Earnings Call Transcript - SST Q3 2024

Operator, Operator

Thank you for standing by, and welcome to the Third Quarter, 2024 Conference Call for System1. Joining me today to discuss System1's business and financial results are our Co-Founder and Chief Executive Officer, Michael Blend; and our Chief Financial Officer, Tridivesh Kidambi. A recording of this conference call will be available on our Investor Relations website shortly after this call has ended. I'd like to take this opportunity to remind you that during the call, we will make certain forward-looking statements. This includes statements relating to the operating performance of our business, future financial results and guidance, strategy, long-term growth and overall future prospects. We may also make statements regarding regulatory or compliance matters. These statements are subject to known and unknown risks and uncertainties that could cause our actual results to differ materially from those projected or implied during this call. In particular, those described in our risk factors included in our annual report on Form 10-K for the fiscal year 2023 filed on March 15 as well as the current uncertainty and unpredictability in our business, the markets and the global economy generally. You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on management's assumptions and beliefs as of the date hereof, and System1 disclaims any obligation to update any forward-looking statements, except as required by law. Our discussion today will include non-GAAP financial measures, including adjusted EBITDA and adjusted gross profit. These non-GAAP measures should be considered in addition to and not as a substitute for or in isolation from our GAAP results. Historical performance and future estimates provided during this call exclude results from total security. Information regarding our non-GAAP financial measures, including a reconciliation of our non-GAAP financial measures to our most comparable historical GAAP financial measures may be found on our Investor Relations website. I would now like to turn the conference call over to System1's Co-Founder and Chief Executive Officer, Michael Blend.

