Earnings Call Transcript - SST Q1 2024

Operator, Operator

Hello. My name is Sarah, and I will be your conference operator today. At this time, I would like to welcome everyone to the System1 Q1 earnings call. I would now like to turn the conference over to Kyle Ostgaard, Vice President of Finance. You may begin.

Kyle Ostgaard, Vice President of Finance

Thank you for standing by, and welcome to the First Quarter 2024 Conference Call for System1. Joining me today to discuss System1's business and financial results are 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 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, particularly 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, Co-Founder and CEO

Thanks, Kyle. Good afternoon, everyone, and thanks for joining us on our Q1 System1 earnings call. Let's get right into our quarterly performance. I'm happy to announce that System1 was able to deliver financial results that exceeded our earlier guidance. System1 delivered $85 million of revenue and $31 million of gross profit. Adjusted EBITDA was $423,000. Owned & Operated revenue was $69 million, down 35% year-over-year and down 13% from last quarter. This was driven by a 12% sequential decline in advertising spend. We generated over 1.2 billion sessions, an 18% year-over-year increase and a 14% quarter-over-quarter increase. Spread was approximately $0.02 per session. International revenue continued to remain a highlight, with international revenue representing approximately 29% of Owned & Operated revenue. This was up from 25% of Owned & Operated revenue in Q4 of 2023. Overall, Q1 was somewhat choppy, but ended on a positive note. The overall advertising marketplace started off a bit weak in January and improved as the quarter progressed. This pattern was expected to match what we see in a typical Q1. Our Q1 volatility was driven primarily by our Google relationship, which, as a reminder, is our largest revenue source. We saw significant volatility from Google during the quarter. Their sell-side pricing moved around more than typical, and the Google product team introduced new features at a very rapid pace with minimal advanced notice to us. Longer term, this is a good thing for System1. We work closely with Google to integrate new features into our tech stack, and their product improvements almost always lead to increased revenues for System1. In the short term, however, the rapid-fire Google changes caused quite a bit of volatility in the overall Google partner ecosystem. Fortunately, things have begun to stabilize with Google. The last couple of weeks of Q1 were particularly strong, and these favorable trends have continued through the early weeks of Q2. If Google pricing and product rollout stay consistent, we expect all of our marketing-driven business lines to benefit. Partner Network revenue was $16 million, and gross profit was $11 million. Revenue increased 5% year-over-year, but was down 5% sequentially as we expected, due to typical seasonality. Sessions were 1 billion, up 134% year-over-year and 32% sequentially as traffic from existing partners increased along with new partners joining the network. Partner Network RPS declined 55% year-over-year and 28% quarter-over-quarter, driven by the same marketplace headwinds that impacted our Owned & Operated business. The marketplace headwinds we faced in our O&O business, namely narrowing RPS spreads and volatility in sell-side pricing, were shared by our partners as well. But notwithstanding that, our Partner Network business continued to perform through solid execution as well as what we believe is the attractiveness of our RAMP platform. Key metrics evidencing this include: in Q1 of '24, total active partners grew 5% from Q4 to over 250 total partners; average revenue per partner decreased sequentially by 9% due to Q1 seasonality and choppiness in the marketplace. Remember, when partners join our RAMP platform, there's a timeframe during which they begin to scale up with us. This is a function of the partner getting more familiar with our platform as well as our constant evaluation and monitoring of their traffic quality. We consider a platform partner to be a scaled partner when they're generating at least $50,000 of revenue per quarter on RAMP. At the end of Q1, we had 57 scaled partners compared to 50 scaled partners in Q1 of '23, representing a 14% growth rate. Moreover, as I mentioned previously, our partners are using us more and for more sessions. It is our hope that as the advertising market continues to improve, the combination of our growth in the number of scaled partners and the increase in the number of sessions will accelerate the growth of our Partner Network business. Moving to our organic businesses. They had a good quarter on several fronts. First, we saw a significant increase in organic traffic of MapQuest and CouponFollow that began in March and should continue through Q2. These increases were driven primarily by favorable changes in the Google Search algorithms. We've been working very hard to improve the customer experience on these sites in the hope our Google rankings would improve. Fortunately, our efforts have begun paying off, with increased traffic that directly drives corresponding increases in revenue. We also saw the launch of several key business development partnerships with our Startpage and CouponFollow properties that we expect to begin paying dividends as the year progresses. Going forward, we are focused in a few key areas. First, we are continuing to invest in our RAMP platform. AI has materially improved our ability to scale our buy-side capabilities, and we plan to open up our buy-side to partners who currently use us primarily for sell-side monetization. Second, our organic properties will keep focusing on their on-site experiences. We'll be launching new and improved apps and we'll be integrating additional distribution partnerships. Third, we are planning to start expanding our subscription business by rolling out more internally-developed subscription products. And finally, we have been exploring the M&A market again as the digital markets stabilize and pricing has started to get a bit more rational. Overall, I'm very pleased with our execution in Q1, especially with respect to product enhancements on RAMP focused on AI-driven automation. We are executing with focus and we are shipping products faster than ever. Our execution is starting to show up in our performance, and I'm increasingly confident we are moving back into growth mode. I also am happy to have Chuck Ursini rejoin System1 in an official capacity as our President and COO. Chuck and I co-founded System1, and Chuck was our original CEO. He has driven much of our execution in the last year, and I'm happy to have him back in an official capacity. As I mention every quarter, System1 management has much of our net worth in System1 shares. We're highly aligned with our longer-term shareholders. Management is in this for the long haul, and we welcome investors who want to come along for the ride. I'll now hand things off to Tridi to discuss our quarterly results in more detail as well as our Q2 guidance. Take it away, Tridi.

