CS Disco, Inc. Q1 FY2023 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to CS Disco's First Quarter and Fiscal Year 2023 Conference Call. At this time, all participants are in a listen-only mode. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. I would now like to hand the conference over to your first speaker today, Aleksey Lakchakov, Investor Relations. Please go ahead.

Good afternoon, and thank you for joining us on today's conference call to discuss the financial results for Disco's first quarter of 2023. With me on today's call are Kiwi Camara, Disco's Founder and Chief Executive Officer, and Michael Lafair, Disco's Chief Financial Officer. Today's call will include forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, including, but not limited to statements regarding our financial outlook, and future performance, our future capital expenditures, our market opportunity and market position, product strategy, and growth opportunities and developments in the legal technology industry. In addition to our prepared remarks, our earnings press release, SEC filings, and a replay of today's call can be found on our Investor Relations website. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results, performance, or achievements to be materially different from those expressed or implied by the forward-looking statements. Information on factors that could affect the company's financial results is included in its filings with the SEC from time to time, including the section titled Risk Factors in the company's quarterly report on Form 10-Q for the quarter ended March 31, 2023, filed with the SEC on May 10, 2023, and the company's Annual Report on Form 10-K for the year ended December 31, 2022, filed with the SEC on February 24, 2023. In addition, during today's call, we will discuss non-GAAP financial measures. These non-GAAP financial measures are in addition to and not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A reconciliation between GAAP and non-GAAP financial measures and a discussion of the limitations of using non-GAAP measures versus their closest GAAP equivalents is available in our earnings release. And with that, I'd like to turn the call over to Kiwi.

