Earnings Call Transcript - ARQQ Q4 2022

Operator, Operator

Good day and welcome to Arqit's 2022 Fiscal Year Earnings Conference Call. On today's call, we will be referring to the 20-F and press release filed this morning that details the company's full fiscal year-end 2022 results, which can be downloaded from the company's website at arqit.uk. At the end of the company's prepared remarks, there will be a question-and-answer period for selected equity research analysts. Finally, a recording of the call will be available on the Investors section of the company's website later today. Please note that this webcast includes forward-looking statements, statements about the company's beliefs and expectations containing words such as may, will, could, believe, expect, anticipate, and similar expressions are forward-looking statements and are based on assumptions and beliefs as of today. The company encourages you to review the Safe Harbor statements, risk factors and other disclaimers contained in today's press release, as well as in the company's filings with the Securities and Exchange Commission, which identifies specific risk factors that may cause actual results or events to differ materially from those described in our forward-looking statements. The company does not undertake to publicly update or revise any forward-looking statements after this webcast. The company also notes that on this call, it may be discussing non-IFRS financial information. The company is providing that information as a supplement to information prepared in accordance with International Financial Reporting Standards or IFRS. You can find a reconciliation of these metrics to the company's reported IFRS results in the reconciliation tables provided in today's earnings release. And now, I'll turn the call over to David Williams, the company's Founder, Chairman and Chief Executive Officer. David?

