.
It's part of what we talked about last call about why we're getting so focused is deadlines and milestones that we want to hit in order to make it so in order to make it a significant driver of 2025 ARR. I think it's a great segue into your second question, which one is the reception like it's astounding. It truly is -- I know that -- some people went to a trade show in September of last year, which was six months ago, things have only progressed since then. This is a real issue. This is an existential issue this industry faces.
Mid- to high-teens growth last year, flat this year expectations. Obviously, that's not a great trend for this industry. It is a trillion dollar global industry that is being attacked. And we think we have a novel solution -- and we have -- we've been doing this for 26 years, helping protect other currency -- fee out currency. I think we can do the exact same thing in gift cards, and it's wonderful to see the reception we're getting from the industry.
This is something that -- as we mentioned before, there's a lot of characteristics of our ecosystem-driven opportunities, but none of the actual requirements of this being an ecosystem adoption so it's unlike anything we've seen, and it's pretty exciting. That's why we've been talking about it. That's part of our decision behind the reorganization and focusing on authentication is this is a big driver of that.
Joshua Reilly
Understood. Got it. And then as you look at a couple of those price-sensitive renewals that you highlighted in the shareholder letter, are those actually having an impact on ARR growth here in Q1 and Q2 that is enough to actually call out? Are you just kind of highlighting those deals to point out a couple of trends in the industry.
Charles Beck
We were highlighting the plots and trends in the industry. As you know, Josh, we don't break down ARR in any detail. There's no material movements from those. But I think that's what Riley was highlighting us. Is was just general trend I think as we get more price aggressive that on continuing deals, it did have some impact on Q1 and likely will in Q2.
But not materially eat we're going out because we don't break down ARR in any sort of specific pluses and minuses.
Riley McCormack
Yes, Josh, it's an example of us investing in the future, right? These are not areas that we need necessarily monetize right now, maybe they're areas that are a little bit more competitive. We want to plant our flag, so we can come back to them. They're obviously outside of the authentication use cases, so we want to plan our flag and so we're willing to get a little more price aggressive with the -- again, making sure that if we decide to come back and focus on the area we're there and also potentially tighten the screws on some people, some competitors that rely on these areas more than we do.
Joshua Reilly
Understood. That's super helpful. Okay. And then last question for me is as we kind of think about the deal with Belgium, it's hard for us to get transparency into what's going on from the elements of the governments over there and everything, all the different moving parts.
Is there any initial proof points you can highlight now that this has been going for a couple of quarters? -- in terms of points of success or time line achievement that we should be considering?
Riley McCormack
Yes. It hasn't been going for a couple of quarters, a couple of months maybe. I think we announced it, we signed it within a couple of days of our last call, however, that was two months ago. But I would -- I would say, though, and I'm not sure if the answer to your question was adoption or if there's upside. There is potential upside from this engagement that's initiative move forward.
So the initial ARR is not all we expect to get as these initiatives move forward. But it's only been a couple of months since the original signing.
Joshua Reilly
Understood. I think more broadly, too, I was just kind of asking is, is this going to be an example that other countries are watching closely and other industry groups in Europe? And maybe just touch on that aspect as well.
Riley McCormack
Yes. So as I mentioned on the last call, I'm happy to read it here as well. Absolutely. We think this is -- there has to be a solution to the plastic pollution crisis. There just has to be. I mean this is a single plant plastic is an incredible material right up into a fact you can't recycle it.
You can't reuse it, right? And that's a big yes, that's a big issue. There is a lot of top-down drivers. PPWR being the biggest that I think will eventually catalyze adoption our belief we've always said this is our solution, not only creates a higher quality and quantity of recycling but also unlocks novel data right?
And what happens to be a data desert for most of these companies, companies have so much data between the origination or the creation of an item right up until it goes across that front of the store scanner but after that period, that post purchase period during when consumers are consuming the product, there is just -- there isn't that data.
There's some qualitative data, there's survey data, but there's no quantitative universal data. And while that's always valuable in the era of Gen AI, having novel clean data to feed into an AI agent is going to be transformational to these industries to these companies. And so our belief is this is where we're focused on Belgium is let's prove out yet again, although I think you saw from APW names press release, everybody agrees our technology is going to lead to a higher quality quantity of (technical difficulty) about how we get to commercial scaled adoption.
One of the things that we want to invest improving by giving them a pay-as-you-go type growth initiative in Belgium is my [gosh] to value the data because PWR is not a global regulation, it's a European regulation. This needs to be something adopted around the world because it's a global issue. And so we're hoping that while everybody is focused on the higher quality and quantity of recycling, which is a massively important outcome, we can also prove the value of this data and get a lot faster, quicker adoption.
So that's how we're viewing Belgium is I think if we had 10,000 people in parallel, trying to go light of every country in the world is not going to make it move faster. What we got to do is excellently execute in Belgium, prove both value props and I think adoption will take care of itself.
Operator
(Operator Instructions) Jeff Van Rhee, Craig Hallum.
Jeff Van Rhee
I've got a few. First, on ARR and the trajectory, can you give us any sense of how you're thinking about ARR trajectory going into the end of the year? I know the prior question was around how do we size this churn, and it's really tough to get a sense of the scope of the churn and then ultimately, what you think you can do with ARR. So I realize you're not giving formal guidance. You probably don't want to dial it in too narrowly.
But any qualitative commentary you're able to share as to how we should think about ARR by year-end?
Charles Beck
Yes, Jeff. So I would go back to some of the statements that we made on the last call that provided some kind of inputs to modeling. Obviously, we set our focus is to get to non-GAAP profitable no later than Q4. You can kind of do some quick modeling there and get to that we don't give specific guidance.
I would also just touch on the fact that Riley just reiterated that we believe the gift card will be a significant driver to 2025 ARR. So just taking some level of market penetration in 2025, I think can give you a sense of magnitude there, but I'd really point you to the model because we don't have a specific guidance.
Jeff Van Rhee
Okay. Charles. And so -- and I think in terms of the gift card pricing, while you're on that, can you just give us a refresh -- I mean, obviously, you're getting further into these, you're seeing more repeatability of the contracts and getting a better sense of what baseline pricing is going to look like. How should people size the gift card TAM based on how the current contracts are being priced?
Riley McCormack
Yeah, it's great. Nothing has changed in our -- we've said a couple of times now $900 million to $1.5 billion. That's US market. Three vectors for growth there. One is we're pricing to buy the market. We want to not just provide higher efficacy, but also reduce BOM build materials. So there's upside there over time.
Two, there is -- we already have a product road map of new features and new attacks we can help again. So just as we continue to roll out different versions and defense against other types of attack this industry is facing. I should expect upside there. And then the third one is that was just a US number, right?
And as I said on this call, we're already having discussions with our partners about how we open other large geographies. This is a global issue, a global industry. It's a $1 trillion GMV around the world. And this is a problem that travels well across borders. There's not a US specific reason for this.
Jeff Van Rhee
Yeah. Okay. And then last, I guess, for me. On the ARR front, you're narrowing the portfolio from [78], I don't recall the exact number of ranges, but you decided to go after these three focal areas. And obviously, with reduced R&D and other support for those other products.
And then obviously, in combination with the comments you made around increased churn there, can you give a [better] sense of what percent of ARR right now is from the three go-forward products?
Charles Beck
Yeah, Jeff, we just don't quantify the composition of ARR in that respect, just like the pluses and minuses of ARR at this point in time.
Operator
Thank you. Ladies and gentlemen, this concludes the question-and-answer session, and this will conclude today's conference. You may disconnect your lines at this time, and enjoy the rest of your day.