Michael Blend, CEO

Thanks, Kyle. Good afternoon everyone and thanks for joining us on our Q3, 2024 System1 earnings call. Despite a mixed quarter with respect to the overall advertising marketplace, we delivered a strong quarter with many positives, including exceeding the high end of guidance on EBITDA. System1 delivered almost $89 million of revenue and $38 million of gross profit. Adjusted EBITDA came in at $10.3 million. These results were driven by the continuation of the trends we discussed last quarter. Our owned and operated products continue to perform well, with revenue up 16% sequentially from the second quarter. As a reminder, our owned and operated products are our businesses, which have organic users and they are not heavily reliant on System1 spending marketing dollars for their growth. Our largest owned and operated products are Startpage, our private search engine, MapQuest, our mapping solution that competes with Google and Apple Maps, and CouponFollow, our promo code website that enables consumers to get great deals while they shop. Now in contrast to the growth in these products, our marketing-driven business lines continue to see the effects of significant choppiness, with our largest advertising partner, which is Google. Now while Google's overall advertising business is doing fine, the specific area of Google we partnered with, which is called their search partner network, has underperformed the rest of the Google business. Because we are closely tied to the search partner network, choppiness within this business line at Google has translated into underperformance on our marketing-driven businesses. That said, and I'll go into this later, we are optimistic that our businesses tied to Google will return to growth in 2025. On the technology side, we continue to see returns from our continued investment in our RAMP platform as we integrate AI deeply into RAMP. We were able to create and launch new marketing campaigns faster and more efficiently, and our product and engineering teams are moving faster than ever. And on our expense side, our focus on reducing OpEx continues, and we're having a positive impact with OpEx decreasing 5% sequentially. All right. Let's get into some of the business details, starting with our owned and operated businesses. Total owned and operated revenue was $71 million, up 7% year-over-year, but down 9% from last quarter. Adjusted gross profit was $26 million, up 11% year-over-year and down 4% from last quarter. The sequential revenue and gross profit declines were caused by a decrease in advertising spend of approximately $5.5 million. Although advertising spend declined, sessions on our O&O properties were over $2 billion, up 125% year-over-year and up 3% from last quarter. RPS and CPS both decreased from the second quarter, making it the third consecutive quarter of declines in these metrics. This trend is driven by lower cost-per-click rates in the United States, as well as a mix shift towards international markets, which also have lower monetization rates in the US. In Q3, international revenue represented 35% of owned and operated revenue compared to 24% in Q3 of 2023. The spread between RPS and CPS in Q3 was $0.13 or 59% compared to $0.04 or 55% in Q2. Overall, I am pleased that we have been able to scale our international efforts quite a bit. But unfortunately, this was offset by a decline in our domestic marketing-driven businesses. In Q3, we launched over 12,000 new marketing campaigns, a more than 50% increase from Q1 of this year. The investments in RAMP are paying off and enabling us to greatly increase our launch throughput with campaign launches increasing every quarter this year. As I mentioned, our O&O products continue to perform really well and in Q3 generated approximately 29% of total O&O revenue and 75% of our O&O gross profit. CouponFollow has continued to have a strong year following a series of Google search algorithm updates that started in May and that benefited the promo code and couponing sites with the best technology. In Q3, CouponFollow experienced a 47% sequential and 108% year-over-year increase in organic sessions to its website and the number of users of our promo code browser extension has more than doubled. Startpage, our private search engine continues to execute well and grew user sessions 22% year-over-year. In addition, we recently completed the rollout of our private browser app by launching the Android version, which joins our iOS version we rolled out in Q2. So far, we have seen significant downloads and engagement with more than 200,000 downloads across Android and iOS. And on MapQuest, we saw 15% growth year-over-year in user sessions and recently have seen the highest usage of our MapQuest mapping service since we acquired the business in 2019. I should add a little perspective to this accomplishment. When we acquired MapQuest from Verizon in 2019, it was a 23-year-old brand in serious decline. And on the Internet, it is highly unusual and very difficult to resuscitate a brand and bring it back to life. Our MapQuest team has not only injected new life back into MapQuest, we are seeing record usage days and are rolling out new innovative products such as our new private Maps app. Overall, our organic products give us a significant hedge against the recent volatility we've seen in our marketing-driven O&O business. Because this business has been so choppy over the last several quarters, I thought it would be useful to get into more detail about the causes. At the highest level, our marketing-driven businesses are driven by two factors; the cost of buying traffic on our buy-side and the amounts we receive for monetizing that traffic with advertisers on our sell-side. For the last four quarters or so, our buy-side costs at our traffic sources like Meta, Google, and programmatic display networks have been relatively stable and in some cases increasing as the overall marketing and advertising market rebounds. Our integration of AI into our RAMP platform has enabled us to scale our campaign launches on the buy-side, and our bidding algorithms have become increasingly sophisticated. I'm really pleased with all the work we have done to scale our buy-side efforts. Now, in contrast, the sell-side has been the root of almost all of our marketing business-related issues. To understand those issues, it's important to remember that much of our sell-side revenue is derived from Google and specifically, the Google Search Partner Network, which I refer to as SPN. The SPN is comprised of non-Google-owned websites and search engines that show Google advertising and it's distinct from Google.com, YouTube, or other Google properties. Google specifically calls out the SPN segment in its earnings. If you look at Google's financial results, which I'm sure many of you do, you will see that SPN has remained largely flat, while the rest of the Google business has climbed. System1 is a very large participant in the SPN via our publishing network, and much of our marketing revenue is generated by purchasing advertising on ad networks like Meta and sending that traffic to advertisers via the SPN. Our core issue related to the SPN is that we have seen large fluctuations in what Google pays us for traffic we send to the SPN. Now, there are several reasons for this, but the most important one is that Google has been making significant efforts to improve conversions for advertisers who advertise on the SPN. These efforts include policy changes, improved screening of traffic quality, and significant product improvements. These efforts are critical to maintaining the health of the ecosystem because the traffic that flows through SPN has to convert for advertisers who advertise on the network. While Google regularly makes pricing adjustments and product changes to ensure high traffic quality, its efforts have ramped up considerably in the past year. Now, System1 applauds Google's efforts. And as one of Google's largest and highest-quality partners, we have been at the forefront of working with Google to improve the quality of the SPN. Unfortunately, as Google rolls out product updates designed to improve the overall network quality, the immediate effect is volatility that impacts all partners including System1. Now, as the cadence of the product updates has increased, it has been challenging even for the higher quality partners like System1 to keep pace and adjust. Now, fortunately, all of these efforts appear to be having the desired effect of increasing traffic quality, which in turn means that advertisers will benefit more, which ultimately will increase advertising rates paid by advertisers in the long-term. As the Google Search Partner Network rebounds, we believe System1 is well-positioned to benefit. We've invested heavily in RAMP, including leveraging AI and machine learning processes for real-time traffic quality detection. In addition, we have always worked closely with our network partners to make sure that we are preserving advertiser trust while maintaining a quality user experience. In short, the more Google focuses on its efforts to maximize value to consumers and advertisers, the more System1 will benefit. Now moving on to our Partner Network business. Partner Network revenues were $18 million and adjusted gross profit was $13 million. Revenue decreased 17% year-over-year, but was up 5% sequentially. Adjusted gross profit decreased 5% year-over-year and 3% sequentially. Total sessions were $2.3 billion, up 159% year-over-year and up 13% sequentially. Partner Network RPS declined 68% year-over-year and 7% quarter-over-quarter. The higher sessions and lower RPS were driven by the same trends that we saw in our O&O marketing business, lower domestic pricing and a bigger mix shift to international markets. In Q3, average revenue per partner increased 7% versus the second quarter. Total active partners decreased slightly from Q2 to approximately 290 partners. At the end of Q3, we had 58 scaled partners, in line with the second quarter. We consider a platform customer to be a scaled partner when they are generating at least $50,000 of revenue per quarter on RAMP. Now like our O&O marketing business, our partner network is dependent on the strength and steadiness of the Google Search Partner Network and therefore is subject to the same dynamics I outlined above. Similar to our O&O marketing business, as the SPN rebounds and pricing increases, we expect that growth in our Partner Network will follow. Overall, I'm really pleased with our performance in the third quarter. Our team has been executing well. Certain parts of our business are exceeding our expectations and we are well-positioned for growth in the areas that remain challenged once the SPN stabilizes. Our product and engineering teams are executing well. We're doing more with fewer people and we remain tightly focused on controlling OpEx. We aren't yet where we want to be but things are moving in the right direction. In light of the ongoing volatility in the marketplace that I highlighted earlier in my comments, we've decided to not provide guidance for Q4 at this time. If we see improvements in stability, we may revisit the possibility of offering guidance later in the quarter. And to close my section of the call, as always, I would like to remind you that management is the largest shareholder group in System1 and our interests are very aligned with yours. As our business gets back into growth mode, we're excited to have you along for the ride. I now pass things off to Tridi to discuss our quarterly results in more detail. Thanks a lot, Tridi. Take it away.

