My first article on Digimarc (DMRC) (An Alternative (and Tangible) Way to Value Digimarc) argued there was a lot more value in the core business than most realized, a revelation made possible by new data provided by the company at a recent sellside conference. And using this new valuation framework, we could then assign a value to the core business, and from there flex the “stub” piece of the valuation (the value assigned to Barcode) based on any new information received in order to assign a value to the total company.
My second article on DMRC (So What Should Digimarc's Barcode Stub Be Worth Today?) attempted to provide a variety of ways to value that Barcode “stub” with the information then available.
On March 11th, the company will be hosting a three hour Capital Markets Day (Digimarc to Host Capital Markets Day on Monday, March 11, 2019) that should provide all sorts of additional details that will both provide a test of the assertions in my first two articles as well as a lot more information that will make my prior analyses that much more refined (and potentially much, much more powerful).
But instead of just waiting for the event in order to do a post-mortem and add additional thoughts, I decided it might be valuable to provide a preview. There are two reasons for this. The first, I think there’s still (significant) upside to the stock ahead of the CMD, if only because the CMD might/should dramatically alter the way the company is thought of/valued by Wall Street.
And secondly, for those investors who want to remain on the sidelines until the CMD to see if what I think jives with what the company will attempt to prove, perhaps reading this now will at least spark enough interest that they tune into what I think should be a really important three-hour presentation.
Digimarc's Barcode business is a much more advanced offering than it was four years ago, but by the management's own admission, they haven't done a good job of articulating this to investors. The goal of the CMD is to close this informational disconnect, by providing an in-depth view into the Barcode platform as it stands today, with a variety of advanced applications and pricing models that goes well beyond the single offering that most investors still think the business is today (charging $50/SKU to watermark packages for front of store efficiencies).
And while the next five paragraphs will be high level and are thus at risk of being boring, don’t give up halfway through, I promise there’s actionable details and numbers coming after that are worth sticking around for.
Based on what the CEO said on the last earnings call (Digimarc Quarterly Conference Calls | DMRC), I believe the structure of the CMD will focus on each specific application of the current Barcode business, what value that application brings to the customer, and thus what value that application in turn will bring to DMRC shareholders (ie, what the revenue model is for each application). And as my second article touches on, there are many applications, value propositions and revenue models within the Barcode business, despite most investors still thinking Barcode is simply a $50/SKU business, simply for front of store checkout speed improvement.
Then, after going through the applications, my guess is the company will take a step back and point out how all of these specific applications are products of a much bigger and more important multi-sided platform. And that whatever the sum value of the specific applications might be, the majority of the total value of Barcode lies very much in the fact it is indeed a platform, and a muli-sided one at that.
Meaning, there’s value not only in the fact that in adding up the applications 1+1=3 (or more accurately, 1+1+1+1+1+1=15) for the customers as they benefit from various applications made possible by the incorporation of the underlying technology on a given item, there’s also additional value from two other angles.
The first, Barcode is a multi-sided platform, meaning it’s a hub of value that many participants benefit from, not just the ultimate payer of the license fee (creating a very powerful network effect).
And second, Barcode is an ongoing construction site, and that while today there’s a ton of value for a lot of beneficiaries from the buildings currently built, a given product’s membership card will also give it access to planned future buildings (for an additional fee, of course), so that in the medium term 1+1+1+1+1+1=15 will become 1+1+1+1+1+1+1+1+1=30, and in the longer term, 1+1+1+1+1+1+1+1+1+1+1+1+1+1+1+1=50.
Below, I’m going to focus just on one application because it is the simplest to explain, has potentially the nearest-term catalysts, these catalysts will be very public, and it alone provides such an incredible amount of value to the Barcode business (and thus DMRC stock), spending time on any other applications today (with the stock below $100 or even $300) would be superfluous and thus a waste of all of our time.
But it is important to reiterate, come March 11, this will just be one of the applications discussed in detail. And while just the deeper dive into the various applications at the CMD should create a lot of value, it is the idea that these are all actually part of a much bigger whole that, if adequately presented and adequately understood, should increase by at least a factor the implicit value of Barcode as outlined by a deep dive into the applications themselves.
