Earnings Call Transcript - SST Q3 2023

Operator, Operator

Thank you for standing by, and welcome to the Third Quarter 2023 Conference Call and Webcast for System1. Joining me today to discuss System1's business and financial results are our Co-Founder and CEO, 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 be making 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 registration statement on Form S-1 filed on April 13, 2022, in our Form 10-K for the fiscal year 2022 filed on June 6, 2023, and in our Form 10-Q for the third quarter of 2023 filed on November 9, 2023, as well as the current uncertainty and unpredictability in our business, the markets, and the global economy generally. You should not rely on forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on 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. 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 results, including a reconciliation of our historical GAAP to non-GAAP results, 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 System1 earnings call. Our biggest news by far is our recently announced sale of our Total Security subscription business. The transaction was valued at approximately $340 million, including $240 million in cash. As part of this transaction, approximately 25% of our total outstanding shares were transferred back to the company. We completed this deal for two primary reasons. First, we are confident System1 will be more successful focused exclusively on our advertising business. While there have been headwinds in digital marketing over the last year, we believe the overall market has been stabilizing in the back half of 2023 and we have continued confidence in our RAMP platform and our team. Our advertising business is positioned for nice growth in 2024, and this deal helps us better execute against our vision. For the second reason, the Total Security transaction improved our balance sheet and capital structure overall. The cash provides immediate and long-term financial flexibility and will support our continued investment in our advertising platform. Additionally, with a reduced share count, as our advertising business starts scaling again, the benefits from that growth are going to be spread across a much smaller shareholder base. Operationally, we don't expect any disruption to our advertising business as a result of this transaction. The subscription business was primarily a standalone business, is easily separable from our technology stack, and is located in a separate office in the UK. We wish the best of luck to the Total Security team and its new owners. Now, let's talk about third-quarter performance. System1 delivered $88 million of revenue and $37 million of gross profit. Adjusted EBITDA was $8.1 million, which is up 33% quarter-over-quarter. The adjusted EBITDA growth was a result of lower operating expenses impacted by cost-cutting measures we have taken throughout the year. The operating expense savings offset a sequential decrease in gross profit. We continue to face some headwinds in our owned and operated business, which is impacting our ability to profitably deploy advertising spend. Owned and operated revenue was $66 million, down 14% from Q2, driven by a 15% sequential decline in advertising spend. We generated over 900 million sessions, up more than 100 million versus Q3 with a spread of over $0.025 per session. Our network advertising business generated $22 million of revenue, and gross profit of $15 million, up 3% quarter-over-quarter. The network business continues to benefit from RAMP platform upgrades made this year that have positioned us very well in the marketplace. We signed 90 new partners in Q3 with 40 of those going live within the quarter. Over the last 12 months, we have signed 275 new partners, including five of the top 10 highest-grossing partners currently on our platform. As we continue to add new partners and expand revenue from our existing base, we expect the network advertising business to deliver solid growth and be a key part of our strategic plan going forward. Now, along with the sale of Total Security, our business highlights in the quarter include new partnerships for search monetization with Ecosia, which is one of the largest independent search engines. We also signed a confidential agreement to monetize search for a large browser company, which we anticipate will be a nice contributor in 2024. On the product side, we announced key feature improvements in our RoadWarrior Driving Direction app, and CouponFollow launched its partner network, whereby we will be providing our promo code technology to third parties. We also continue integrating AI throughout our RAMP platform and business processes. As I mentioned on our last earnings call, AI is enabling us to scale our advertising campaigns at a pace we haven't seen before. And it feels like we are just scratching the surface with our uses of AI. Looking back at the last 12 months, 2023 definitely was a challenging year for System1. We dealt with an uncertain advertising market, we had liquidity challenges related to our high debt burden, and we spent several months evaluating the sale of our subscription business. In response to these challenges, I think we made the right decisions to set up our company for long-term success. We narrowed our business focus to our core competency in advertising, we made substantial reductions to our operating expenses, we continue to invest in our RAMP platform, and the Total Security sale brought in a large injection of cash to our balance sheet. Looking forward to 2024 and beyond, I believe System1 is a rejuvenated company set up to return to solid growth. We have excellent technology, strong relationships with our network and advertising partners, and we are solidly profitable. And most importantly, we have a focused and highly motivated team all moving in the same direction. That said, while we are optimistic about 2024, I don't have a crystal ball about what the overall economic environment is going to look like. And after a very rocky 2023, I don't want to promise performance that we aren't confident we can meet or exceed. I encourage our shareholders to look at System1 as a long-term investment and judge our success on an annual basis. I know that's what we do. What I can tell you is that, except for the last 18-month blip, your System1 team has a long history of producing results that have generated great returns for our shareholders. And as I'd like to state every quarter, management is highly aligned with you. We put in our own capital this year to provide the company with extra liquidity, and we currently own almost 40% of System1 after the retirement of the 29 million shares. As a leaner and hyper-focused advertising business, we are ready for the next chapter of System1. I'll now hand things off to Tridi to discuss the quarterly results in more detail as well as provide Q4 guidance. Take it away, Tridi.