David Williams, CEO

Hello and welcome to Arqit's fiscal year 2022 results conference call. Before discussing Arqit's performance, I would like to reflect for a moment on the recent passing of our Co-Founder, colleague and friend, Andrew Yeomans. Andrew was responsible for early foundational patents of Arqit. He was a person of great intelligence, ethics, and warmth, and he is daily missed. We will honor his life and achievements by seeking to fulfill the promise which he saw in Arqit. Promise is an appropriate word for Arqit's first full fiscal year of commercial operation. For the period ending September 30, 2022 we generated $20 million in revenue and other operating income, compared to $48,000 for the prior fiscal year. However, revenue generation alone does not paint the appropriate picture of the promise which we see for the business. Arqit has made great strides in our technology, business model, and go-to-market strategy, announcing this week three hyperscale channel partners which validate our technology and give us access to large global customer bases. As a result, we believe we have now built a pathway to success. In May of this year, the White House urged all organizations to prepare for the transition to post-quantum cryptography. Also in May, the National Security Agency stated that symmetric keys are the recommended solution. We believe Arqit is the only company in the world that can deliver zero-trust cloud-fulfilled symmetric key agreement at scale. Customers can now buy our product through three hyperscale channels: AWS, Dell, and Fortinet, along with other trusted partners. We're ready to deliver the requirements of the White House and others. I stated on Arqit's 2022 half-year earnings call that Arqit was improving its understanding of how customers want to consume the product. I also mentioned that the ease of implementation is a major purchasing decision factor. We've learned that end customers largely want to consume our product through products and services that are already part of their technology architecture, making it easier to implement. Arqit's go-to-market strategy focused initially on direct enterprise license sales, followed by the launch of a cloud-based platform-as-a-service. In time, we expect to generate channel strategies and market access through leading global technology partners. The assurance of our security, proven by the GCHQ accredited University of Surrey in May, accelerated interest in our products from leading technology vendors. Consequently, we reoriented most of our finite sales and marketing resources during the year toward developing these relationships. While this shift in resources detracted from realizing potential short-term enterprise license opportunities, we are delighted with the outcome. The integration of our symmetric key agreement software with the products of AWS, Dell, and Fortinet provides access to significant global sales and marketing resources and large existing customer bases. Today's announcement of the integration with the Fortinet Fortigate series of firewalls enables unbreakable quantum-safe encrypted connectivity between customer locations, safeguarding both data in transit and at rest. Fortinet has launched the integrated product for all global customers, and the joint proposition can be found on both companies' websites. Fortinet has consistently shipped more security appliances than any other vendor for nine consecutive years and reportedly has a greater than 35% market share. For end users, particularly the large existing Fortigate customer base, this makes the Arqit purchasing decision and the implementation of our software easy and seamless. For Fortinet, the integration of our product serves as a potential sales differentiator, which we hope will help them to drive unit growth and customer retention. For Arqit, the partnership provides us access to Fortinet's massive installed base and potential new customers, leveraging Fortinet's global sales organization, which is expected to result in annual recurring revenue. Similarly, Arqit and Amazon Web Services announced the integration of QuantumCloud with Amazon S3, a cloud-based object storage service. This integration will allow AWS customers to protect their data against current attacks and future quantum threats. AWS, being the largest global cloud service provider with a market share reportedly exceeding 30% of the $83 billion global market, makes this integration a significant opportunity for us to reach a very large customer base. It is poised to accelerate our customer reach, and joint marketing initiatives with AWS have commenced. Moreover, this week we announced a partnering agreement and a joint sales mission with Dell Technologies to integrate Arqit's product into a range of products available to the U.S. Defense Department and other customers. This solution will be available through the Dell order fulfillment system and is initially accessible via Dell's federal and technical teams. We're very excited about the immediate opportunity this partnership presents within the Defense Department and other Federal Department markets. We see additional broader opportunities with Dell across its global business activities. We believe that prioritizing and consummating these channel partner relationships is potentially transformational for Arqit. We expect these relationships to significantly accelerate our go-to-market strategy, bringing forward the timeline by several years for when we anticipate doing business with such fantastic hyperscale companies. Two additional important initiatives are gaining traction for us in 2022. We have recently signed a contract with TraxPay, a leader in supply chain financing solutions, to deliver quantum-safe digital finance instruments, enabling supply chain access for more efficient and secure business conduct. Financial institutions such as Deutsche Bank, DZ Bank, Nord LB trust TraxPay's financing solutions and maintain strategic partnerships with that company. Arqit's trade secure service utilizes distributed ledger technology secured by QuantumCloud to provide customers with referenceable digital promissory notes and digital bills of exchange, which are easier to manage than paper-based alternatives, unique, transferable, and variable. The adoption of digital assets in this market is being driven by the U.K. government's upcoming electronic trade documents bill, which will legalize electronic transferable documents. Other leading trade jurisdictions around the world are likely to adopt similar legislation. This opens up the potential $17 trillion global market in supply chain finance for digital assets. We believe Arqit is the only company in the world capable of complying with the requirements of this legislation, specifically that the digital asset must be tamper-proof. Only Arqit has published a security proof that demonstrates provable security. Without such proof, no digital asset can be described as tamper-proof. We believe that digital transformation in the financial services market is likely to accelerate at scale now, as banks experimenting with private ledger technology should take note of the importance of quantum security. We're very excited about the opportunity for digital transformation more broadly beyond trade finance. Finally, Arqit Software has been selected by prime contractors as part of the potential technology solution for two U.S. government programs of record. The contracts were expected to be signed and built during the fiscal year 2022, but billing has slipped into the current fiscal year. There are challenges in the U.S. government contracting market due to ongoing budget resolutions and international operational requirements. However, despite these challenges, we are delighted that months of effort by our commercial and technical teams have been rewarded with these important contracts. Participation in these programs of record is crucial validation of our technology and represents what we believe to be just the beginning of our opportunities within the United States and other government defense sectors. These contracts and our Dell channel partnership position us for potential future success in this significant marketplace. In addition to acceleration in our go-to-market strategy, innovation in our technology is influencing the financial profile of the company. We announced today, under a separate press release, that as a result of additional innovations, Arqit no longer requires satellite delivery of replicated randomness to data centers as part of the symmetric key agreement process at endpoints. Arqit developed a terrestrial method for delivering this replicated randomness to data centers some time ago. The security of encryption keys created on the endpoint using our lightweight software agent is as robust with the terrestrial method as with the satellite method. The security proof work we published earlier in the year satisfied us of this conclusion. Therefore, we determined that we do not require satellites and associated ground systems in the background of our technology stack. The implications of this are as follows. We've begun conversations to sell a partial or complete interest in our satellite system under construction to multiple parties. Some government clients are interested in on-premises control of key agreement for specific reasons, which includes a concept known as eavesdropper detection. We will continue to fund the construction of this asset until a sale agreement is reached. If the sale appears unlikely, we would discontinue construction. Arqit will not build further satellite infrastructure beyond this and intends to license its quantum satellite IP to subsequent customers with similar requirements. This will enable those customers to construct their own domestic sovereign systems, and we are observing demand for this offering. We expect these changes in our technology strategy will have a positive effect on future results, with some capitalized satellite costs recouped through planned sales of the satellite currently under construction. Additional revenues are anticipated through the licensing of our quantum satellite IP, alongside the elimination of future capital and operating expenditures associated with satellites as part of our core product offering. Arqit intends to continue performing under its satellite construction contract with the European Space Agency and recognizes income from related projects under that contract. We have recently completed a new security proof demonstrating that the satellite technology holds validated security, which has been shared with these new customers under NDA. These changes in our technology infrastructure are significant. We believe they simplify our business model by centering on selling our symmetric key agreement software platform-as-a-service. The benefits of moving away from hardware infrastructure are potentially significant from a financial perspective. The most important takeaway is that these benefits are achieved with no negative impact on the security of the keys created at endpoints by our software, and it removes operating expenses. It is now beyond doubt, that the world needs stronger and simpler encryption. We believe, and leading cryptographic experts corroborate, that Arqit's symmetric key agreement software delivers just that. The partnerships we have announced further validate our technology. However, our promise is not fulfilled merely by possessing superior technology and staff. Our promise is fulfilled by delivering our product to customers to secure their data. The acceleration of our go-to-market strategy presents Arqit a faster pathway to maximizing the opportunities that these partnerships represent. With that, let me turn the call over to Nick Pointon, our CFO, for a few remarks on our financials.

