Earnings Call Transcript - QNST Q4 2022

Hayden Blair, Investor Relations

Thank you to everyone joining us as we report QuinStreet's Fourth Quarter and Fiscal Year 2022 Financial Results. Joining me on the call today are Chief Executive Officer, Doug Valenti; and Chief Financial Officer, Greg Wong. Before we begin, I'd like to remind you that the following discussion will contain forward-looking statements. Forward-looking statements involve a number of risks and uncertainties that may cause actual results to differ materially from those projected by such statements and are not guarantees of future performance. Factors that may cause results to differ from our forward-looking statements are discussed in our recent SEC filings, including our most recent 8-K filing made today and upcoming 10-K. Forward-looking statements are based on assumptions as of today and the company undertakes no obligation to update these statements. Today we'll be using both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP financial measures are included in today's earnings press release, which is available on our Investor Relations website at investor.quinstreet.com. With that, I'll turn the call over to Doug Valenti. Please go ahead, sir.

Douglas Valenti, CEO

Thank you, Hayden. Welcome, everyone. As indicated in our press release, fiscal Q4 played out pretty much as expected. Monthly auto insurance revenue in the quarter stabilized at a level generally flat with February and March. Results in auto insurance are likely to continue to essentially bounce along the bottom for the next couple of quarters as carriers continue the process of raising their rates in response to inflation and supply chain pressures. We expect a positive inflection in auto insurance marketing budgets and revenue in January as one, carrier combined ratios reset for the new calendar year; and two, consumer shopping for insurance increases in reaction to the higher rates. Our non-insurance pipe vertical revenue results were good. We grew revenue there at a strong double-digit rate year-over-year. Even given current conditions in auto insurance and the complicated macro environment generally, our team executed well and our results and outlook are good. We are EBITDA and cash flow positive with a strong balance sheet containing over $95 million of cash and no bank debt, and we continue to invest aggressively in a long list of exciting big growth initiatives. We are investing across the business, including to be ready to fully benefit from the other side of this rate transition period in auto insurance. I think it's important to note that our investments have been paying off. We now have three nine-figure revenue legs on our more balanced and diversified business platform. They include auto insurance, home services, and what we call our credit-driven client verticals comprised of personal loans and credit cards. All three represent big total addressable markets and enormous untapped opportunities for our future growth. Also, our new product pipeline is easily the most exciting ever, adding new dimensions and vectors of growth and promising transformative new levels of value to our clients and the channel and competitive advantage and increasing margins to us. Overall, we have the most balanced business and best mix of big scale opportunities in company history. The future is really bright, and not just in the long term. We are very likely to be growing at strong double-digit rates at big scale with rapidly expanding margins and cash flows in the back half of this fiscal year as the auto insurance market normalizes. That is the most likely scenario, and we are well-positioned for it. We plan to continue to invest aggressively in these big opportunities and growth initiatives and in our product and technology capabilities to scale profitably and sustainably for the foreseeable future. We also plan to remain nicely EBITDA and cash flow positive while doing so and to maintain a strong balance sheet. Turning to our near-term outlook. And a reminder, we just entered our new fiscal year, fiscal year 2023 on July 1. We expect revenue and EBITDA results for the full fiscal year 2023 to be at least flat to fiscal 2022. In other words, we expect to grow this year. Auto insurance challenges will likely continue through the end of the calendar year and then inflect positively beginning in January, our second half. Non-insurance client verticals are expected to continue to grow at strong double-digit rates throughout the fiscal year. It is hard to give more specific guidance given the complexity of the environment and remember, we are only one month into our new fiscal year. We'll of course update our outlook for the full year as the year progresses. We expect business dynamics and results for fiscal Q1, the current quarter ending in September, to be similar to what we saw in the June quarter with a little added conservatism in auto insurance as carriers enter the heavy weather season and with a little lower EBITDA mainly reflecting that auto insurance conservatism, but also the impact of routine annual increases in employee compensation coincident with the beginning of the new fiscal year. So specifically, for fiscal Q1, we expect revenue to be between USD 135 million and USD 140 million and adjusted EBITDA to be between USD 3 million and USD 3.4 million. I want to reiterate that overall we expect to remain EBITDA and cash flow positive throughout fiscal 2023 despite the challenges in auto insurance, and we expect to maintain our strong balance sheet while continuing to invest aggressively in opportunities and future capabilities across the business. Now I wanted to make a few more comments on our business relative to the macroeconomic environment. First, we have included contingency planning for a possible recession in developing our FY 2023 expectations. In the event of a recession, we would still expect to be at least flat in FY '23 revenue versus FY '22 with still positive cash flow and EBITDA. We have grown through both of the two previous recessions. Remember, we have been around for over 23 years. Performance marketing is typically one of the last budgets to be impacted as the economy softens because, by definition, clients can tie their spend directly to revenue. Further, our business helps consumers better shop and save for needed products and services. In particular, consumer shopping for insurance tends to increase significantly in a softer economy. Even more generally, our business footprint is well positioned for a downturn, leveraged more to prime and homeowner consumers in our insurance, home services and credit card client verticals, and to helping lower income consumers deal with the financial pressures of inflation or a downturn in our personal loans client vertical. A second comment regarding the macroeconomic environment specifically with respect to the more direct effects on us from inflation. We are not seeing nor do we expect a big impact on our costs. Media is our biggest cost. It is largely unaffected by inflation and is actually typically more affordable in a softening economy. Increases this year to employee compensation, our second biggest cost, will be less than 1% of revenue, up a little from a more typical 0.5% historically, but still quite manageable and largely immaterial. A third point on the macro environment with respect to the strong dollar. We have essentially no international revenue and we are actually positively leveraged to the strong dollar because almost one-third of our employees are in India. Fourth, regarding the macro context. As we have noted in the past, we have little exposure to display advertising or Apple iOS tracking changes and we would not expect challenges in those areas to represent a meaningful risk to or impact on our business or results. I'd note that trends in advertising are indicating some softening of display advertising and social media budgets, but again those areas are not our domain. Performance marketing, search traffic and higher intent media are our domains. Finally, an update on our share repurchase or buyback. We bought back 1.7 million shares of our stock or approximately 3% of the shares outstanding last quarter for a total of $17 million, aligning our actions and money with our confidence in our business and opportunities.