Tridivesh Kidambi, CFO

Thanks, Michael. Thank you everyone for joining us today. I wanted to start by echoing Michael's comments on the Total Security transaction. The transaction sets us up both for greater success now and in the future. We received $240 million of gross cash in the deal. And since the close of the deal on November 30th, we have used a portion of that cash to repay all of our unsecured and related party debts, and have also paid down the entire balance of our $50 million secured revolver, 100% of which remains available to us if needed. In addition to ensuring that our liquidity and working capital needs are addressed, the primary use of the remaining cash will be to de-lever the company in the most effective way possible, and we will and are exploring all available options to do so, including accretive M&A. Outside of the cash proceeds, the buyers are assuming approximately $67 million of inter-company debt owed by System1 to Total Security, and the transaction also included a waiver of $60 million in potential earn-out payments due to the Total Security management team, and the transfer of approximately 29.1 million shares of System1's Class A common stock back to the company, which was then subsequently retired. Those shares transferred to System1 represented approximately 25% of the company shares outstanding. In addition to the reasons Michael mentioned earlier around focusing on the advertising business and simplifying the overall business, the liquidity provided by the transaction affords us the opportunity to continue to make investments into the core business and our RAMP platform. We will continue to be focused on investments that benefit both the owned and operated and the network advertising businesses, while continuing to maintain our historical discipline and measured approach to investment and capital allocation decisions. Before moving on to a discussion of our Q3 results and guidance, I wanted to remind you that I will be speaking to results with respect to the remaining business only, excluding results from Total Security. Now, on to Q3 results. Q3 revenue was $88 million as compared to $177 million last year, a 44% decrease year-over-year. The year-over-year decrease is driven by the owned and operated advertising business, which was down 54%, while network advertising revenue was up 63%. Adjusted gross profit was $37 million, down 18% year-over-year. Revenue less advertising spend for the owned and operated advertising segment declined 36% to $24 million. Network revenue less agency fees was up 49% to $15.3 million versus $10.3 million last year. Continuing a trend that we have been seeing throughout the year, both cost per session, CPS, and revenue per session, RPS, were down sequentially. In Q3, RPS was down $0.02 sequentially to $0.07 per session, while CPS was down $0.01 to $0.05 versus $0.07 last quarter. Our spread between revenue per session and cost per session was a little under $0.03. On the network advertising business, RPS remained flat at $0.03 per session. Operating expenses net of addbacks were $29.1 million, down 3% year-over-year, which reflects the impact from cost reductions we have made throughout the year. As a reminder, while we have been making changes throughout the year, the most significant of the cost-cutting measures we undertook occurred in early September. Q4 will be the first period in which we see a full quarter of those reductions in the quarter. Adjusted EBITDA was $8.1 million versus $15.8 million last year, down 49% year-over-year, and representing a 22% margin on gross profit. Now, on to Q4 guidance. We expect to see a continuation of the RPS and CPS trends we have seen all year, with RPS and CPS either flat or declining in tandem and RAMP maintaining our spread around $0.03 on a per session basis. We expect our network advertising business to continue to deliver significant year-over-year growth in Q4, with gross profit up approximately 29% versus last year. We are estimating Q4 revenue to come in between $93 million and $96 million, representing a 33% year-over-year decline at the midpoint. We are estimating gross profit to come in between $35 million and $37 million, representing a 16% decline year-over-year at the midpoint. We are estimating adjusted EBITDA to come in between $7.5 million and $9.5 million. Our EBITDA guidance reflects a 5% sequential growth at the midpoint quarter-over-quarter, as well as the fourth consecutive quarter of EBITDA growth for the business. With respect to liquidity, as of today, we have approximately $140 million of cash and $370 million of debt under our secure term loan. While our recent financial performance has been negatively impacted by market conditions, we continue to feel bullish about the future and the future opportunities that come along with it. With the recent investments we have made in the platform, cost saving measures taken this year and those to come in the future, primarily in the OpEx areas, specifically G&A, as a result of our smaller footprint from the Total Security disposition, as well as the overall financial flexibility created from the Total Security transaction, we believe we are set up for success.

