Innodata Inc Q3 FY2024 Earnings Call

Good day, everyone, and welcome to the Innodata Third Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the question-and-answer session. This call may be recorded. It is now my pleasure to turn the conference over to Amy Agress. Please go ahead.

Thank you, Nicky. Good afternoon, everyone. Thank you for joining us today. Our speakers today are Jack Abuhoff, CEO of Innodata, and Marissa Espineli, Interim CFO. Also on the call today is Aneesh Pendharkar, Senior Vice President, Finance and Corporate Development. We'll hear from Jack first, who will provide perspective about the business, and then Marissa will follow with the review of our results for the third quarter. Before we get started, I'd like to remind everyone that during this call, we will be making forward-looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations, assumptions and estimates and are subject to risks and uncertainties. Actual results could differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's earnings press release in the Risk Factor section of our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We undertake no obligation to update forward-looking information. In addition, during this call, we may discuss certain non-GAAP financial measures. In our SEC filings, which are posted on our website, you will find additional disclosures regarding non-GAAP financial measures, including reconciliation of these measures with comparable GAAP measures. Thank you. I will now turn the call over to Jack.

Thank you, Amy, and hello, everyone. The third quarter marked another leap forward for Innodata. We delivered record revenue of $52 million, representing a 136% year-over-year increase in organic growth. Adjusted EBITDA was $13.9 million, or 27% of revenue, which was 5 times our adjusted EBITDA in Q2. Our cash reserves increased to $26.4 million, up by $10 million from last quarter. We're very pleased with our results this quarter, and as a result of strong business momentum, we are raising our 2024 full-year revenue guidance. We now anticipate revenues between $52 million and $55 million in Q4, which, if achieved, would translate to between 88% and 92% year-over-year growth for the full year 2024. Our strong business momentum is reflected in revenue growth, margin expansion, broadening customer relationships, and continuing progress on our strategic roadmap. We are laser-focused on providing Big Tech companies with the data engineering they require to develop generative AI frontier models. We believe our efforts are paying off. In the third quarter, we generated $30.6 million of revenue from just one of our Big Tech customers. Previously, we estimated that the programs and expansions we had won with this customer would result in approximately $110.5 million of annualized run rate revenue once fully ramped, which implies obtaining $27.6 million in quarterly revenue once fully ramped. We are pleased to find that revenue received in Q3 from this Big Tech customer exceeded this estimate. We have seven other Big Tech customers as well, and we believe they will collectively become a significant part of our revenue makeup next year. They are all investing aggressively in generative AI. These seven other Big Techs include a prominent social media platform that we won in Q3. Like the other Big Techs, they are building their own traditional and generative AI models and leveraging Innodata for data engineering. We had mentioned last quarter that we expected this company would sign with us, and we're excited to report that they indeed have. We believe the initial value of the one engagement to be approximately $3 million in annualized run rate revenue at full ramp. Our confidence that these seven other Big Tech customers will collectively become a significant part of our revenue makeup next year is bolstered by the progress we made this quarter in building relationships, expanding work, securing new wins, gaining traction, and earning trust. The number of projects and pilots we have underway with these customers significantly increased in Q3 and are expected to increase in Q4. This includes several pilots running now which hold the promise potentially of 7 or even 8-figure wins. Last quarter, we also spoke about our pursuit of an agreement with an existing customer to colocate our staff at their sites. As we've reported, we've signed this agreement and we expect our resources to transition to working at one of their sites as early as next week. We believe colocating on customer sites positions us to further build trust and expand our collaborative relationship with customers as we look to capitalize on opportunities together. Additionally, last quarter, with another one of our Big Tech customers, we won new engagements projected to result in approximately $3 million in revenue based on our customer's projections. This followed the successful execution of two smaller projects. We are pleased to see the relationship growing and we're in discussions with them on potentially other significant opportunities. In our last call, we also mentioned the possibility of engaging with another Big Tech company, which is one of the most valuable companies in the world and one of the companies most often talked about in connection with generative AI. Based on discussions, we now anticipate getting a pilot off the ground with this company in the next several months. We're also pleased to announce that in the third quarter, we had our second win with the federal government, a deal to provide news briefs and media monitoring to a second federal government agency. Similar to our agreement with the first government agency that we signed last quarter, this new agreement will leverage the generative AI capabilities we have built into our Agility platform. We are seeking to expand further into the public sector, and these federal sector