Nick Pointon, CFO

Thank you, David. We only commenced commercialization and began generating revenues late in the second half of our fiscal year 2021. Therefore, the comparison of our fiscal year 2022 results with the comparable period in fiscal year 2021 may not be meaningful across all financial metrics. For the 12-month period ended September 30, 2022, we generated $20 million in revenue and other operating income from new QuantumCloud contracts and other activities. Our QuantumCloud revenue totaled $7.2 million for the period produced by five contracts. The bulk of the QuantumCloud revenue came from contracts with Virgin Orbit and AUCloud. As David noted, the reorientation of much of our sales and marketing effort to realize our announced channel partner relationships impacted our direct enterprise license sales activity during the second half of our fiscal year. Other operating income for the fiscal year was $12.8 million, resulting from Arqit's ongoing project contract with the European Space Agency. Despite the announced shift in our technology strategy, we expect to continue to perform under our contract with ESA, realizing future other operating income. Our administrative expenses equate to operating costs for those more familiar with U.S. GAAP. During the period, our administrative expenses were $72.2 million compared to $14.6 million for fiscal year 2021. The significant increase in expenses reflects considerable post-NASDAQ listing growth in our operating infrastructure costs and personnel. Additionally, $22.9 million of the increase pertains to a non-cash charge for share-based compensation. Our employee base grew from 73 to 145 during the period. Since the end of the fiscal year, we have reviewed our budgeted headcount and operating cost growth for fiscal 2023 to align it with revenue and focus on our key partner initiatives. As a result, we have provisionally capped the fiscal year 2023 headcount at no more than 195 employees and have decreased non-employee budgeted costs by 8%. In total, we have reduced our budgeted costs for fiscal year 2023 by 18%. Furthermore, we will benefit from reallocating certain employees to support our key partner initiatives while deferring, reducing, or eliminating costs from less prioritized activities. Our operating loss for the fiscal year was $52.1 million compared to a loss of $172.6 million for fiscal year 2021. As a reminder, the operating loss for fiscal year 2021 included a $155.5 million reverse acquisition expense associated with our transaction with Centricus. We generated a profit before tax of $65.1 million. However, we reported an adjusted loss before tax of $52.3 million, which in management's view reflects the underlying business performance once the non-cash charge in warrant value is deducted from operating profit before tax. During the period, 1,852,736 warrants were exercised, generating cash proceeds to Arqit of $21.3 million. We closed the period with a cash balance of $49 million versus $87 million as of fiscal year-end 2021. Please note that we have filed today a universal shelf registration statement and an ATM prospectus supplement. These filings represent sound financial housekeeping, providing the company flexibility in corporate finance matters going forward. With that, I'll turn the call back to David.