Thanks, Aleksey. Good afternoon everyone, and welcome to our earnings call for the first quarter of fiscal year 2023. Revenue for Q1 2023 was $33.1 million. Adjusted EBITDA was negative $13 million and total customer count grew to 1,388. Revenue was above the high end of our guidance range and adjusted EBITDA significantly exceeded our guidance range. We have made steady progress on the operational changes that we expect will lead to profitability, including the launch of our new office in Delhi. As Michael will share in more detail, this has allowed us to improve our adjusted EBITDA outlook for this year and pull forward our anticipated timeline for achieving positive adjusted EBITDA from Q4 2024 to Q3 2024. Q1 was a very exciting quarter for us from both the product and the sales and marketing perspective. First, let's talk about product. We are huge believers in AI at Disco. Recent advances in large language models as well as important advances in technologies like vector search represent, in my opinion, the most important technology development since the mass adoption of the internet in the 90s. These technologies, which AI Labs throughout the world have been working on for years, are finally ready to be incorporated into products that can deliver real value to everyday users. In Q1, we introduced Cecilia, an integrated AI chatbot for large scale Ediscovery. Cecilia will allow lawyers to ask natural language questions and receive narrative answers based on information in the documents in a customer's private Disco Ediscovery database. To support her answers, Cecilia will provide citations to documents in the database, allowing lawyers to verify her responses, cite evidence in support of them, and use the documents as a starting point for further investigation. Cecilia is differentiated by her ability to answer questions based on private data rather than the public internet or public corporate documents. To do so at Ediscovery scale in databases that may involve millions or tens of millions of documents, to cite evidence in support of her answers, and to do all this while being integrated into a secure platform that lets lawyers do other legal work. We launched Cecilia at Legalweek in New York and allowed customers and prospects to begin testing her. At these initial demonstrations and in conversations with our top customers, we are hearing fantastic feedback. Lawyers immediately see the power of Cecilia to accelerate the process of understanding the facts and finding evidence in legal disputes and investigations. I would have loved to have had Cecilia help me on cases when I was a practicing attorney. We anticipate that Cecilia will be generally available in 2023 after an initial staged rollout. We will provide further information on pricing at that time as well. Cecilia is both the first step in our productization of modern AI technologies and a continuation of Disco's investment in AI that dates back almost to our founding. I am often asked about Disco AI and the direction we are going. Disco AI is a collection of technologies that is fully embedded in our platform and that is productized to allow lawyers to seamlessly use AI in the course of legal work. Disco AI powers predicted tags that help lawyers identify documents related to particular legal issues. Our predicted tags technology predicts how a lawyer would tag a document based on how lawyers have tagged other documents in the past. For every document, predicted tags generate scores for each tag that indicate how likely Disco AI believes the document is to be tagged a certain way. Users can search by these scores to find documents that are likely to be what they’re looking for. They can incorporate predicted tag scores as part of more complicated searches in filters and search visualization. Predicted tags can help them review documents more quickly by telling them what to look for in a document. They can be used to sort documents for review, ensuring that lawyers are looking at more of the important documents per unit time and finding more of the important documents more quickly. Predicted tags can also provide real-time quality control on human reviews, identifying areas where human reviewers disagree with Disco AI’s recommendation. Disco AI also powers topic clustering with automatic indexing, which can take millions of documents and organize them by relevant topics, which allows lawyers to understand what topics are covered by documents in a database before beginning a review. Disco AI also powers cross-matter AI, which allows lawyers to use models trained on earlier matters on new matters. This allows lawyers and ultimately their clients to leverage the work they invested in prior matters to accelerate review on new matters that involve similar facts or legal issues. When we think about Disco’s product roadmap, we consider modern AI technologies unlocking features in four areas: question answering, document analysis, drafting and document generation, and providing a natural language user interface for Disco’s platform, allowing users to simply ask the computer to perform specific tasks. Our ability to take modern AI and integrate it into a broad platform where lawyers already do their work represents a material advantage for Disco relative to pure-play AI companies. To be clear, these are ideas for future product development, not product features that we have today. But we believe this framework can help you understand how we are thinking about productizing modern AI technologies into our platform and give you insight into why we believe these technologies will be impactful in accelerating and automating legal work and improving the experience of practicing law for our customers. Artificial intelligence is not the only element of our platform we are excited to discuss. This quarter we also announced the release of Timelines in Case Builder. Timelines allows lawyers to collaboratively create events and facts, link them to depositions, documents, and other evidence, and assemble them into timelines and chronologies that the legal team uses to understand, develop, and present their case. Our customers have been asking for the capability that Timelines provides for some time and we are very pleased to bring it to market. Operationally, we are continuing our push to globalize with the opening of our new office in Delhi. Through our India presence, we will be able to provide 24/7 customer service and support to our customers worldwide and continue to scale out other business functions like engineering. This team will augment our existing team of Discovians in North America and Europe and will be a tailwind on our path to profitability. With that, I will turn it over to Michael.

Thank you, Kiwi. In Q1 2023, revenue was $33.1 million, a decline of 4% year-over-year. The year-over-year decline in the quarter is attributable to the smaller matters we saw in the review business. Our gross margin in Q1 was 76%, up from 74% in Q1 of the prior year. As we mentioned before, our gross margins fluctuate from period to period based on customers' usage. Sales and marketing expense for Q1 was $17.5 million or 53% of revenue compared to 45% of revenue in Q1 of the prior year. This represents an increase of approximately $1.9 million in the quarter year-on-year. Research and development expense for Q1 was $13.1 million or 39% of revenue, compared to 32% of revenue in Q1 of the prior year. General and administrative expense in Q1 was $8.6 million or 26% of revenue compared to 22% of revenue in Q1 of the prior year. Operating loss in Q1 was $14 million, representing a margin of negative 42% compared to negative 25% in Q1 of the prior year. Adjusted EBITDA was negative $13 million in Q1, a margin of negative 39% compared to a margin of negative 23% in Q1 of the prior year. Net loss in Q1 was $12.1 million or negative 37% of revenue compared to a net loss of $8.6 million or negative 25% of revenue in Q1 of the prior year. We ended Q1 with $187.6 million in cash and cash equivalents. Operating cash flow for Q1 was negative $14.8 million compared to negative $11.4 million in the prior year. On May 9, we took cost-cutting actions that impacted a number of employees across all departments. Now turning to the outlook. For Q2 2023, we are providing revenue guidance in the range of $31 million to $33 million and adjusted EBITDA guidance in the range of negative $12 million to negative $10 million. For fiscal year 2023, we are reiterating our prior revenue guidance of $135 million to $145 million and raising our adjusted EBITDA guidance from negative $42 million to negative $38 million to negative $40 million to negative $36 million. Our target for Q4 2023 is an adjusted EBITDA margin in the negative teens. Additionally, we are pulling forward our path to profitability timeline by one quarter. We now expect to be adjusted EBITDA positive in Q3 of 2024.