Tridivesh Kidambi, Chief Financial Officer

Thanks, Michael. As Michael mentioned, there were market-related challenges in Q1, especially early in the quarter, but we remain bullish given that March came in not just above the first 2 months of the quarter but also above expectations. And we delivered results above the high end of the guidance range for revenue, gross profit, and for adjusted EBITDA. As I discuss Q1 results, I want to highlight that year-over-year comparisons continue to be a challenge as we haven't yet rebounded to the levels of advertising demand we saw in the first half of 2023 due to continued macro declines in the advertising market through the first 3 quarters of last year. And in Q1 of last year, our Owned & Operated SEM business still contributed $6 million of gross profit as compared to approximately $2 million of gross profit a quarter starting in Q2 of 2023 and continuing through last quarter. Also, we typically expect a sequential decline in Q1 versus a seasonally strong Q4. Now on to our operating results. Q1 revenue was $84.9 million, representing a 30% year-over-year decline and sequential decline of 12%. That was good for $900,000 above the top end of our Q1 revenue guidance range that we provided in March. Owned & Operated advertising revenue was $69 million, representing a 35% year-over-year decline and a sequential decline of 13%. Network advertising revenue was $15.9 million, up 5% year-over-year and down 5% sequentially. Adjusted gross profit was $31.2 million, down 18% year-over-year and 17% sequentially, and that was above the high end of guidance by $1.2 million. Revenue less advertising spend for our Owned & Operated advertising segment declined 16% sequentially to $22.5 million. Network revenue less agency fees was down 17% to $10.9 million versus the prior quarter. Owned & Operated cost per session and revenue per session were both down $0.01 sequentially to $0.04 to $0.06, respectively, with the spread down slightly to approximately $0.02. On the network advertising business, revenue per session was $0.02 per session. Most importantly, total sessions processed by RAMP in the most recent quarter was 2.26 billion, up 22% sequentially and 53% year-over-year. Adjusted EBITDA impacting operating expenses, which are net of add-backs, were $30.8 million, down 7% year-over-year. As a reminder, we expect Q1 to be a high watermark for OpEx driven by FY '23 audit costs. Adjusted EBITDA was $422,000 versus $5.2 million last year, which came in above the high end of the Q1 guidance range by $1.4 million. With respect to liquidity, we ended the quarter with $69.9 million of unrestricted cash on our balance sheet and a term loan balance of $296 million. Our net leverage at quarter end was approximately 9.19x. I want to reiterate my comments from our last earnings call with respect to capital structure. We remain comfortable that our current liquidity, including the $50 million of availability on our revolver, provides ample cushion for all of our short- and medium-term liquidity needs. We remain highly focused on maximizing equity value for our shareholders while remaining focused on continuing to delever the business, and we will continue to be opportunistic on debt repurchases. For example, we extinguished an additional $1.2 million of term debt for $720,000 of cash on April 30. And per Michael's comments, we will continue to explore accretive M&A, where we have a track record of execution and success. Most importantly, we'll continue to prioritize investment and execution to drive organic growth in our core advertising business. Although we have recently seen more stability in the market through the first several weeks of Q2, there's still quite a bit of uncertainty in the online advertising environment in which we operate, as evidenced by the recent news about Google delaying the deprecation of cookies. So again, we will not be providing full-year guidance for 2024 at this time other than to say that we expect to deliver year-over-year growth in revenue, adjusted gross profit, and adjusted EBITDA in the second half of 2024. We are estimating Q2 revenue to come in between $88 million and $90 million, representing an 8% year-over-year decline at the midpoint. We're estimating adjusted gross profit to come in between $33 million and $35 million, representing a 16% decline at the midpoint, and we estimate Q1 adjusted EBITDA to come in between $5 million and $7 million, slightly down year-over-year at the midpoint. We remain cautiously optimistic about the digital advertising market stabilizing this year and remain extremely bullish about our ability to execute against both near- and long-term opportunities. Thank you.