Tridivesh Kidambi, CFO

Thanks, Michael. Overall, we are very pleased with our third quarter financial results where we came in at or above the high end of our guidance for all of our key financial metrics, with the highlight being our $10.3 million of adjusted EBITDA representing year-over-year growth of 28% and quarter-over-quarter growth of 4%. Now on to our operating results. Q3 revenue was $88.8 million representing a 1% year-over-year increase and a sequential decline of 6%. Revenue was $800,000 above the high end of our Q3 revenue guidance range that we provided in August. Owned and operated advertising revenue was $70.8 million, up 7% year-over-year, but down 9% sequentially. Our owned and operated results were primarily driven by our product businesses, which generated $20.7 million of revenue, up 31% year-over-year and 16% sequentially. Network revenue was $18 million, down 17% year-over-year, but up 5% sequentially. Adjusted gross profit was $37.7 million, up 1% year-over-year and down 3% sequentially. Adjusted gross profit was above the midpoint of guidance by $700,000. Revenue less advertising spend for our owned and operated advertising segment declined 4% sequentially to $26.4 million. Specifically for our owned and operated product businesses, revenue less advertising spend was $20 million, up 35% year-over-year and 16% sequentially. Network revenue less agency fees was $13.1 million, down 3% from Q2 and down 15% sequentially. Owned and operated cost per session and revenue per session were both down sequentially to $0.02 and $0.03, respectively. On the network advertising business, RPS was $0.01 per session. Most importantly, total sessions processed by RAMP in the most recent quarter was $4.4 billion, up 142% year-over-year and 8% sequentially. In general, this quarter made it apparent how the diversity of our business lines are a real asset to the overall business as the organic nature of our product businesses served as a strong bulwark against the choppiness of the paid advertising markets. While we have seen significant volatility on our marketing-driven businesses resulting from sell-side product and policy updates, our core product utilities, such as mapping, private search and coupons and promo codes, provide us the opportunity to sidestep this volatility and continue to attract users that we can then monetize, which also allows our RAMP platform to continue to generate gross profit and adjusted EBITDA for the company. On to operating expenses and EBITDA. In Q3, operating expenses net of add-backs were $27.3 million, down $1.5 million quarter-over-quarter and down $1.8 million year-over-year. As I have stated continuously throughout this year, we have been working hard to reduce our operating expense structure over the last year, and we expect to continue to drive sequential cost savings on a quarterly basis for the foreseeable future. Adjusted EBITDA was $10.3 million in Q3 versus $8.1 million in the same quarter last year. Adjusted EBITDA came in above the high end of our Q3 guidance range by $300,000. We are extremely proud of our ability to generate sequential growth in adjusted EBITDA despite a slight sequential decline in adjusted gross profit. With respect to liquidity, we ended the quarter with $69.1 million of unrestricted cash on our balance sheet and an outstanding balance of $285 million of term loan debt under our credit agreement. Our net leverage at quarter end was approximately seven times. Per Michael's earlier comments, given the current volatility in the marketplace, we have decided not to provide financial guidance for the quarter at this time. The uncertainty in market conditions makes it challenging to offer an accurate outlook, especially during the seasonally strong Q4. However, should we observe a stabilization in the overall market environment and pricing dynamics, we may consider issuing guidance at a later time during the quarter. While we remain focused on navigating these conditions in the short term and remain confident in our ability to seize on our long-term opportunities, we are committed to achieving financial outcomes that demonstrate our operational success. Thank you for joining us today.