We will now begin the question-and-answer session. Your first question comes from the line of Koji Ikeda with Bank of America. Please go ahead.

Hey guys. Thanks for taking the questions. Maybe a question for Kiwi or Mike. I wanted to focus on this AI opportunity here. How do you think about Cecilia and these other AI tools as potential TAM expanders? Specifically, how could they lead to less data needing to be ingested onto the platform?

It’s a great question. I think we’re in the early days of understanding what the technology is going to do to different categories of spend. There are areas where the use of AI will be deflationary, for example, in our core review business. The AI that we’ve integrated into our products has already been deflationary in the review business, allowing us to deliver significant savings to customers who switch from traditional review methods to AI-powered review. Moving forward, we’ll see categories of legal work that may reduce spend through increased efficiency, while also expanding the market for legal services because there will be more possibilities using these AI technologies. Consider compliance for instance—companies that deal with large amounts of data from emails and documents can replace traditional audit processes with AI systems that can provide actionable insights, benefiting both legal and compliance departments. We think AI will create value while also streamlining legal processes.

Got it. Thank you Kiwi for that. And just a follow-up for Michael. In your remarks, you mentioned adjustments in operations leading to higher adjusted EBITDA outlook. Could you elaborate?

The higher adjusted EBITDA outlook is related to the May 9 commitment to reduce our workforce, representing about 47 employees and roughly 8% of our global workforce. You’ll see more details about this in the upcoming filings, but that’s tied to pulling our guidance forward.

Your next question comes from the line of Tyler Radke with Citigroup. Please go ahead.

I wanted to piggyback on that last question. Kiwi, which of the AI functionalities are your customers asking about the most? Which do you think provides the biggest opportunity for revenue uplift?

We’re currently seeing increased interest in generative AI functionalities, particularly in question answering and document generation. When asking customers about their interest in AI tools, they often express excitement about both question answering, as seen with Cecilia, and document generation. I believe there are remarkable opportunities to build products in all four AI categories we discussed. In particular, Cecilia allows clients to ask questions in natural language and receive accurate answers from vast private databases. It is a game-changer, and we’re excited about the potential impact on our customers’ practices.

Thanks very much. That’s really helpful. And maybe one for Michael. The Q2 guidance projects continued year-over-year revenue declines. How are you anticipating the back half of the year with uplift from Cecilia and AI capabilities?

Cecilia and the new technologies are generally not factored into our guidance for 2023. While they hold great potential, we're not counting on them for this year’s revenue growth. We're seeing some positive signs in our pipeline metrics that we believe will manifest as revenue growth soon, but we need that to translate into concrete outcomes, particularly in the back half of the year.

Your next question comes from the line of Jackson Ader with SVB. Please go ahead.

Kiwi, regarding the large customers you mentioned reducing their usage, are they turning to other providers or just reducing the amount of work with Disco?

There may be exceptions, but we’re primarily seeing large customers reduce usage on our platform rather than defecting to competitors. They are finding ways to minimize costs while still operating within existing legal matters. This includes carefully managing data and optimizing workflows to reduce overall expenses without sacrificing effectiveness. While our larger customers are being cautious, we believe Disco remains an invaluable resource for them.

Thank you. Michael, can you provide details on the 47 employees involved in the workforce reduction?

The workforce reduction impacted employees across all departments.

Your next question comes from the line of Derrick Wood with TD Cowen. Please go ahead.

What caused the quarter-over-quarter rebound in new customers, and what is the average deal size for those new customers?

