Earnings Call Transcript - SEMR Q4 2022

Operator, Operator

Good morning. My name is Audra, and I will be your conference operator today. At this time, I would like to welcome everyone to the Semrush Holdings Fourth Quarter 2022 Results Conference Call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there’ll be a question-and-answer session. A transcript of the prepared remarks will be available at investors.semrush.com after the call. At this time, I would like to turn the conference over to Bob Gujavarty, Vice President of Investor Relations. Please go ahead.

Bob Gujavarty, Vice President of Investor Relations

Good morning. I'm Bob Gujavarty, VP of Investor Relations, and welcome to Semrush Holdings fourth quarter 2022 results conference call. We'll be discussing the results announced in our press release issued after market close on Monday. With me on the call is our CEO, Oleg Shchegolev; our CFO, Evgeny Fetisov; our President, Eugene Levin; and our CMO, Andrew Warden. Today's call will contain forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements concerning our expected future business and financial performance and financial condition, expected growth, adoption and demand for our existing and any new products and features, investments and acquisitions and their anticipated benefits, industry and market trends, our competitive position, our market strategies, market opportunities, our guidance for the first quarter of 2023 and the full year 2023 and statements about future operating results, including margin improvements, profitability and free cash flow goals can be identified by words such as expect, anticipate, intend, plan, believe, seek or will. These statements reflect our views as of today only and should not be relied upon as representing our views at any subsequent date, and we do not undertake any duty to update these statements. Forward-looking statements address matters that are subject to risks and uncertainties that could cause actual results to differ materially from these forward-looking statements. For a discussion of the risks and important factors that could affect our actual results, please refer to our most recent quarterly report on Form 10-Q and our annual report on Form 10-K filed with the Securities and Exchange Commission as well as our other filings with the SEC. Also during the course of today's call, we will refer to certain non-GAAP financial measures. There is a reconciliation schedule showing the GAAP versus non-GAAP results currently available on our press release issued yesterday after market close, which can be found at investors.semrush.com. And with that, let me turn the call over to Oleg.

Oleg Shchegolev, CEO

Thank you, and good morning to everyone on the call. Fourth quarter revenue of $69 million was up 28% year-over-year and up 5% from the previous quarter. Despite a more challenging economic environment, revenue came in above our expectations. We reported a strong year, with full year revenue of $254 million, up 35% year-over-year as we surpassed range estimates throughout 2022. We have a well-positioned business with a growing market, and we are excited about who we are as a business. I wanted to provide a few highlights on 2022, and then Eugene will talk about our strategic initiatives for 2023. In 2022, we launched our first brand marketing campaign, conducting experiments across various channels to determine the best results. We had several successful brand marketing campaigns, attracting new audiences and users to Semrush beyond our core customer growth, which is particularly promising. Despite a challenging environment, we delivered record new customer additions in 2022, though net customer additions were slightly lower than the previous year. We continue to see record new customer additions, which were partially offset by churn of existing customers. For example, over 30% of customers who chose Semrush returned to the platform. For the customers who returned following the COVID-19 lockdowns in April 2020, the return rate was over 40%. This level of customer retention demonstrates the value of our product to marketing professionals for organizations of all sizes. We are using targeted personalized promotions to help reduce churn and we're already seeing improvements in the first quarter. We are optimistic about future growth based on record new customer additions and the history of customer returns post-pandemic. In fact, we had a strong start to 2023 with record new customer additions in January and February. Other important leading indicators, registrations, and trials have hit peak levels, with trials up 79% year-over-year in February 2023, which is significant. Looking ahead to our 2023 guidance, we expect this year to yield balanced growth and significant margin improvement starting in the third quarter. We anticipate returning to a non-GAAP breakeven run rate in Q3 through our growth and efficiency initiatives. For the first quarter, we expect revenue in the range of $70.3 to $70.7 million, which would be up approximately 23% year-over-year. We expect a non-GAAP net loss in the first quarter of $8 million to $7 million. For the full year, I anticipate revenue in the range of $306 million to $309 million, representing growth at the midpoint of about 21% year-over-year. We expect non-GAAP net income equivalent to $3 million for 2023, including roughly $1.3 million of exit costs. I remind investors that post our relocation program, about 30% of our costs are now incurred in euro and euro-related currencies. My guidance for 2023 non-GAAP net income assumes a year-fixed rate of approximately $1.08 to $1 for the remainder of the year. I remain very encouraged by the trends in our business and have been efficient in deploying capital. We are focused on achieving non-GAAP profitability in Q3 2023. We are uniquely positioned across geographies, industries, and customer size with no consolidations. Our pricing strategies target the widest possible customer base and we offer our customers a high degree of flexibility. These qualities will make us more competitive in 2023. In closing, I want to thank all our employees, customers, and partners for helping us achieve strong growth while navigating a challenging year. We remain focused on creating shareholder value and executing our strategy to drive growth and future profitability. Before I turn it over to Eugene, I want to highlight the recent announcement we made appointing Brian Mulroy as Chief Financial Officer, effective April 10, 2023. Brian brings an exceptional background to Semrush, with over 23 years of experience in finance and technology. He has strong leadership skills, recently holding SAP finance roles at Microsoft and Nuance Communications. I also want to thank Evgeny for his contributions to Semrush over the last four years. His expertise was instrumental in building our financial foundation, and we wish him success in his future endeavors. Now, I pass it to Eugene.