Gregory Wong, CFO

Thank you, Doug. Hello and thanks to everyone for joining us today. For the June quarter, total revenue was $146.5 million. Adjusted net income was $2 million or $0.04 per share. Adjusted EBITDA was $5.1 million. Overall, non-insurance client verticals made up 56% of Q4 revenue and grew 26% year-over-year. Insurance made up 44% of Q4 revenue. Looking at revenue by client vertical, our financial services client vertical represented 69% of Q4 revenue and was $128 million. Doug covered the details of what is going on in the insurance client vertical in his remarks. Within our credit-driven client verticals of personal loans and credit cards, we continue to be pleased with our performance and execution in Q4, increasing revenue by 47% year-over-year and eclipsing a $130 million annual run rate for those combined businesses. Revenue on our own services client vertical increased 20% year-over-year to $44.3 million or 30% of revenue. We expect this early stage client vertical to continue to deliver double-digit organic growth for as far as the eye can see. Other revenue was the remaining $1.4 million of Q4 revenue. Turning to our full fiscal year 2022 performance. We reported record revenue of $582.1 million. Our financial services client vertical represented 72% of full year revenue and was $417.1 million. Our credit-driven client verticals grew 73% year-over-year offsetting insurance effects. Our home services client vertical represented 27% of full year revenue and grew 18% year-over-year to $158.8 million. Other revenue represented the remaining $6.2 million of full year revenue. Adjusted EBITDA for fiscal year 2022 was $31 million. Turning to the balance sheet. We generated $28.7 million of operating cash flow in FY '22 to close the year with $96.4 million of cash and equivalents and no bank debt. As a reminder, last quarter we announced a share repurchase program reflective of the expected transitory nature of the insurance industry challenges, the strength of our underlying business model and financial position, and confidence in our long-term outlook for the business. During the June quarter, we repurchased 1.7 million shares of common stock at a total cost of about $17 million. In summary, we feel great about our business prospects and financial model. For the full fiscal year '22, our non-insurance client verticals grew 28% year-over-year and we believe that will support a period of fantastic total company growth when we get to the other side of this current environment in insurance. As a reminder, the last time we exited a transitory cycle like this in 2017, we doubled our insurance business within 12 months. Looking forward, our objective is to continue to invest in our people, products, and technologies to drive long-term growth in the business while also delivering positive adjusted EBITDA and cash flow to shareholders.

John Campbell, Analyst

Just two quick questions on the guidance. So first, just relative to the first quarter guidance, it looks like you guys are calling for like a mid-to-high single-digit sequential decline in revenue. It seems like that's a period you guys historically have grown in. Just I guess from a seasonality standpoint, you guys called out stabilization in insurance and kind of bouncing off the bottom. So I guess what explains why you'd see that degree of a sequential decline from what you just posted?