The rebound in new customer additions comes from improved churn rates and proactive efforts to engage with prospective clients. Typically, we see customers starting with middle five figures in spending, gradually increasing to six figures as they adopt more services. There hasn't been any significant change in the first-year spend size.

As customers investigate ChatGPT and AI, has it changed the sales cycle or introduced new vendors?

So far, the interest in ChatGPT has been an accelerator rather than a hindrance. Our announcement of Cecilia generated tremendous reaction at Legalweek, sparking interest from both existing customers and prospects looking to explore our offerings. This has effectively boosted our lead generation and solidified our position in the market.

Your next question comes from the line of Arvind Ramnani with Piper Sandler. Please go ahead.

What is the outlook for the review business going forward?

I have a cautiously optimistic update about the review business. We did see a quarter-over-quarter increase, although modest. It’s important to note that all large reviews that previously influenced our results are now gone. We're finally seeing encouraging trends in our pipeline and metrics for growth. Nonetheless, I maintain cautious optimism until we see more solid results in the upcoming quarters.

Is AI viewed as an opportunity or a potential threat?

AI is clearly an opportunity for us. We are committed to leveraging AI across all aspects of our operations and product development. While we acknowledge that some areas of legal work may automate with AI, Disco's history and early investments in AI position us well to take advantage of these developments and drive significant value for our clients.

Your next question comes from the line of Brent Thill with Jefferies. Please go ahead.

Is the trend of revenue not growing in line with pipeline improvement a near-term or longer-term trend?

The cautious discussions from customers regarding budgets reflect a near-term trend driven by current economic conditions. However, I remain confident in the market's long-term growth potential. I believe we will see continued exposure to legal issues and increasing volumes of data, which will ultimately drive demand for our services.

Your next question comes from the line of Scott Berg with Needham. Please go ahead.

Can you provide insights on the push toward corporate sales versus law firm sales?

We are seeing substantial success in forging direct relationships with corporate clients, significantly outpacing overall logo growth and further strengthening our enterprise sales group as we continue to focus on direct corporate partnerships. This strategy is expected to be a key growth driver for Disco moving forward.

What sales or product use do you anticipate driving revenue growth?

Our original product, Disco Ediscovery, continues to be the primary revenue source, and we anticipate ongoing growth from that segment. Review has the potential to contribute to growth as well. However, our newer products will likely provide growth opportunities, although they may not drive substantial overall revenue growth immediately.

Your next question comes from the line of Matthew Kikkert with Stifel. Please go ahead.

What impact do you expect from the new office opened in India?

We believe that our new office in Delhi will significantly enhance our capabilities. We view it as an opportunity to provide high-caliber talent and strengthen our operations rather than merely a low-cost expansion. It will allow us to support our global operations, enhance our customer support, and ultimately contribute positively to our profitability profile.

Your next question comes from the line of David Hynes with Canaccord Genuity. Please go ahead.

Can you quantify the magnitude of the trimming you’re seeing in customer spending?

While we don't have precise figures, anecdotally, we see reductions around the 10% to 15% mark for large customers in terms of overall usage. However, this estimation should be taken with caution as it's based on individual discussions.

What are the assumptions for operating expenses as you aim for breakeven by Q3 2024?

We are committed to managing our operating expenses through various levers, including revenue growth, cost optimization, and efficiencies gained via our globalization strategies. We're focused on a balanced approach to achieving profitability, including careful management of our non-staff cost.

Your final question comes from the line of Mark Schappel with Loop Capital Markets. Please go ahead.

What initiatives do you have to prepare your sales force for Cecilia?

We have implemented a company-wide education campaign regarding AI technologies and their applications. We synchronized our announcement with Legalweek, where we showcased Cecilia and conducted demonstrations for customers to engage with the product. Ongoing training for our sales and solutions architect teams is in place to ensure they are well-prepared to discuss this new offering with clients. Thank you for joining us today and for your interest in Disco.

This concludes today’s conference call. You may now disconnect your lines.