Kyle Ostgaard, Vice President of Finance

Thank you, Tridi. We are now going to open the line for some questions.

Operator, Operator

Your first question comes from Dan Kurnos with the Benchmark Company.

Daniel Kurnos, Analyst

Great. Good start to the year, guys. Maybe, I guess, we'll start with what Tridi just kind of talked about, kind of high level. Obviously, Google pushing out cookie deprecation until next year, there's a ton of issues around that. We've also had a TikTok ban passed in the house. It seems like kind of the Wild West right now. Can you guys just kind of help us think through how your partners are looking at the environment right now? And in the confines of Google probably making a bunch of changes to Privacy Sandbox and a bunch of other things, just how you're thinking about being able to maintain sort of consistent spread as we go through this volatile period.

Michael Blend, Co-Founder and CEO

Thanks, Dan, and thanks for joining. It's good to hear from you. Regarding cookie deprecation, we believe it will actually benefit us. We are quite confident that as third-party cookie-based advertising diminishes, contextual advertising will become more effective. We're not worried about cookie deprecation; in fact, we're slightly disappointed that it's been pushed to 2025. We remain optimistic that some version of it will still be implemented. Everything we're hearing from Google suggests they're more focused on delaying rather than reversing their decision on cookie deprecation. As for TikTok, we don't have much exposure there. We do advertise on TikTok, and it's been quite effective for us, although most of our presence is international. Therefore, we don't foresee issues with U.S. users continuing to advertise through TikTok in international markets. Overall, on a macro level, we're beginning to see the advertising market stabilize, as evidenced by recent Q1 reports. While we are cautious about declaring stability and growth for the latter half of the year, we currently don't see anything particularly concerning.

Daniel Kurnos, Analyst

Got it. That's really helpful. And since you brought up international, Michael, I feel like I ask you this every call and sort of like it's coming, it's coming. You flagged it as a highlight, especially in O&O in Q1, and just kind of curious what sort of opportunity set you're seeing further from here.

Michael Blend, Co-Founder and CEO

I mean sure, you can kind of talk about the numbers specifically, but we definitely remain under-indexed. International is starting to tick up. You want to kind of talk about where we are there, Tridi?

Tridivesh Kidambi, Chief Financial Officer

Yes, I think we mentioned in the prepared remarks that international as a percentage of our Owned & Operated revenue was close to 30%, 29% in Q1, up from 25% in Q4. And so again, I think for our internal efforts, we're doing a good job marching against getting closer to where we think that should be on a worldwide basis, which is in and around 50%. And so we think we're making good progress there overall.