Eugene Levin, President

Thank you, Oleg. I'm pleased with our results in 2022 and even more excited about the future. In 2023, we will focus on expanding our product portfolio while leveraging new technologies and changes in the search landscape, driving operational efficiency and managing expenses across the organization to deliver positive free cash flow. Let me cover each area in more detail. First, we plan to continue updating and adapting our product as we have every year to incorporate new sources of data and improved functionality. We will further develop our platform by one, adding new apps to the App Center; two, increasing our capacity to onboard new apps, making the onboarding process more automated; and three, allowing bundles to be purchased outside of main subscription plans. As the leading online visibility management software vendor, Semrush is uniquely positioned to benefit from two strong tailwinds: generative AI and changes in the search engine industry landscape. Generative AI is not a standalone product, but rather a technology that can be used across our entire portfolio. We have implemented generative AI in several of our products, including our writing system and position tracking. This year, we plan to expand our portfolio of products to utilize this technology within our core products and in the App Center. As the search and web landscape evolves, digital marketers will increasingly rely on digital landscape data. As the reliance on this data grows, we will see a spike in demand for data and insights. For instance, Bing is becoming a more significant player in the search engine space and gaining market share, which will benefit us as we can sell products for Bing optimization in addition to what we offer for Google. Moreover, optimization for combined chat and search interfaces is more complex than traditional search engine optimization and requires sophisticated products that we can provide. We can address online visibility questions, and as search engines introduce new interfaces, we can help our customers navigate this ever-changing environment. Second, we will focus on operating more efficiently. We expect to launch more efficient marketing campaigns, drive increased productivity within sales, and reduce G&A spending as a percentage of revenue. With respect to marketing, we will fine-tune our go-to-market strategy to concentrate on territories and channels that yield the best return on investment. We expect to allocate more of our budget towards those channels and campaigns that deliver the highest ROI. We have invested in our organic search team in 2022, which is beginning to yield results. Our organic search non-brand channel is performing above plan, and our focus on optimizing our paid channel has resulted in better-than-expected ROI in the first quarter year-to-date. Consequently, we expect marketing spend as a percentage of revenue to decline throughout 2023. In our sales teams, especially in expansion and retention, we are testing automated strategies to grow and retain customer accounts at scale. Sales efforts will focus on expansion and raising sales team productivity to drive improved average check growth. Our view right now is that we will invest in efficiency in 2023 to yield even better performance in 2024. Collectively, these actions should enhance sales efficiency and enable us to grow our reach. We will continue to manage expenses as this is the most prudent strategy for us to navigate the current environment. We believe we are appropriately staffed for the current demand environment and expect modest headcount growth for the remainder of 2023, lower than in 2022. Lastly, we are focused on delivering positive free cash flow. Efficiency and agility are core to how Semrush operates. We have historically managed capital well, and we will continue to pursue a growth strategy with a clear path to profitability. I will now turn the call over to Evgeny for a more detailed discussion of our financial performance.