David Williams, CEO

Thanks, Nick. The pioneering activities of our incredible team of engineers, innovators, and commercial officers in fiscal year 2022 have created a pathway to success. We have assurance that our product delivers as advertised. We better understand how customers want to consume our products, and now we have hyperscale channels through which to reach end-user customers. With this knowledge, we must now focus on the hard work of execution in 2023. We're pleased with all that we have accomplished in the fiscal year and are optimistic about our future. So I now hand the call back over to the operator for Q&A.

Operator, Operator

Our first question comes from Scott Buck with H.C. Wainwright. Your line is now open.

Scott Buck, Analyst

Hi, good morning guys. Thank you for taking my questions. David, the first one, how should we think about these channel partnerships converting to revenue?

David Williams, CEO

Hi, Scott. The Fortinet project is perhaps the easiest to understand. They are making our software available to their entire global customer base as an upgrade, which will cost each individual customer a single-digit percentage increase in the unit cost. Therefore, it becomes straightforward to model price times volume against the existing and future customer base of Fortinet. We will provide further details at our upcoming Capital Markets Day, which we hope to host soon. AWS is very similar; they have started joint marketing with a specific group of larger customers, and we can begin to assess likely penetration rates of those customer bases, making the price times volume metrics quite clear. We have indeed published our pricing on a British government cloud website, so for trade users of that portal, Arqit pricing is now public. Price times volume calculations are becoming easier to ascertain. These organizations have significant global reach, and we estimate penetration will be in the 20% to 30% range over the medium to long term, representing a substantial opportunity to fulfil our business plan without a significant increase in Arqit's direct sales and marketing costs. With customers like Dell, we are concentrating more on a smaller number of government and defense projects, but each of those projects comes with considerable funding. I've already mentioned that there are two programs of record we are currently pursuing, which we hope will generate substantial revenue this year. Once the product is certified and authorized by government clients, we expect to see fairly rapid adoption. Therefore, those defense customers will maintain an enterprise license orientation, while the ventures with AWS and Fortinet will be establishing a recurring revenue model. We are diligently working to sign a couple of additional hyperscale channel partners for similar arrangements.

Scott Buck, Analyst

Great. That's very helpful. I'm curious, what is the level of product education you've already provided the partners? And how should we think about how those sales channels begin to scale?

David Williams, CEO

Well, you can see the joint proposition now featured on Fortinet's website and within their partner portal. We've already been actively working over the last couple of months across various jurisdictions with Fortinet's sales staff, and we have a list of customers we are jointly targeting. Similarly, the Dell and AWS teams in different departments have been trained on the product, understand its function, and know how to sell it. Currently, presentations of this integration are being proposed actively within those customer bases. So, while there's still more education required for sales teams and distribution channels, that effort has begun in earnest, and we're starting to see positive prospects coming through the pipeline.

Scott Buck, Analyst

That's great. And is there any exclusivity arrangements in any of these partnership contracts that would meaningfully restrict your ability to sign additional channel partners?

David Williams, CEO

No, we've not entered into any exclusive partner conditions.

Scott Buck, Analyst

Okay. Great. And then I wanted to ask a bit about the work you're doing on the trade finance side, as obviously, that's a significant market. I'm curious, how far out are we from that becoming a meaningful revenue contributor?

David Williams, CEO

We expect our first revenues from that project during the current half year. We initially plan to fully launch around spring next year, pending the passage of legislation by a particular government, but we have already begun service planning due to one very large global partner who wishes to start using the product before the legislation is even passed. We haven't pitched that product to a single potential customer who said no yet. Every single one we approached has expressed interest. It has numerous advantages, not just in cybersecurity. The way the product is designed enhances cash flow for the vendor and reduces risk for the bank financing the invoice. It’s truly a win-win situation. Therefore, we expect some revenue to materialize certainly within the current fiscal year. This is a massive global market, so I am optimistic about our growth potential in that area. Additionally, we are already initiating discussions with other types of financial services organizations regarding employing this product in different financial sectors, such as insurance, for example. I am fully convinced that, despite recent challenges in the blockchain industry, the regulated financial services market is adopting digital assets at scale, and we are engaging in some very interesting discussions as financial institutions acknowledge the pressing need for quantum-safe technologies.