The Ellen MacArthur Foundation has an initiative called the New Plastics Economy (New Plastics Economy). An initiative within the New Plastics Economy initiative is the Holy Grail Project, the objective of which is to decide how best to identify different plastic items so that they can be sorted, and thus recycled. It is being led by a gentleman from P&G (PG), Gian de Belder (Towards a New Plastics Economy: Achieving global sustainability through collaboration - The Procter & Gamble blog).
The Holy Grail Project has narrowed its list of identifying technologies to two, chemical tracers (sometimes referred to as chemical taggants) and digital watermarks (the latter, of course, being one application of DMRC’s Barcode technology).
And among others, the Consumer Goods Forum (Who are the Members of The Consumer Goods Forum?) , whose members use 20% of all the plastic used globally (The consumer goods industry moves to act on plastic pollution), has already said they will support whatever decision the New Plastics Economy group makes regarding which ID tech the industry should adopt (Consumer Goods Industry Moves to Act on Plastic Waste ).
In other words, whatever decision the Holy Grail Group makes, it will be adopted by the industry voluntarily, most likely with an immediate flurry of press releases from each company in order to capture the PR benefit of publicly announcing they are on board with saving the planet.
In addition, I would expect there will also be regulation enforcing the Holy Grail Group’s decision, to make sure there are both carrots and sticks to not only adoption, but also adopting correctly (so, for example, watermarking an item incorrectly doesn’t actually cause harm by incorrectly identifying plastic type A as plastic type B, which is worse than not identifying it at all).
And the Holy Grail group has set a deadline of May for publishing the results of the final, upcoming tests of these two options, although based on two publicly available signs from de Belder himself, it seems like the decision is a foregone conclusion.
The first is this tweet of an article mentioning all the benefits of digital watermarking (Gian De Belder on Twitter).
The second is this video of de Belder presenting to the EU Parliament just last week, the relevant portion starting at the 16 minute mark (Petcore/EU Parliament Meeting Video). While the slides (and the various reference to Digimarc Barcode therein) speak for themselves, notice too his scanning of a product with his smartphone. That is the DMRC Barcode in action.
And this inevitability also seems to be the view of the industry, not just the man in charge of making the decision, although I’m sure those facts are related. There are a lot of pros to using watermarking, and a lot of cons to using chemical tracers, but instead of delving into all those, the one that alone makes the upcoming decision seem to be a foregone conclusion is the difference in the number of possible unique IDs that are able to be created using watermarks versus tracers.
And the reason this is such a big deal is that governments don’t want to know just what type of plastic an item is made of, but also who made it, and where they made it. There are a variety of laws in the EU that are going into effect now that are trying to properly allocate the negative externality of the environmental and economic impact of plastic usage to both a country and then within a country, a company, level. For a sorting technology to provide this functionality, there’s a lot more information needed than just the type of plastic, but also where it was made, and by whom. The number of possible permutations using chemical tracers is double digits, meaning less than 100 different types of unique ID’s could be created. With watermarks, it’s billions. Game, set, match.
So we’ve covered the who and the when and the why and the if. Now, the fun part. How much?
I encourage everyone to read the article de Belder tweeted (Watermarks can harmonize sorting processes amid regulation squeeze: Petcore Conference 2019 review, Part 2), it has a lot of information in it, including next steps (a fully-funded, country-wide rollout in 2019 in at least one EU country. IE, this application should produce revenue to DMRC starting this year, and this revenue is already funded).
But despite the importance of that article, this article (Shifting conditions, mounting pressure: Petcore Conference 2019 review, Part 1) has even more. Notice the paragraph about how low recycling rates cost (in just the EU alone!) $80-120 BILLION per year. It’s unclear if this is total costs, including environmental and disposal costs, or just the cost to the industry of having to use virgin plastic instead of recycled plastic (recycled plastic feedstock, besides being better for the world, is also cheaper for the buyer).
So while the DMRC CEO said on the last earnings call he hasn’t yet finalized how he will price this application, we know the following: There is no other viable option and the savings from increasing recycling rates are at least $1 billion/year for each percentage point recycling rates go up in just the EU alone (if the fact only 5% of plastic being recycled has a cost of at least $80-120 Billion, that means the fact 95% of plastic is not being recycled has that same cost. If we split the difference of the cost range and say the cost is $95 billion, you get to my math of each point of additional recycling being worth $1 Billion. And again, this amount is per year).