Michael Blend, Co-Founder and CEO

We are currently underrepresented in the EU, which has been implementing privacy regulations at a fast pace. Both our Owned & Operated and Partner Network are underrepresented in this region, indicating a significant opportunity for us. In Asia, our performance is strong, and while there are opportunities in South America, it is not the main revenue source. The primary revenue potential internationally lies in the EU, particularly the U.K. and Asia. We believe we will continue to grow our overall share in international markets.

Daniel Kurnos, Analyst

Without giving away your roadmap, is there anything else you can share with us on either the internal developments as it relates to things you're doing with Startpage or CouponFollow and how that might be additive to the balance of the year? And Michael, interesting to hear the commentary about internally developed subscription products, given the history. I'm sure you have plenty of experience now and you certainly had some before. So just love to get some color on how you're thinking about attacking that TAM as well.

Michael Blend, Co-Founder and CEO

Yes. I'll answer those points one by one, Dan. We mentioned earlier that in Q1, around March, Google implemented one of their major algorithm updates, which positively impacted both MapQuest and CouponFollow, improving our rankings on Google. This improvement requires significant effort, as enhancing the customer experience on our sites can take 6 to 12 months to reflect in our rankings. We're pleased to see that update roll out and benefit us, particularly since we started reaping those rewards in March. We expect to maintain this benefit throughout the year, as our rankings have stayed steady since then, with some ongoing improvements. We have made significant progress in developing some exciting applications related to MapQuest, Startpage, and CouponFollow, which we plan to launch, probably in Q2, although a couple of them might slip into Q3. These will involve monetizing through our traditional advertising tech stack, and we also anticipate re-entering the subscription business. Just a reminder, we sold our larger subscription business last year, but we still operate a smaller one. We believe we possess considerable in-house knowledge in both creating and marketing subscription products, which we intend to leverage for new offerings.

Operator, Operator

Your next question comes from the line of Thomas Forte with Maxim Group.

Thomas Forte, Analyst

Great. So first off, Michael and Tridi, congrats on the quarter. You sound very optimistic about your business, which is encouraging to hear. One question and one follow-up. So Michael, when I think about your core competency, it's connecting advertisers and consumers with intent. The consumer environment, the consumer spending environment right now is pretty challenging, so I'm wondering how you're navigating those challenges, and then if you've ramped your efforts in travel or some additional categories to perhaps mirror where the discretionary spending is focused today.

Michael Blend, Co-Founder and CEO

Yes, Tom. As we've discussed over several quarters, changes in consumer demand generally impact pricing on the buy-side. As the economy fluctuates, we are able to adjust our pricing to align with consumer preferences. We have observed movements within various verticals since we cover a broad range of the economy, effectively targeting the verticals that consumers are interested in. In the health category, we have noticed steady performance, which aligns with the overall U.S. economy. This category represents around 18% to 20% of total advertiser spend. Interestingly, automotive is beginning to show some growth in the areas where we advertise. With dealerships starting to invest again, we will focus on this trend. In finance, while some segments have significantly declined, like the mortgage sector, which is currently challenging for us, other areas related to rising interest rates are beneficial. We are seeing interest in banking and higher interest rate savings accounts, reflecting consumers seeking opportunities to earn more from elevated interest rates. Overall, we are not experiencing the consumer weakness that you referenced. In fact, we observe a degree of stability on the consumer side, and while we are not declaring a return to normal, our situation feels notably better than in early 2023.

Thomas Forte, Analyst

Great. And then I know you're not giving a full year outlook, but I was hoping that you could just high level the following. So with this being a presidential election year, an expectation that there'll be a large portion of digital advertising going toward that, historically, has that presented opportunities and challenges? How have you navigated that situation historically?

Michael Blend, Co-Founder and CEO

We haven't experienced the same situation as in the past, so this will likely be the third or fourth presidential cycle we've encountered at System1. The marketplaces we operate in haven't seen many changes as the elections approach. I expect the video market will be affected significantly. However, since we don't focus much on the video sector, we are not anticipating any substantial impacts from it, whether positive or negative, related to the surge of activity expected in the last couple of months of the year. Tridi, could you provide some insights on our expectations for 2024?