wins are validating the success of that strategy. Now let me talk a bit more about our go-forward strategy and opportunities for growth. Our strategy encompasses both services and platforms. On the services side, we intend to be a go-to partner for Big Techs that are building generative AI frontier models and enterprises that seek to transform their products and operations with generative AI technologies. We believe these are lucrative markets, which we are well-positioned to serve. On the platform side, we are utilizing our B2B industry platforms and enterprise platforms that leverage generative AI and traditional AI for particular niche use cases. McKinsey recently released research showing six distinct opportunities in the generative AI value chain, ranking services and applications as two of the three most attractive opportunities. The first focus area is Big Tech. We believe we are still in the early days for Big Tech in their generative AI investments. Recent disclosures indicate that these companies are seeing their generative AI investments yielding business benefits by enhancing current products and providing optionality for future growth and new products. Several of the Big Techs have signaled increased generative AI investment in 2025. A report issued this past Monday by Morgan Stanley predicted combined CapEx for Amazon, Google, Meta, and Microsoft reaching approximately $300 billion in 2025 and $337 billion in 2026 as they continue to invest in multiyear generative AI and large language model-enabled opportunities. A significant component of this investment is training data, with Big Techs requiring two types of data for training large language models: pre-training data, which is historically scraped from the web, and supervised fine-tuning data, which is purpose-built by humans. Most of the work we do for the Big Techs involves creating supervised fine-tuning data, which consists of instruction-tuning data, sometimes called demonstration data, and RLHF, or Reinforcement Learning from Human Feedback. You can think of instruction-tuning data as the data that teaches models to think, respond to user prompts, follow user direction, and perform complex reasoning. It is data we create specifically for them; it is not web data or third-party data. We anticipate over the next several years, Big Techs will require progressively more complex demonstration data to support foreign languages, long context understanding, multimodality, industry-specific models, and agentic capabilities. Models perform better with supervision, and fine-tuning data must be high quality, large scale, highly consistent, and diverse. We believe Innodata will be at the forefront regarding this data. In addition to supplying supervised fine-tuning data, we are increasingly identifying opportunities to source and transform pre-training data. The current models mostly rely on scraped data, which may become problematic for two reasons: IP-related issues around unlicensed third-party data with sparse legal precedent, and the potential for training new AI models with data produced by AI models, leading to model collapse. We are also finding expanded opportunities in LLM safety and evaluation, with six engagements currently. We're leveraging insights from these engagements into a new platform currently under development. In past months, we've demonstrated a prototype of our new platform to three of our Big Tech customers and several enterprises, and it has received positive feedback. Our second focus area is enterprise services. For enterprises, our strategy is to provide a range of services to help businesses adopt enterprise generative AI. Our focus will be on integration and customization, providing strategic consulting services, AI services, digital services, and managed services - all necessary for IT teams and business units to transition from legacy systems to AI-first solutions. We believe enterprise generative AI investment is in its early days, and companies are on the brink of significantly increasing their investments. Lastly, our third focus area is enterprise platforms. We're developing B2B industry applications and enterprise applications for niche workflows where human judgment interacts with unstructured data. Agility, for example, has shown 26% year-over-year growth this quarter alongside an acceleration in new bookings. Before I pass the call to Marissa, I want to highlight the considerable progress we've made this year in developing a strong company culture and attracting talent across key areas. We believe this work has enabled us to scale and exceed the expectations of some of the most demanding and fast-moving companies worldwide. This year, we've made several senior-level hires across delivery, technology, solutioning, pre-sales, recruiting, and sales and marketing. We plan to make additional strategic hires in Q4 and early 2025. In terms of brand-building, we've been certified by Great Place To Work for the second consecutive year, as well as being recognized as Most Preferred Workplace and Most Preferred Workplace for Women by Team Marksmen. We're honored to have received the 2024 Asia Best Employer Brand Award and the 2024 Asian Leaders Award. We've also earned the 2024 Trailblazer Excellence Award for innovative contributions to the IT business process management industry concerning employee engagement, satisfaction, culture, development, and recognition. Two of our country managers received awards for their exemplary leadership. Additionally, National Awards for Excellence have recognized us as a Best Organization to Work For and awarded us for environmental responsibility, women's empowerment initiatives, and corporate social responsibility initiatives. I'll now turn the call over to Marissa to review the financial results, after which Marissa, Aneesh, and I will be available to take questions from analysts.