Operator, Operator

Thank you, Tridi. We're now going to open the line for some questions. On the line is Tom Forte from Maxim Group. Tom, go ahead with your question.

Tom Forte, Analyst

Great. Thanks. So Michael, you did an amazing job explaining a lot of the things that are going on. So let's start with MapQuest. What have you done that's enabled you to essentially resurrect the brand? And what gives you confidence that you can continue to grow it on a go-forward basis?

Michael Blend, CEO

Thank you, Tom, for your question. When we acquired MapQuest from Verizon over four or five years ago, it was a brand in decline with no investment from Verizon, which meant it wasn't adding features or improving its mapping capabilities. Upon acquisition, we took over the technology, and it took us a couple of years to transition it to our technology stack. We began adding features that we believed customers would appreciate, such as enhancing the points of interest with more detailed information. We also switched technology providers and incorporated various data sources. Improvements were made to the mobile apps, which are essential for attracting users. These efforts have led to an increase in direct users and more visibility through search engines, with users typing in addresses and seeing MapQuest appear due to the brand's recognition and improved experience. Recently, we launched a new private mapping app that ensures user privacy, allowing people to navigate without revealing their destinations. Additionally, we plan to introduce subscription products related to MapQuest. This quarter, we experienced our highest traffic day since acquiring the brand from Verizon. In summary, our approach remains consistent: we focus on enhancing the products whenever we acquire companies.

Tom Forte, Analyst

Then my next question is on the industry itself, you did a wonderful job explaining what's going on with kind of a specific Google product. But does it help you essentially that the digital advertising market, there should be a lot less emphasis now that the election is behind us and that sort of thing? So I know that you're withholding guidance due to a lack of visibility in the ad market. But is it beneficial to you that advertisers essentially focus more on goods and services and less on candidates?

Michael Blend, CEO

Yes. The conclusion of the election should assist us on the buying side. While purchasing ads on platforms like Facebook, we compete with all other advertisers. An influx of election-related advertising increases competition. When that decreases, it should resemble a more typical marketplace. Consequently, we anticipate slightly lower pricing, although I haven’t reviewed the data recently to confirm that. However, I suspect we’ll see pricing normalize a bit following the surge over the past four to six weeks. The reason for withholding guidance isn’t the overall volatility in the advertising market but rather what we expect in the next six to seven weeks. On the buy side, we anticipate an increase in costs due to a rise in advertising activities for the holiday season. Typically, we would counterbalance that with improved pricing on the sell side when selling to Google. However, due to the volatility in the Google Search Partner Network, we're not entirely certain we will see the anticipated increases. While things appear stable so far, because the upcoming six weeks are crucial, we believe it’s wise not to commit to any numbers until we have clearer visibility.

Tom Forte, Analyst

All right. So then last one for me and then I'm going to hand it off to Dan. So RAMP is an amazing technology. You were early in leveraging artificial intelligence. I was curious if you made any adjustments to RAMP that make it more effective today than maybe it was last quarter or last year.

Michael Blend, CEO

So, the pace of product improvements we're making to RAMP is pretty remarkable. I know that a lot of companies have been talking about AI. It's really been the buzzword for the past year or year and a half. As I mentioned, some of the early use cases for AI that have been really, really effective have been in the advertising space. So, we talk a lot about being able to create better content using AI, which we have been able to do. We're using it to create our content with editors looking over the results and making sure that what we're publishing is truthful and authentic. But then on the advertising creative side, the ability to produce entertaining, engaging ads that people will click on has gone up dramatically, by at least an order of magnitude on our side in terms of ease of producing those, and I think it's going to end up being a couple of orders of magnitude. So yes, to answer your question since last quarter, yes, we've been making continual improvements in the platform. And I expect every quarter over the next year or two, we're going to see dramatic improvements. So, our platform is much better, much more automated, much more scalable. You're not yet seeing this in our numbers, primarily because of the reasons I outlined in the earlier remarks.