Scott Buck, Analyst

Now that makes a ton of sense. And then last one for me, David, any hesitancy you're seeing among potential customers just given the rising level of macro uncertainty?

David Williams, CEO

No, I don't detect any particular impact from macro uncertainty, aside from what I mentioned regarding the U.S. Defense Department, which is facing a continuing resolution that complicates budget creation and affects everyone to some extent. There are budget applications being applied that wouldn’t have been anticipated a year ago. However, what we observe is that every organization now understands the necessity to upgrade its encryption. We recently conducted surveys, and everyone we've spoken to recognizes the urgent need for improved encryption. This isn't just a mature market facing difficulties; we are starting from almost zero. Only in May did the White House require all organizations to prepare for cryptocurrency transformation. This market is poised to grow from a low starting point, and we expect it to accelerate rapidly. Thus, I don't see macroeconomic factors having a relevant effect for us.

Scott Buck, Analyst

Okay. Great. I appreciate your time this morning, guys. Thank you.

David Williams, CEO

Thanks.

Operator, Operator

Our next question comes from Nihal Choksi with Northland Capital Markets. Your line is now open.

Nihal Choksi, Analyst

Yes. Thank you for taking my call. So how long would Dell and AWS relationships have been active? Were they part of that $740 million pipeline a few months ago?

David Williams, CEO

Yes, good question. The initial relationships definitely began about 18 months ago. We certainly had hopes and expectations prior to entering the market that those projects would come to fruition. However, I must mention that engagement from these companies greatly accelerated following our publication of the security proof in April this year. We subsequently generated independent validation that uniquely amongst all global companies, Arqit Software produces zero-trust, provably secure keys. This validation, especially from an organization accredited by GCHQ, lent considerable credibility to our offering. Our associates at PA Consulting also conducted their own assessments. Thus, this level of independent validation, securely shared with these customers under NDA, has expedited our education process with them. As a result, I feel optimistic that we will have several large corporations signing up to utilize our products throughout the current financial year. Yes, those companies were included in our pipeline from the outset, but their engagement has indeed accelerated significantly over the last six months.

Nihal Choksi, Analyst

Understood. Were they part of that $740 million pipeline indicated during the recent roadshow?

David Williams, CEO

Yes, all those companies were certainly included in that pipeline of companies with whom we aspire to do business and expect to generate revenue.

Nihal Choksi, Analyst

Understood. Has your understanding of the value of that pipeline for each of those partners shifted since stating the initial $740 million pipeline?

David Williams, CEO

Yes, it has indeed. We've engaged with those companies in-depth over the past few months concerning the nature of the opportunities available. We have developed specific pricing and have a clearer understanding of the probable volume of trade with those companies. For instance, Fortinet has an extensive installed base, and we have gained access to strategic planning discussions with partners like Fortinet about which customers are likely to be interested in purchasing the product, alongside knowledge of pricing. Therefore, we can now build our projections for price times volume and penetration based on actual insights from our partnership discussions rather than on assumptions. I now feel I possess a more comprehensive view of our medium-term business prospects and greater confidence as a result.

Nihal Choksi, Analyst

Got it. Breaking down that price times volume equation with the greater detail and confidence you have now, how has that pricing changed since 13 months ago, and how has volume changed since about 15 months ago?

David Williams, CEO

Well, if we look back about a year and a half ago, we initially projected selling enterprise licenses at fixed prices. At that point, we weren't equipped to produce an annual recurring revenue-focused price, since we lacked the information required. In my view, and this sentiment is widely understood, an ARR revenue model is advantageous for a company like Arqit. It is indeed preferable to have an ARR-style of business rather than enterprise licenses. When you offer fixed enterprise licenses, you often end up giving away too much for a modest return. We anticipated that we would be engaged in that type of arrangement for a couple of years because we didn't expect to successfully partner with hyperscale channel vendors. However, the ARR framework for our product sold to a vast customer base is likely to yield better financial outcomes in the medium to long term than enterprise licenses would. Consequently, this feels like an acceleration of our go-to-market strategy, and my confidence in this regard has much improved.