Thank you, Jack and good afternoon, everyone. Revenue for Q3 2024 reached $52.2 million, reflecting a year-over-year increase of 136% and 83% on a year-to-date basis. On a sequential basis, we observed a 60% increase of $19.7 million from Q2 2024 revenue of $32.6 million. Adjusted gross margin for Q3 2024 was 44%, reflecting a sequential increase from the 33% we achieved in Q2 2024. The comparatively higher gross margin in Q3 was due to incurring $3.6 million in recruiting costs in the second quarter, to support a substantial expansion of our organization and prepare for a significantly larger revenue base. Excluding the unusually high recruiting costs in Q2, the adjusted gross margin in the second quarter would have been approximately 44%, consistent with the third quarter. In Q3, these recruiting costs came down significantly to $500,000. Adjusted EBITDA for the third quarter was $13.9 million, or 27% of revenue, up from $3.2 million year-over-year and approximately 5 times last quarter's adjusted EBITDA. Net income was $17.4 million in the third quarter, up from $371,000 in the same period last year and $0 last quarter. Our third-quarter net income was benefited by $5.6 million as a result of recognizing a deferred tax asset related to our accumulated net operating losses, or NOLCO, and other deferred expenses from prior periods. Our cash position at the end of Q3 was approximately $26.4 million, up from $16.5 million at the end of Q2 and up from $13.8 million at year-end 2023. In the third quarter, we did not draw down our $30 million Wells Fargo credit facility. The amount drawable under this facility at any point in time is determined based on a borrowing base formula. On our last earnings call, we reported filing a universal registration statement on Form S-3 with the SEC. On October 10, 2024, the SEC declared the registration statement effective, giving us the flexibility to sell up to an aggregate of $50 million worth of our security in registered offerings. However, at this time, we have no specific plan to raise money. Lastly, as Jack mentioned, we are raising our 2024 full-year revenue guidance. We now anticipate revenues between $52 million and $55 million in Q4, which, if achieved, would translate to between 88% and 92% year-over-year growth for the full year 2024. Thank you, everyone, for joining us today. Nicky, please open the line for questions.

And we'll take our first question from George Sutton with Craig-Hallum.

Jack, obviously, an outstanding quarter. Congratulations. So I was thrilled with the results in the quarter, but frankly, even more thrilled with the ability to guide for the same revenue in Q4, which is obviously suggestive of both your largest customer staying very large. But I wondered if you could just give us deltas quarter-over-quarter as you think through the composition of the equivalent revenue growth in Q4.

I'm sorry, here. Well, first of all, welcome to the call. Thank you very much. Maybe you could just restate the question a little bit for me. I wasn't quite following what you're looking for.

You're guiding to Q4 revenues equivalent to Q3.

Yes.

Q3 was historic. So I just want to make sure I understood what kind of deltas we should anticipate within that number from Q3 to Q4? Is it the large customer taking the same amount? Is it new customers coming in with initial programs, which ultimately could give us some upside potential? Just trying to get a sense of the delta.

Got it. Okay. Thank you. So I think that obviously, there are a lot of moving pieces. What we're very enthusiastic about is, first, with our largest customer, we see them continuing. We see the opportunity for them to grow and expand in 2025, actually. As we look over Q4 and next year, what we see is a lot of momentum, and we've seen that momentum in Q3. We see that momentum continuing in Q4. We measure that momentum in terms of relationships, trust, but also in terms of expansions, pilots, new wins, and traction. We're confident in saying that we believe now that that group of companies is collectively going to become a very significant part of our revenue makeup next year. In terms of Q4, we think that we'll start to see that, but we believe that it will become even more prominent in 2025 and help us drive continued growth.

So a question as I read through the large GPU users for training models, what they're talking about is, yes, we're spending billions on GPUs, but what we need to spend more on is the ability to create new use cases for the AI. And the way we do that is we have to train the data. That's the data engineering part of that. That is exactly what you do, correct? So I just want to be clear when we read these transcripts of some of the players in the space, making these very eloquent logical reasoning why they're spending so much now on data, I believe that's exactly what is benefiting you, correct?

That's exactly right. The key focus for us in developing these capabilities lies in supervised fine-tuning data. When considering compute and algorithms, along with data as essential components for the models, we believe data is the most critical element for achieving high performance and developing use cases. Observing the trends in data and the necessity for training in domain specificity, multimodality, more complex reasoning, and agentic capabilities, it all points back to data. We are very excited about this and are engaged in significant internal efforts to prepare for these requirements, including extensive experimentation. This process will continue into the next year, and we believe we are well-positioned to adapt to our clients' evolving needs.

Super. I'll turn it over to others who can come up with other adjectives for the quarter.

Our next question comes from Allen Klee with Maxim Group LLC.

Congratulations on a strong quarter. You mentioned that your recruiting costs have decreased. Can you discuss your direct costs? Do you believe they are at an appropriate level now, or is there a possibility that they might increase at a different rate than revenues?