Operator, Operator

The next question is from Dan Kurnos from The Benchmark Company. Dan, go ahead with your question.

Dan Kurnos, Analyst

I hope you can hear me. It's been a hectic night, so I will do my best to ask without repeating anything you’ve already mentioned. I wanted to follow up on one of Tom's questions. Given the change in administration, I’m curious if you have any thoughts on the ongoing ad tech trial. While remedies haven't been established yet, what do you think it could imply for Google and the overall ecosystem? Additionally, there seems to be a perspective that the lower end of the consumer market might be revitalized due to the recent changes in administration. What could this mean for advertising spending or couponing as we approach the holiday season?

Michael Blend, CEO

I appreciate you joining, Dan. It's great to talk with you. Regarding consumer spending, it's difficult to predict what might happen, especially with a potential change in administration. There's a lot of speculation about interest rates, but I don't want to make any assumptions. The ongoing antitrust trials could be significantly impacted by this change. I’m not an expert, but it seems that the groups that initiated these antitrust suits against Google and other tech companies might see a reduced focus on these issues. Specifically for Google, it's unclear what the new administration's stance will be. I've heard that they may have an adversarial approach toward Google, which could mean limited relief for the company. However, there's also the possibility that some cases against Google could be dropped. Until we have more clarity, it's hard to make any predictions. Overall, the administration change might not negatively affect Google in terms of the antitrust trials. Another point of interest is the TikTok ban, which I believe is coming up in a couple of months. There's a mix of opinions within the new administration about enforcing that ban. Since the law passed, it’s uncertain if it can be disregarded. The outcome for TikTok will be intriguing, as it will significantly influence the advertising market overall, even though we don't have a large domestic business with TikTok. The presence or absence of TikTok will lead to notable changes in the advertising landscape.

Dan Kurnos, Analyst

I understand it might seem a bit abstract, but I bring it up because your company tends to perform well in disrupted markets. If we reach December and there’s uncertainty in spending patterns post-election, I wonder how prepared you are to take advantage of such situations. Are you anticipating any disruptions? Additionally, Michael, you previously mentioned that while you do not operate TikTok in the domestic market, your international presence is strong and we hear about a recovery overseas. I'm interested to know what you're observing there and how it affects the business.

Michael Blend, CEO

Certainly. To your first question, absolutely, we thrive during market disruptions, and we would welcome such changes. If advertisers pull back on spending, other advertisers will certainly step in to take advantage of that. Regarding TikTok, we are seeing ongoing strength internationally and have been impressed with the team we work with there. We are significant advertisers now, which allows us to have a large team from TikTok collaborating with us, and we hold all-day meetings with them. They have been very responsive to our needs, including creating custom technology for us when necessary. Thus, I anticipate continued strength there, and I do not expect any changes internationally through TikTok.

Tridivesh Kidambi, CFO

Yeah. And Dan, this is Tridi again. Nice to talk to you. International remains a bright spot for us as well. So Michael mentioned in his remarks, 35% of owned and operated revenue in Q3 versus 23% or 24% last year. So again, to your point, an area of real growth for us albeit at a kind of lower RPS just given rates internationally versus domestic.

Michael Blend, CEO

Yeah. And I think, Dan, you mentioned promo codes and couponing. Yeah, we would expect that as we see every year, the holiday season is going to be a strong one for CouponFollow. We for sure see a burst of activity that pretty closely mirrors shopping trends domestically, where our strength on CouponFollow is domestic.

Dan Kurnos, Analyst

Yeah. We're hearing about a pull forward and a shift to e-com this year. So I think that would probably benefit you guys. I guess we'll see how that plays out. I guess I'll probably leave it there. I would love to ask you guys about new product launches and what they're going to contribute to the P&L. But since we don't have Q4 guidance, I don't think I'll get much of an answer at this point. So I appreciate it. Thanks for all the color guys and good luck and good job on Q3.

Michael Blend, CEO

Thanks for joining. Appreciate it. Always good to talk with you.

Operator, Operator

We are now going to turn it back to Michael Blend for closing remarks.

Michael Blend, CEO

Okay. Thanks, Kyle. Thanks everybody for joining. Happy that we had a quarter in which we could fulfill our guidance for all of the investors out there. Thanks for following us and we look forward to speaking with you next quarter. Thanks again.