Operator, Operator

Thank you, Tridi. We're now going to open the line for some questions. The first question comes from Dan Kurnos with Benchmark. Dan?

Dan Kurnos, Analyst

Great, thanks. Michael, Tridi, good to see you guys again. Nice for you to be out there.

Michael Blend, CEO

Nice to see you, Dan.

Dan Kurnos, Analyst

So, Michael, look, we're smaller, leaner and meaner, we're back to our roots here after the transaction. And a couple things I want to drill down on. So, first, I would just ask you, number one, obviously, we've had this shift in focus recently, network versus O&O, right? Obviously, network has been growing pretty rapidly. You did mention in your prepared remarks some of the features and improvements we're seeing with RoadWarrior and CouponFollow. And I would think the latter, with the explosion of retail media, probably has a long runway. So, maybe you can just, to start with, help us think through how we should kind of see the expected balance of focus going forward now that you're back to your roots here? Number one. And then, within that, like, scaling back up, how aggressive do you think you need to be in sort of reinvigorating either of the base O&O or network platforms post software?

Michael Blend, CEO

Yeah. Thanks, Dan. Thanks for the question. So, network versus O&O, first of all, network is growing really well. As I mentioned, our new RAMP product, which we released earlier this year, has been really well regarded in the marketplace. So, we expect our network partners to continue piling on, keep scaling with us. So, we're feeling pretty good about that. O&O is really where we're hoping to get a lot more scale out of next year. It was a pretty rough year for us in 2023, kind of starting in late 2022. Pretty optimistic about the ability to scale O&O next year, primarily a few things really. The first one being, and this is just kind of more subjective than anything, the focus of the company now. 2023 was a pretty difficult year overall for System1. Digital marketing on a macro level was pretty choppy. We had a lot of focus on completing our Total Security transaction the last few months. And so, I think the focus of the company on O&O is there. But more specifically, our RAMP platform, when we started incorporating AI into it, we're starting to see some really interesting things in our ability to scale in terms of the potential ability to put advertising dollars to work. And specifically, I've kind of talked about what AI is starting to enable us to do. When you look at our platform and the way that we operate, we're a bit different than most advertisers out there in market. So, if you look at an advertiser like GEICO or American Express, they've got a pretty straightforward way of advertising their product. They've got a few different creatives that might make sense for people looking for credit cards. In the case of American Express, they've got a few different channels that they operate in. Typically, they'll be heavy on SEM and the search engines, maybe on Facebook, and then maybe a little bit on the native networks. We're pretty different at System1 and that we advertise across hundreds of different verticals. So, we'll be in everything from healthcare, and in healthcare, we might be in 50 different verticals in healthcare. We'll be in auto, travel, finance, really everything you can speak of. And when you combine those hundreds of different verticals with all the different marketing channels we're in, everything from native advertising on Taboola and Outbrain to Facebook to TikTok to Google to wherever you can spend money profitably. We're going to be in thousands of different campaigns at once. That makes us a somewhat unique advertiser in the marketplace. And what AI is allowing us to do is really automate those campaigns. What I mean by that is, when you think about what an advertising campaign is composed of, it'll be a lot of different images. So, images designed to appeal to consumers. It might be a call to action. Come get a discount on this or we've got great deals on this or whatever that might be when you're speaking to a consumer. It may be a video. It's a lot of different kinds of creatives. And it's actually somewhat difficult when you get across hundreds and thousands of campaigns to keep up with those creatives and automate new creatives. What AI is starting to allow us to do is roll those out and literally press a button with some editorial oversight and iterate on creatives over and over again. And that's on the front-end. And then, on the back-end, we're enabled to automate our bidding processes. So, as a campaign is working or not working, we're scaling up our advertising by up or down to adjust for how much we're making off that campaign. And so, as I'm looking at 2024, I think as we've done a pretty good job over the last couple, I'd say, quarters and specifically the last quarter, integrating the new capabilities of AI into the platform. As I'm looking forward to 2024, the thing that gives me a pretty good amount of comfort in our ability to scale O&O are the new capabilities that we're rolling onto that.