Let’s assume machines at sorting centers being able to accurately identify which type of plastic an item is made from, combined with whatever incentives companies and countries will introduce to avoid having to pay for their products not being recycled, thrown on top of the fact that consumers will also be able to search with their phones how to properly recycle a given item all combine to increase recycling rates from 5% to 25%. That’s at least $20 Billion of value created. Could the enabling technology for this increase not get 5% of that, or $1 Billion/year? That’s about what QCOM’s patent rate is for its technology. What if these factors increase recycling rates to 50%? That’d be $45 Billion of value created, and even 3% of that is $1.35 Billion a year. What if the effective cut is 10%? That’s $4.5 billion. Per year.
And keep in mind, this is 100% margin license revenue, payable annually, all of which will accrue to DMRC. It is important here to note that there is a DMRC partner that has led this charge, Filigrade, but they don’t have any patents around this technology. Notice, in fact, the slide in the article de Belder tweeted, that mentions the signal as being Digimarc Barcode + NIR (Near Infrared, which is the inadequate tech currently being used), or the slides from the EU Parliament meeting, which all refer to the technology as Digimarc Barcode.
Filigrade will probably get some consulting work out of this as they are somewhat (at least today) the tip of the spear of using watermarks to recycle, but they won’t get any of the license fee. It’s not their tech. And in truth, DMRC could instead actually get a percentage of Filigrade’s consulting work if they so choose, as they do with other partners on a case-by-case basis. But we will ignore this upside for now.
So whatever this industry-led but also soon-to-be government enforced initiative ends up bringing into DMRC’s topline, it is very safe to say it will completely change the economics of the underlying business.
Getting to EPS implications: Let’s just use $1 Billion/year. And keep in mind, this is just a) the EU b)just recycling c)just recycling of plastics d)even on just this subset of a subset of a subset, might still be too low.
This $1 Billion of revenue will drop $1 Billion to the Gross Profit line, as it’s simply a license fee and thus 100% GM. I’d assume DMRC would have to hire some more back office people to handle all the processing and payments (or at least pay to outsource this work). And probably they’d be smart to hire some lobbyists or other government liaisons to proactively address any potential issues or concerns. And for sure they’d want to hire an internal help desk to help the multiple ecosystem partners that will come on board to make this a reality (although again, since this technology is decently well known, it’s also likely third-party firms will rise to address this vacuum, including, for example, Filigrade).
But in reality, do they need more than 50 new people (or 50 new FTE) to do all this? 100? Remember, either others will do the actual watermarking of the products themselves, or DMRC will, but if it’s the latter, DMRC will then get paid even more than their license fee, so doing the analysis purely as a license model makes the analysis cleaner AND more conservative. And whatever the additional opex that is necessary to support this one application ends up being, it’s still a rounding error.
Let’s assume 100 people (or FTE) at $150,000 all-in costs, that’s $15 million. The company is currently burning $25 million a year. So offsetting this $1 billion in revenue is $40 million of expenses. That’s $960 million of EBIT, and the company’s tax rate (all-in) is 21%, and they have 12 million shares outstanding.
That math works out to this single application, in a single geography, for a single substrate would allow the company to earn $63 per share of fully-taxed earnings per year.
One can flex these numbers anyway one sees fit, decreasing the potential value the company will realize and/or increasing the necessary opex, and the fundamental conclusion is still the same. Just the recycling component of just plastic, just in the EU, is an absolute game changer for the company and its stock.
And keep in mind. This is just a single application the company will be discussing in two weeks time at their CMD.
Obviously, it’s necessary to now discuss where all the above could be wrong. And this is perhaps the hardest part of this analysis, because I truly struggle to figure out where this thought breaks down, despite its (almost) literally unbelievable conclusion.
Where could all the above be wrong?:
If: The Holy Grail Group has publicly committed to making a decision in May, and there’s a lot of pressure on the industry to come up with a solution, so I don’t see this dying on the vine. Remember, too, there’s already funding for the first country wide rollout of the adopted technology. So that also de-risks the "if." And a group representing 20% of global plastic usage has already committed to following the New Plastic Economy’s suggestion, so not only do the next steps seem almost a lock to happen, so too does industry adoption.
Moreover, regardless of voluntary adoption (which is actually very likely), this is something that will be legislated, also almost certainly supporting whatever decision the Holy Grail Group decides as de Belder et al are already in front of the EU Parliament (The PET industry in the circular economy is a brief synopsis of the full meeting from which the above linked video of de Belder presenting came). In sum, either tracers or watermarks are going to happen, starting very soon.