Nihal Choksi, Analyst

Great. So you mentioned $7 million in QuantumCloud for the fiscal year 2022. What is that expected to translate to in ARR for the same fiscal year?

David Williams, CEO

We haven't published that number, so I'm afraid I can't provide that figure. We will try to offer more granularity at our Capital Markets Day, which we are looking to organize early in the new year.

Nihal Choksi, Analyst

Got it. Okay. And what do you expect Arqit needs to do beyond educating partners' sales teams to drive customers of Dell, AWS, and Fortinet to adopt the Arqit Solution? What more will Arqit be doing beyond that sales team education?

David Williams, CEO

In many cases, we are involved in direct bids to larger organizations alongside those companies. This means visiting those large organizations perhaps with our own technical experts to educate the end customers. This approach typically results in substantial contract sizes. However, primarily for the ARR type of revenue business, supporting the channel is crucial. This involves, and I personally have been traveling to six countries over the last six weeks, engaging with clients, participating in large events, conferences, and exhibitions where our partners are presenting and educating. Additionally, we must ensure that all distribution channels of these hyperscale vendors are well-informed. Therefore, it's about supporting the channels with marketing material, white papers, information, and research. Ensuring we have salespeople on the ground who can address inquiries is also vital. We have now deployed sales personnel in Australia, Singapore, the Middle East, several jurisdictions in Europe, and North America. These salespeople typically support the key account managers of those large vendors as needed. Ultimately, for Fortinet and AWS in particular, this is a cloud-fulfilled sale. Customers simply need to purchase the product through the marketplace, select their options, process payment, and acquire the software. Thus, there is essential channel management, and while sales team education is necessary, we expect that as time goes on, revenue generation will be driven primarily through straightforward online fulfillment.

Nihal Choksi, Analyst

Got it. A couple more quick questions here. Just to revisit the $7 million in QuantumCloud revenue, is that all expected to be subscription revenue, or do some of those contracts also include perpetual enterprise licenses?

David Williams, CEO

It's primarily enterprise license revenue. Some of those licenses we are expecting to renew and to expand.

Nihal Choksi, Analyst

Okay, so just to clarify, when you mention enterprise license revenue, is that typically term-based, or is it a perpetual arrangement?

David Williams, CEO

Yes, typically enterprise licenses are term-based. However, what we often see is that an enterprise license for some customers will begin with a narrowly defined usage range. For example, one might state that the enterprise license grants rights to use the service within a specific market segment and for a limited number of endpoint devices and keys. As the customer expands their utilization, they may need to purchase more.

Nihal Choksi, Analyst

Yes, got it. Finally, regarding the $50 million ATM you announced this morning, what share price range do you expect to utilize it, and what is your current cash burn rate?

David Williams, CEO

We don't anticipate utilizing the ATM anytime soon. I don't believe we included any statistics in that document; that was part of a plan initiated by our bank when we conducted our SPAC. It was anticipated that this would be an ordinary course of business process to pursue. Thus, we haven't given this much further thought.

Nihal Choksi, Analyst

And regarding the cash burn rate?

David Williams, CEO

That's not a published statistic. I'm unsure if I can provide you with any further granularity on that.

Nihal Choksi, Analyst

Okay, great. Thank you. Congratulations on these partnerships you have announced; they are indeed significant.

David Williams, CEO

Thanks for your questions, Nihal. We appreciate your engagement.

Operator, Operator

We have no further questions at this time. Now, I will turn the call back over to David Williams for closing remarks. David?

David Williams, CEO

Thank you. It's been a very interesting year in which our business model has developed technically and commercially far beyond our initial expectations. We look forward to engaging with our investors and analysts again in 2023 and appreciate your interest and support as fellow shareholders. Thank you.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.