Douglas Valenti, CEO

It's really indicative of what we mentioned about insurance. We have been at a low point, but as we move into the more severe weather season, we anticipate that clients will be even more cautious with their budgets to prepare for potential losses, especially from hurricanes in the Gulf, South, and Southeast. We've already observed a bit of this, and we've incorporated that into our guidance.

John Campbell, Analyst

Okay. That's helpful. And then on the full year guidance, I know you guys are kind of leaving that open and going to update us along the way. But on the flat revenue just on my back of a napkin math, it looks like even kind of trough insurance revenue for the remainder of the calendar year, maybe it looks like you've got to have just a modest recovery, maybe mid- to kind of high single digits out of insurance in the back half. That to me seems awfully conservative especially just given the commentary around you guys doubling the insurance business coming out of the last cycle. Is that about right? Am I thinking about the right assumptions there? And then Doug, also did you mention that the flat revenue already assumes a recession?

Douglas Valenti, CEO

We're not expecting a significant change; if we were to remain flat, we would anticipate a modest increase in auto insurance in the second half, considering the strong growth in our other sectors. As we've mentioned, predicting what will happen in insurance is challenging. However, everything suggests an increase starting in January. The loss ratios, or combined ratio, will reset, and consumers will likely face higher rates, prompting them to shop around. We've observed this trend a few times in the past, and all the carriers are telling us to prepare for a notable surge. While I would say setting a conservative expectation is likely, it's been quite uncertain in the insurance market. I don't believe we're taking an unreasonable risk by establishing what we think is the baseline for our guidance. Regarding a recession, we conducted a separate analysis examining various scenarios and risk-adjusting the businesses we thought might be impacted. Each business leader provided a detailed assessment of how they believed a recession would affect them, and our conclusions indicated that we would at least maintain flat revenue compared to fiscal year 2022. This suggests we've set a fairly conservative baseline as an initial guide. We want to assure everyone that in all the scenarios we've explored, which we consider realistic and conservative, we believe we will experience growth this year, despite the first half being negatively affected by auto insurance.

John Campbell, Analyst

I understand. Could you provide an update, Doug, on how spending typically changes as we enter the new calendar year and budgets are established? Is there usually a significant increase in spending right away or does it tend to build up gradually over time? What has this looked like historically?

Douglas Valenti, CEO

Typically, there's a significant increase at the start of the new calendar year. This was evident in the past year when we saw combined ratios and new budgets resetting. In January, we experienced a sharp increase compared to the previous cycle, following a notable drop in insurance spending in late 2021. Carriers initially thought their costs would be manageable, but then realized expenses were much higher than expected, leading to a decrease in spending again in February and March. This pattern is consistent with historical trends, where January often sees a substantial jump due to the resetting of ratios and the introduction of new budgets. We anticipate a similar situation this January. Additionally, insurers have raised rates to improve their economics, allowing them to market more aggressively, while consumers are also responding by shopping around for better rates. This creates a situation I refer to as a super cycle in insurance, where the combination of resetting ratios and increased consumer activity drives market dynamics. If this aligns with a softening economy, it could lead to even more shopping behavior among consumers. Previously, during a rate-raising cycle in auto insurance, we did not face a recession, but this time could be different. As I mentioned in past calls, we doubled our insurance revenue within a year of adjusting rates and ratios. All indications from our discussions with carriers and the factors we've noted suggest a strong second half, provided that carriers continue to successfully increase rates on a state-by-state basis. While some carriers have seen significant progress, others are lagging, but we expect improvements after the upcoming November elections. Thus, everything points to a robust market ahead. We're setting our initial projections conservatively, acknowledging the current challenges in the insurance market but confident it will recover based on historical patterns.

Jason Kreyer, Analyst

Just a couple questions for you. First off, I was just wondering if you could just talk about the home services segment and how that's kind of progressing in this environment. It seems that consumers may be pulling back on large ticket items, so I was just kind of wondering if that has any implications on your home services partners?