Evgeny Fetisov, CFO

Thank you, Eugene. And many thanks to Oleg and the Semrush team. I have truly enjoyed my time working together. It has been an incredible journey in preparing our company to go public, and we have achieved tremendous results in our path to growth. Now, turning to our Q4 and full year 2022 results. Q4 revenue of $68.8 million was up 28% year-over-year and up 5% sequentially. For the full year, revenue was $254.3 million, reflecting a 35% increase year-over-year. Growth was driven by higher average revenue per customer and an increase in the number of paying customers. We have noticed an increase in revenue from higher-priced core customers at the expense of lower-paying customers. Our dollar-based net revenue retention for the fourth quarter was 118%, down from 126% in the previous year, consistent with our prior expectations. We continue to believe that net revenue retention will settle in the mid-teens long-term. ARR was $275 million as of December 31, 2022, up 28% from the prior year. As a reminder, December is typically a soft month due to the holiday season, and we fully expect sequential acceleration in ARR in the first quarter. In 2022, margins were impacted by brand marketing campaigns and higher personnel costs in new locations, as our operating expenses grew faster than revenue, primarily due to our education program, which cost approximately $11.3 million. Fourth quarter gross margin was 82.6%, an increase of over 400 basis points year-over-year. Gross margin benefitted from higher revenue and lower costs for hosting and third-party services. This decrease in costs should continue, and I expect gross margins to remain above 80% throughout 2023. Operating expenses, excluding equity costs, totaled $70.2 million in the quarter, up 53% year-over-year and up 22% sequentially. The year-over-year increase was primarily driven by headcount growth as we ended the year with 1,503 employees, including 214 contractors, which is up 25% from a year ago, as well as costs associated with operating in high-cost locations. Sales and marketing expenses amounted to $39.6 million in the fourth quarter, up 54% year-over-year and up 30% from the previous quarter. The increase largely reflects higher headcount and increased spending on brand and performance marketing programs. Additionally, the sequential and year-over-year increase was partly a result of a reclassification of costs from G&A to sales and marketing, as previously, marketing leadership expenses were recorded in G&A. We expect sales and marketing expenses as a percentage of revenue to decrease in 2023 as we drive greater efficiency. Research and development expenses totaled $13.3 million in the fourth quarter, up 94% year-over-year and 31% sequentially. The increase reflects higher headcount and an increased compensation expense related to operating in higher-cost geographies. I expect R&D spending to remain consistent with the fourth quarter as a percentage of revenue as we continue to build our platform and deliver new products and functionality. G&A expenses totaled $17.4 million, reflecting a 31% increase year-over-year, but was essentially flat from the previous quarter. The year-over-year increase was due to higher public company costs and investments in new locations, systems, and personnel. The sequential comparison benefitted from separating executive costs into distinct functions. In 2023, G&A expenses will grow in absolute terms but at a lower rate than revenue growth. During the quarter, solid revenue growth and higher gross margins were offset by elevated expenses, including nearly $2 million in exit costs, resulting in a non-GAAP net loss of $11.6 million compared to a non-GAAP net loss of $2.9 million in the prior year. I would also note that we have relatively low shareholder dilution due to stock-based compensation, in part because a large share of our workforce is located outside of the U.S., where stock-based compensation is less prevalent. Turning to the balance sheet, we ended the quarter with cash and cash equivalents and short-term investments totaling $237.5 million, down from $246.6 million in the previous quarter. Our cash flow from operations for the fiscal year was negative $9.6 million, and we incurred approximately $4.2 million in capital expenditures along with capitalizing $1.7 million in software development costs. In summary, we continue to execute well despite a more uncertain economic climate. Looking ahead to 2023, I am confident that we will deliver another year of growth while also improving margins. With that, I'm happy to take any questions. Operator, please open the line for questions.

Operator, Operator

We'll go first to Elizabeth Porter at Morgan Stanley.

Elizabeth Porter, Analyst

Great. Thank you for the question. I wanted to ask about the demand environment. Net adds softened in Q4 after being fairly robust for the last couple of quarters. And I recognize you mentioned some higher churn. Were the softer adds in Q4 fully attributable to churn? Or were there any changes in the new demand environment that began to emerge in Q4 compared to Q3? Any color on that would be very helpful. Thank you.

Andrew Warden, CMO

Thank you very much for the question. This is Andrew. I would say that the net customer additions have been well within our guidance. Like everyone else, we are seeing an impact from the macroeconomic environment on our overall customer base. However, I want to emphasize that we've added a record number of customer additions in Q4, and this growth has continued into Q1 of this year. We're witnessing the results of the brand marketing campaigns we ran in 2022 carrying into 2023.

Elizabeth Porter, Analyst

Great. And then on the increased sales focus and growing average check size going forward. Given the NRR softness you've seen across many other companies, how should we think about the growth in ARR per customer into 2023? Can that sustain double-digit growth?

Evgeny Fetisov, CFO

Elizabeth, this is Evgeny. We should expect the average check to grow, I would say, in line with what we saw in Q3 and Q4. There will be an impact from the macro environment. However, as we return to a more normal environment, we expect average growth to slightly accelerate.

Parker Lane, Analyst

Hi, guys. Thanks for taking the questions. You alluded to supporting the Google use case that many of your customers are adopting today. Have you already started to see the benefits of that, either through new customer acquisition or expansions? Or do you view that as more of a long-term benefit for the business?