Sure. First, welcome to the call, Allen, and thank you for joining. I believe that recruiting costs will depend on what we anticipate in the future. However, we are aiming to reduce those costs by building robust internal recruiting capabilities, which help us significantly lower the unit cost of recruiting. In the last quarter, our recruiting costs were $0.5 million, while we expected them to be $300,000 due to the anticipated growth, so we were satisfied with the $500,000 figure. Moving forward, I think it will respond to our observations, influenced by our internal efforts.

One thing that caught my attention is that when I examined your operating expenses year-over-year, excluding direct costs, it increased only by 33% while your revenues grew significantly more. This indicates strong operating leverage. Given that you are growing, you'll need to increase spending. How do you feel about your ability to maintain operating leverage with your expenses?

Yes, I believe we will continue to experience strong operating leverage. In the last quarter, our revenue increased by $19 million sequentially. When adjusting for recruiting costs from Q2 and Q3, our adjusted EBITDA improved by approximately $8 million, indicating a flow-through rate of about 41%, which is impressive. The Big Tech market is appealing not only because of the spending and projected capital expenditures but also due to its operational efficiency in terms of market engagement. While it's essential to build and maintain relationships, a large sales team isn't necessary; instead, we need skilled talent. I see this as a key driver moving forward. As we prepare for 2025, we're focused on leveraging our current position and planning for the future. We have an exciting plan for 2025, supported by a talented and energetic team. We will introduce our strategy at a global offsite in Athens in January. We're thinking innovatively about our next steps. We’ve made important hires, including a leading Ph.D. in AI and machine learning, who will play a crucial role in our future. We are optimistic that some of the most exciting developments in the coming year might be those we've yet to discuss. We are aiming for a highly efficient model that provides operating leverage and allows for strategic growth.

And then, I mean, two key factors for your growth are just the demand outlook, which I believe is going to definitely be there. And then also critical is that you keep the quality of what you're doing to win business competitively. Can you talk a little about what you've done and will be doing to ensure the quality of your offerings remains top-notch?

Sure. There’s no single factor that’s more critical than data quality. We’ve established a lot of processes and capabilities in driving quality and consistency that have historically benefited the largest information providers and are now aiding Big Tech companies. Next to data quality, agility is paramount – the ability to collaborate with engineering teams and adapt to their evolving needs as models are tested and retested. We have the relationships and capabilities in data quality, as well as agility, and we are optimistic about our growing momentum with all Big Tech customers as we look ahead to 2025.

That's great. My last question is on Agility. Good growth there. Could you talk about some of the initiatives you have going on?

On the Agility side, we're all-in on generative AI. We’ve integrated technology across our workflow spanning from identifying prospects for distributing news all the way through to analytics. We've infused generative AI technology seamlessly and effectively, leading to an increase in our win rate and market share. Analysts are now rating us extraordinarily high in terms of AI integration and across other criteria as well. We are excited about the direction this business is headed.

Our next question comes from John Katsingris with Wedbush.

Congrats again on a great quarter. So looking into recent federal wins and contrasting that to the enterprise opportunities you guys are executing, what do these engagements mean for Innodata's broader strategy? And how can we view the relationship between the two longer term?

Great question. The recent federal work, particularly related to the Agility side, delivers immediate value to the agencies we work with. We've got a lot of distinct capabilities and believe we can expand the federal market's importance. While we're not expecting this sector to substantially contribute in 2025, we plan to make inroads, which likely will contribute as we move forward. The federal government is making significant technological investments and is expected to increase their focus on this sector, and it's our goal to navigate this space and build our business there.

Our next question comes from Hamed Khorsand with BWS Financial.

My question was, how have you been in conversations with your other large tech companies as far as scaling as fast as you can, like your largest customer?

So a few things we see there. We observe that all these customers have significant spending intentions and ambitions. We compete with similar companies for their business. We're optimistic that the strategies executed for our largest customer will resonate similarly with these others. We note positive momentum in the metrics we track, like relationships built on trust, expansions, and new wins. We are confident that these companies will become significant revenue contributors next year.

And we show no further questions at this time. I will turn the call back to Jack Abuhoff for closing comments.

Great. Thank you. We're thrilled with our results this quarter. We've never felt more excited about our business and our ability to execute our strategy with the current market opportunities that we're seeing. We believe generative AI is a transformative technology still in its earliest stages, and that high-quality training data will be crucial to high-performing frontier models of the future. We believe we are and will continue to be ideally suited to support Big Tech companies building these models and enterprises adopting them. Thank you all for participating in the call today. Q3 was a record quarter, and we are proud of our accomplishments, but equally excited about where we are headed. Thank you.

Thank you. This concludes today's program. Thank you for your participation, and you may disconnect at any time.