Douglas Valenti, CEO

Yes, we haven't observed any pullback in that area, and it really depends on the specific segment of home services, particularly home improvement, where we mainly operate. To clarify, we have not seen any decline. In fact, this quarter our home services continue to show strong double-digit growth rates, and we are experiencing the same consumer behavior as we have for the past year or more. Currently, there is no indication of weakening consumer demand in our home services business, and we are not anticipating any changes in the upcoming months. Overall, our home services focus on home improvement, and as Angie's mentioned in their recent report, this sector is performing well for several reasons. Homeowners have significant value in their properties due to price increases. Additionally, the new housing market has slowed due to rising mortgage rates, prompting consumers to invest in their existing homes rather than purchasing new ones. When combined with the fact that the aspects of home improvement we cover are not entirely discretionary, and that homeowners—who are our primary consumers—are in excellent financial condition, we do not foresee a substantial slowdown. In our recession contingency planning, we did factor in a 20% potential decrease for the home services business, even though the team managing that area believes any potential fluctuations will not affect our growth rate significantly. We adopted a more cautious approach than the team running the business and more conservative than what our current observations suggest. Overall, we are not seeing any signs of a slowdown.

Jason Kreyer, Analyst

And then just my second question here, just going back to the guide here with the declining revenue in the first quarter guidance, but in the full year to go plan to go flat, I was just wondering if you could kind of talk about your conviction in that early calendar year '23 rebound, and then just tied to that, it seems that this is now like the second or third time that carriers have had to reprice policies in an effort to improve the combined ratio, so I'm just wondering what you might be hearing from them that may lead you to believe that they're going to get it right this time?

Douglas Valenti, CEO

Our confidence is quite strong, even though predicting the future is challenging. What bolsters our assurance is our previous experiences in the auto insurance sector. It’s not a new scenario for us or our clients, and everyone is aware that combined ratios will reset in January with higher rates on the horizon. Historically, this scenario has prompted increased marketing budgets and aggressive consumer shopping, leading to a super cycle that has resulted in significant growth rates each time it occurs. This pattern aligns with historical data and reliable analytics. While I wouldn't say our confidence is extremely high due to the inherent uncertainties in forecasting, potential challenges do exist. For example, if carriers manage to secure rate increases, it could pose a problem. So far, those carriers that pursued rate hikes early and aggressively have mainly succeeded, although some states, particularly in the Northeast, have been more resistant, allowing smaller increases than carriers deem necessary given current conditions. Generally, history suggests that states may eventually relent because their citizens need auto insurance, and failing to allow carriers to set adequate prices could lead to broader issues. The current situation is more complex and prolonged due to significant inflation and rising costs, but I attribute this to the overall environment rather than the actions of the carriers. Many carriers have effectively implemented changes in most states, with others following suit. Thus, I see no indicators that the latter half of the year will not perform strongly based on our historical insights and what we are currently observing.

James Goss, Analyst

I don't mean to repeat myself, but regarding the adjustment of the combined ratios, I'm curious if that is affected by competition and market share acquisition in comparison to other companies. Does this complicate the idea that improvements happen as quickly as they typically do? I understand you mentioned that historically things tend to even out, but it appears to be taking longer this time, as we have been discussing this issue for at least a year or two.

Douglas Valenti, CEO

Hasn't been two years, but the softness started back, Greg, I think it was last September.

Gregory Wong, CFO

Yes, mid-September timeframe.

Douglas Valenti, CEO

You are correct in feeling that it has been a long time, and it indeed feels longer mainly because we are experiencing the worst period of rapid inflation combined with constrained supply chains in the last 50 to 70 years. It's an unusual environment for adaptation, so it's not disappointing but rather understandable that it's taking time. Some carriers may try to gain an advantage during this period as others raise their rates, but when you look at individual carriers, that's not the main factor at play. The primary concern is that without a rate increase, they cannot be profitable, which is a sentiment echoed by all public carriers and mutuals. They are not eager to steal market share if it means losing money on new policies. Unlike in the past, this factor is less significant now due to the challenging economic conditions.

James Goss, Analyst

I was a couple of minutes late joining the call due to three events happening today, and I apologize if this has already been discussed. The auto chip shortage seems to have disrupted many things, likely altering the balance between new and used cars, and it appears we are still waiting for this situation to resolve. I'm curious how you view this as part of the current landscape we are facing.

Douglas Valenti, CEO

I'm not certain how the auto chip supply chain issues are directly impacting the situation. However, from what we've heard from clients and what they've stated publicly, including in recent announcements, it's clear that used car pricing has significantly negatively impacted economics. Many policies include replacement clauses, and when a vehicle needs to be replaced, the cost of similar vehicles has risen by 20%, 30%, or even 40% compared to previous prices. Some public carriers have specifically identified this as a major factor contributing to their combined ratio challenges. Additionally, the lack of new cars likely shifts demand towards used vehicles more than usual, which is my speculation, but it's evident that the rising costs of automobiles, especially used ones, have been pointed out by several carriers as influencing the combined ratio and loss cost issues.