Dan Kurnos, Analyst

Got it. That's very helpful. I want to explore that a bit further, Michael. Next year is likely to bring significant changes, right? We’ll find out if Google actually eliminates the cookie, which seems possible. But, as you know, publishers often think if something isn’t broken, there’s no need to fix it. So, we’ll see how many people are scrambling when the changes actually occur. For you, as you observe the market, I know you don’t engage in CTV because the pricing has been inconsistent and the return hasn’t met expectations. It will be interesting when Amazon enters the scene and we see more inventory available. It appears there’s some downward pressure there. What do you observe by channel and from your data set? How confident are you that you’ll be able to maintain margins throughout the year, regardless of any disruptions? Disruption often works to your advantage, but what challenges do you anticipate in the marketplace?

Michael Blend, CEO

We believe that maintaining our spread is relatively simple because we can adjust our buy-side pricing based on what we earn on the sell side. The focus is more on how effectively we can utilize our marketing budget rather than on maintaining that spread. Currently, we are optimistic about the market situation. We have received numerous inquiries since we are actively operating in both the buy and sell sides regarding the state of the digital marketplace. I can say that Q4 appears to be stable. It doesn't resemble last year's Q4 when the market dipped significantly in November and December. While it may not look like a typical year with considerable growth, it is manageable. Looking ahead to next year, we expect a return to normal market conditions, and we do not foresee a major decline in the digital advertising sector. As for areas where we anticipate growth, although we are not currently involved in Connected TV, we are observing promising opportunities in video, particularly with platforms like TikTok, which is enabling us to achieve better scale than before. We expect this momentum to carry over into Reels and YouTube as well. While we haven't previously tapped into significant scale within the video segment, we are beginning to gain traction here, and I foresee this becoming a substantial growth area for us in 2024.

Dan Kurnos, Analyst

And maybe we can just talk a little bit about some of the O&O initiatives, right? I mean, you mentioned RoadWarrior, you mentioned the opening up of CouponFollow to 3P, which I love, right? I mean, it feels like pretty easy to just kind of dump in their API and go or whatever, however you guys want to connect. So, I guess from your perspective, how should we think about what other properties where you have other initiatives or opportunities that we should be anticipating? And I'm not asking necessarily for specifics because you don't want to give your playbook out, but just how should we be thinking about that? And are there any categories or verticals where you guys feel you have maybe a competitive advantage where you come out with a new product or feature tool that can really drive accelerated growth in O&O?

Michael Blend, CEO

Yes, we do have initiatives in place. Thank you for your question. Similar to our work with network partners using RAMP, we have some specific market-leading products that we want to expand through partnerships. One example is CouponFollow, which I mentioned earlier. This is a promo code database that aggregates codes from various e-commerce companies. We also offer a product that automatically inputs promo codes into your shopping cart while you shop. Both of these products are ones we plan to market and provide as white label solutions for other companies, and we have already signed deals to bring them to market. Another example is Startpage, which is one of the leading private search engines worldwide and has millions of satisfied users daily. Many other companies want to offer Startpage to their consumers, so we are actively seeking partnership opportunities for that as well. On the Mapquest side of our business, we have a strong mapping product and provide a mapping API to third parties, which has developed into a solid business area for us. Overall, we will continue to identify any products in our portfolio suitable for partnerships, and you can expect to see more of this in 2024.