Eugene Levin, President

Thank you for the question. This is Eugene. Honestly, right now, we're not seeing a significant demand for this feature. Our reference was about the potential for gaining market share and how that would benefit our business, rather than immediate customer requests. We also utilize competitive intelligence products to assess the actual usage of these new features, and while we observed an initial spike, we are currently not witnessing substantial growth; it has stabilized. We are monitoring the situation. I just want to highlight that if Bing becomes a strong player in the search engine space, we would certainly be eager to provide our customers with new features.

Parker Lane, Analyst

Understood. Thanks for clarifying that. On the generative AI front, did you develop those solutions in-house for writing assistance and tracking, or were those tools contracted out to a third party?

Evgeny Fetisov, CFO

We are indeed utilizing GPT extensively. However, we also employ our own models. The key is giving the GPT algorithm the right input, which our algorithms determine. This input is crucial in making the content perform well, and then we leverage the generative capabilities of GPT.

Scott Berg, Analyst

Hi, everyone. Thanks for taking the questions. I have a couple here. I wanted to start by addressing the churn comment. I appreciate that 30% of your customers who churn returned to the platform. But how should we interpret the elevated churn in the quarter? Can you isolate small versus large customers? Were there specific regions or verticals where you observed higher churn?

Eugene Levin, President

Yes. In Q4, there was no specific region or segment that stood out. I would note that many of the larger customers who churned in Q4 have already returned in January and February. Their departure was more of a delayed renewal rather than true churn. Despite their uncertainties in December, many have returned, which aligns with Oleg's earlier commentary. On the lower end, we have not seen similar returns yet, but we remain optimistic based on historical patterns.

Scott Berg, Analyst

Got it. That's helpful. Regarding profitability comments, I'm trying to understand how leverage in your model will manifest this year, considering the significant net loss guided in Q1, which has generally improved in the second half of the year to reach your guided profitability for the year. Does the leverage primarily come from G&A, or is it more in cost of goods? You mentioned potential improvements in sales and marketing expenses, so could you elaborate on where that leverage will stem from in the second half?

Evgeny Fetisov, CFO

Scott, this is Evgeny. The flexibility will be driven by three main factors: One, gross margin will solidly be above 80%; two, marketing spending will decrease substantially as a percentage of revenue. Finally, other costs will also decline as a percentage of revenue. G&A expenses will decrease, as will sales costs relative to revenue. The only area that will likely see a slight increase would be R&D, which will rise slightly above 20%.

Michael Turits, Analyst

Good morning. I have a couple of questions. First, regarding relocation costs, where do we stand in terms of having a comparable basis for analysis considering you incurred relocation costs this year, but you were fully operational in the higher-cost region this year? How much of a headwind do we face this year? And as we move into '24, should we expect that headwind to disappear, making things more comparable?

Evgeny Fetisov, CFO

Michael, thank you for the question. I would break it down into two parts. There are one-time costs, which we can clearly identify at over $11 million in 2022. We expect about $1.3 million of those in 2023, most of which will occur in Q1. After that, we anticipate those costs will subside. Additionally, there will be ongoing higher costs associated with operating in the new locations. We believe Q4 offers a solid basis for modeling our business moving forward. As mentioned, we plan to improve profitability each quarter in 2023, with enhancing margins and efficiencies.

Michael Turits, Analyst

Thank you for that detail. And congratulations on the successful transition of the business operations. Regarding generative AI, as a company operating in search engine optimization, how does your ability to add value change as search broadly shifts towards chat functionality away from traditional listings?

Eugene Levin, President

Thank you. This is Eugene. This is definitely a topic our team spends considerable time discussing. At this stage, we don't know the final implementation details. We've seen only a few examples of how this transition will occur, and the approaches we've observed have been quite user-friendly. However, we don't know what Google will ultimately do. Based on what we have seen thus far, the outputs from this model are quite similar to generating featured snippets based on top articles. It essentially provides an answer that takes up more space and combines information from several sources. In most instances, we've seen thus far, the expectation is clear to those sources. From a technical perspective, optimizing for this is quite similar to optimizing for featured snippets, a service we've provided for quite some time. There is evident demand for features supporting tracking featured snippets, as well as proactive recommendations on how clients can rank and gain visibility in these snippets. While it is challenging to predict until we see the actual completion of implementations, we are optimistic about our ability to assist our clients in meeting their needs.

Operator, Operator

And that does conclude the question-and-answer session and today's conference call. We thank you for your participation. You may now disconnect.