James Goss, Analyst

Okay, and one final one, are there any new consumer verticals you have your eye on, potential or you're in early stage of development?

Douglas Valenti, CEO

Yes, the primary focus for new consumer verticals is in what we refer to as trades, particularly sub-verticals within home services. Currently, we have scaled operations in about four home services verticals, though we consider ourselves to be truly at scale in just one. We have a presence in 16 and believe we can expand into dozens more. We work daily to enhance the scale of the 16 verticals we are involved in and to identify additional opportunities within that broader list. This ongoing effort constitutes our main investment and activities towards new consumer verticals. Additionally, we have begun exploring new verticals in financial services and banking, which has evolved significantly from its earlier, narrower definitions. Now, these offerings include brokerage accounts, wealth management, financial advisory, and more, all of which are new for us. We are also venturing into new segments of credit cards, focusing heavily on prime and super prime customers while also adding mid-prime and sub-prime options, which present new opportunities. We are expanding in personal loans, concentrating on debt consolidation, especially credit card debt consolidation, alongside other avenues for consumers on both prime and subprime sides. Furthermore, we are introducing new products in insurance. Historically, we have almost exclusively worked with direct budgets through direct carriers, but we are now beginning to develop leads for agent networks, supported by various initiatives and projects with major carriers aimed at improving integrations with these agencies. In discussing our verticals, we see significant new business potential within these broad definitions, with substantial incremental opportunities available. However, beyond insurance, credit cards, home services, personal loans, and banking, we do not foresee any imminent new verticals to enter. We have ample capacity within our defined focus to generate billions in revenue. Over recent years, we have strategically exited businesses in education, B2B, and mortgage to concentrate on areas we believe present the best opportunities. Thus, we see many promising growth opportunities within our current scope to sustain high growth rates for the foreseeable future, with no immediate plans to enter entirely new vertical areas.

Joichi Sakai, Analyst

I just had a question on the demand and the use of QRP in this environment, insurance environment, and then I wanted to ask about your thoughts, and are we at the bottom? I know last quarter, it seemed like you thought we were at the bottom as far as repricing goes and stuff like that, I wanted to get your thoughts on that?

Douglas Valenti, CEO

We're making significant progress with QRP, though as I mentioned previously, the insurance environment has caused a noticeable slowdown in activity and pipeline development. While we continue to make headway, agencies are currently more focused on addressing lost carrier coverage and budget issues rather than on integrating new products, which has slowed the pipeline. However, our enthusiasm for the project and its long-term potential remains high. We anticipate that as the insurance sector rebounds, the pipeline and our progress will pick up speed once again. This remains one of the most promising opportunities we've encountered in terms of its impact on our clients and our business. We're dedicated to this initiative, and while the pace has decreased due to current insurance challenges, our excitement about the direction we're heading has not waned. In terms of the bottom of the repricing, we've been at the lowest point for about five to six months. The main risk we face until January is related to how carriers approach potential weather events in August and September. If we experience a normal weather season, we expect to maintain a steady performance, fluctuating around $1 million a month, until January. However, if this hurricane season turns out to be severe, it may lead to a further decrease in auto insurance rates. We have anticipated an average to below-average hurricane season. Overall, we are in a stable position, but a significantly bad hurricane season could impact auto insurance more severely. Nonetheless, this wouldn't drastically affect our results since other business areas are still performing well. We also expect our combined ratio to reset in January, setting us on a path for a new growth cycle.

Gregory Wong, CFO

Yes, Chris. The decline in gross margin both sequentially and year-over-year is really twofold and it's all insurance-related. So, the first would be, it's just a loss of operating leverage against the lower insurance revenues as we're carrying more employees than we typically would at these revenue levels as we keep investing through this transitory period in insurance so we come out the other side much stronger. So, second would be also associated with auto insurance as our medium margins are lower than they typically would be due to the macroeconomic pressures in auto where pricing is down from carriers. So, we're temporarily running a lower margin than we would in a normal environment, so that's it, both of those impacts. I expect those both would correct themselves as carriers begin to spend again and the top-line leverage comes back, and as you get normalized pricing and we get our margins back in those businesses, so those are the impacts in there, both of it might be in a pretty short term until we see the cycle turn.

Operator, Operator

And we'll take our first question today from John Campbell with Stephens Inc. Next, we'll hear from Jason Kreyer with Craig-Hallum. We now hear from Jim Goss with Barrington Research. And that will conclude the question-and-answer session for today. The replay information will be available on the QuinStreet's Investor Relations website. Thank you for your participation. You may now disconnect.