Dan Kurnos, Analyst

Cool. And if I can just squeeze one more. I know I've gone on a little bit, but I don't want Tridi to feel left out here. So, you've got the injection of capital or cash, I guess you say, from the sale. You've taken some cost actions. I just want to get a sense from you, like, where we think or how we should be thinking about just broader leverage in both on the margin side in 2024, like how much is an element of scale? How much is an element of cost? How much is an element of investment, right? And then, I'm sure you're very aware of where your debt is trading, Tridi. So, to the extent that we should think about open market, if it's available, or other forms of debt reduction that would also be accretive to shareholders? Just curious on your thought process of putting the capital you have to use.

Tridivesh Kidambi, CFO

Yeah, thanks for the question, Dan. As I mentioned in the prepared remarks, we did take a portion of the capital that we brought in from the Total transaction, the Total Security disposition, and paid down some of our kind of related party unsecured debt, some of the shorter-term financing that we did earlier this year, and also paid down the revolver to create flexibility for us from a capital perspective. And again, the main intention of that debt is going to be to de-lever the company in the most effective way possible. So, if you look at kind of the midpoint of guidance that we provided pro forma for some of the expense reductions that we took earlier this year, it would put leverage above kind of six times, which is not where we would look to be as a company. I think we've said before, we'd like to get down closer to three times. And I think given some of the uncertainty in the ad markets that Michael mentioned, even with a clear path of execution, I think getting to that target level of leverage is probably late '24, early '25. And so, as a result of that, again, we're going to take a holistic look at how to de-leverage the company with what's available to us. It includes potentially M&A if it's accretive, but I think most importantly for us was to have the debt, essentially give ourselves breathing room from a liquidity perspective against our financial covenants, et cetera, and just put ourselves in a place where we can really focus on operating the business and executing against our core initiatives.

Dan Kurnos, Analyst

Tridi, in light of that statement, I can analyze the figures since the leverage calculation provides additional insight. When considering the scaling of the business from an EBITDA margin and cash flow perspective, I’m thinking about the balance between re-scaling the owned and operated business and implementing cost initiatives, assuming the overall macro environment remains stable and unchanged.

Tridivesh Kidambi, CFO

I believe that's accurate. We anticipate some growth in gross profit, and under our model, this growth should directly translate to EBITDA. We expect to maintain operating expenses at current levels in the implied guidance for Q4 and into next year. There might still be opportunities for savings, particularly related to services and our infrastructure, especially since we are now a bit smaller after selling Total Security. However, in terms of our organization and how we are positioned to pursue the opportunities presented by RAMP, I feel confident about our current team.

Michael Blend, CEO

Yeah. We feel like the team we've got in place, after we did a fair amount of restructuring in '23, slimmed down the team. We feel like we can scale the business back up without significant headcount increase.

Dan Kurnos, Analyst

Perfect. Sorry for monopolizing the calls. It's been so long, guys. I wanted to get all that out there. So, great to see you guys.

Michael Blend, CEO

Good to see you, Dan. Thanks for the questions.

Tridivesh Kidambi, CFO

It's good to see you.

Dan Kurnos, Analyst

Thank you.

Operator, Operator

There are no further questions. We're going to turn it back to Michael Blend for closing remarks.

Michael Blend, CEO

Okay. Well, thanks everybody for joining us. It's been a little bit of time since we were able to hop on a call with all of you. Look forward to seeing you. We're going to start hitting the conference circuit again now that our transaction is behind us. So, if you can make any of the conferences we're going to be at, we'd like to meet you in person. But until the next time, happy holidays, everybody. Thank you.

Tridivesh Kidambi, CFO

Thanks, everyone.