The second “if,” of course, is which of the two finalists will be chosen…tracers or watermarks. I can tell you that the industry seems to have already accepted it will be watermarks. And while this is based on my own due diligence (which is harder to prove), objectively I think de Belder’s tweet supports that fact. As does the above referenced clip of his presentation to the EU Parliament.
But moreover, an analysis of the details should also allow one to assume watermarking has already won. Whereas watermarking for recycling will bring a lot of additional benefits to adopters (which is part of the value of the platform and will be discussed further on March 11th), tracers have a lot of drawbacks. They require the addition of glow-in-the-dark chemicals to containers carrying food and drink, something which in reality is probably safe, but would undoubtedly concern a large percentage of the population. These tracers then need to be removed during the recycling process, which will for sure at least add cost to the recycling process, and from what I’ve heard, also isn’t able to be done 100% of the time.
Moreover, in almost any reasonable watermark pricing scenario (including numbers well above the ones discussed above), tracers are more expensive than watermarking, and again don’t provide any additional value for that cost. Tracers also have no consumer interaction potential (and I’m talking here just about allowing consumers to know how to recycle an item, but this lack of consumer engagement from tracers applies to any payoff, not just recycling), as phones today are not able to read the UV chemicals, whereas conversely any phone with a camera can today read DMRC watermarks. Remember here de Belder doing this exact thing as part of his presentation to the EU Parliament working group.
But the biggest reason (by far) watermarks are better than tracers, and the one that supersedes all the above logic, is that by using tracers there is only a small number of ID variations possible, a limitation watermarking does not share, and which alone just makes tracers a non-starter.
When: We know the deadline for the final decision of the Holy Grail Project (May, which is really, really close, and thus a positive). And while the next steps, the full implementation of watermarks, might take a while, I don’t consider this that big a risk to the stock, because if investors are comfortable with the “if,” which they should be now, but for sure will be in a few months, I’m not sure if it matters how long it takes for the industry to reach full implementation. The upside is so large that using a risk free (or even a really large non-risk free) rate, discounted cash flow analysis will argue for a valuation to the stock many, many times higher than here, regardless of how many periods one is discounting by.
In addition, the “when” of full implementation will be preceded by a flurry of press releases the companies themselves will issue to get the PR benefit from adopting this technology, and again these are most likely only a few months out (in support of the Holy Grail Project's decision).
More importantly, beyond just words, I would assume adoption will have market share implications, and thus people will race to watermark their plastic regardless of expected timelines. Once consumers realize the tiny change to how the plastic looks makes that product more likely to be recycled, whether or not a product is watermarked should impact buying behavior. And if that is indeed the case, how does everyone in every category not rush to at best be the first, or for sure not be the last, in that category to adopt?
How much: For this, the easy answer is we’ll hear more in two weeks (on March 11). But the reality is, even it it’s a quarter of the $1 Billion/year we used to get to our $63 EPS, and even if that’s the total for global recycling of everything, not just plastic, and even if none of the other massive applications prove to have value, it’s enough.
Well, to be fair, it’s enough unless a network-effect-driven, government-mandated-with-massive-switching-costs (because of the network effect) business should only trade at 2x a couple years out fully-taxed EPS ($250 million-$40 million=$210 million, after tax and divided by 12 million shares is $13.65/share of EPS).
The March 11th CMD is going to be very interesting for a lot of reasons, and just based on the analysis of one application, there’s a strong reason to believe the stock might continue to price in upside ahead of it.
Because the toughest question I ask myself isn’t a bottom up one, but a top down one. “Can this stock really be so mis-priced, and the world asleep to such a game changing technology?”
And while it is a legitimate question (perhaps because it is, at least as far as I can tell, the ONLY question), the beauty of it is that we’ll have a part of that answer in 2 weeks (3/11), and the rest in 3 months (May decision of the Holy Grail Group).
And I just find it hard to believe, based on all the above, there isn’t a percentage of market participants who will say “I’m willing to place a small bet on the fact that yes, this is truly a massively misunderstood and thus mispriced opportunity,” if only because:
1) the time to knowing if they’re right is so close,
2) the downside risk at $30 or even substantially higher so low (as highlighted in my first two articles), and
3) perhaps most importantly, the upside in being right so large.
Disclosure: I am/we are long DMRC.