Tridivesh Kidambi, Chief Financial Officer

Yes. I mean I think to that point, just some of the uncertainty that Michael highlighted around how we're thinking about ad markets. We obviously chose not to guide for the full year, but we do think, kind of given our current trends, the stability we are seeing, we do expect to see growth in the back half versus our second half of 2023. You start to see that a little bit in our Q2 guidance, specifically around EBITDA. But I think kind of Q3, Q4, we expect to be guiding to and delivering growth across all 3 of the key financial metrics.

Michael Blend, Co-Founder and CEO

Yes, we are going to address some declines we experienced in the past. As we move toward the end of the year, we anticipate returning to a growth phase, as Tridi mentioned. Specifically for us and the broader digital display market, we believe the deprecation of cookies will have significant impacts based on our testing and historical observations, particularly regarding iOS. A similar change in Safari notably affected pricing in the display and programmatic markets. Therefore, we expect there will be both winners and losers when Chrome's cookie deprecation occurs. We believe we will be among the winners. However, if you consider what lies ahead in the overall advertising market, this will likely be a more significant factor for us than anything related to the presidential election.

Operator, Operator

Your next question is a follow-up from Dan Kurnos.

Daniel Kurnos, Analyst

I thought I'd just sneak one more in, Michael. Just on RAMP and scaling the buy side, I just want to get a sense from you. You kind of talked about it in the past, but a few things. Just how you're thinking about the opportunity, how much you have to invest on that side. Obviously, a lot of that's moving towards self-service, feels like, and you touched on it in the last response, to a degree, but it also theoretically can help open up the opportunity with additional formats, whether it's video or other things, in theory. So I'm just kind of curious how you're looking at that opportunity and what it might mean for the P&L.

Michael Blend, Co-Founder and CEO

Yes, we experienced a significant advantage with the introduction of generative AI. Our position in the marketplace as a unique advertiser allows us to stand out. Unlike traditional advertisers, who may focus on a narrower scope like credit cards or mortgages, we promote across a vast range of sectors. With just 100 variations of ads across those sectors, we can quickly reach thousands of distinct ad formats. Manually creating these formats, which include various tones, colors, and styles, poses a challenge. However, AI has enabled us to automate many of these processes. Additionally, we use machine learning AI for managing bid pricing. Considering the multiple verticals and advertising platforms we utilize—from Facebook and Google to TikTok—the complexity of our advertising system grows rapidly. At this stage, we can scale our advertising efforts far more efficiently, thanks to the integration of AI into our platform. This positions us among the largest advertisers globally. Moving forward, we plan to extend these capabilities to others who want to use our platform, which we haven't fully done before. We believe this will provide those users with a competitive edge. Most of our partners typically do not have large engineering teams to develop similar capabilities, often employing between 5 to 30 people. By offering this type of scale, we aim to transform RAMP into a more software-oriented product, resembling a demand-side platform (DSP). We anticipate that this will not only enhance our Owned & Operated business, which is already showing positive outcomes, but also attract more users to our platform and increase retention.

Tridivesh Kidambi, Chief Financial Officer

And Dan, this is Tridi. Just to address the P&L impact, as you mentioned, we have already recalibrated and reorganized our OpEx base at the end of last year to align with specific initiatives and goals in product and development. To Michael's point, we are focused on creating a platform that can be used internally from start to finish, and eventually consider how it can be shared externally. For at least the next 12 months, our current team and OpEx capacity should be adequate to develop these medium-term initiatives. So in short, we do not expect any increase in the P&L.

Michael Blend, Co-Founder and CEO

Yes. I don't expect significant additional costs associated with this. One of the advantages we have is that the automation on our platform enables us to achieve more with the same staff.

Operator, Operator

This concludes the question-and-answer session. I will turn the call to Michael Blend for closing remarks.

Michael Blend, Co-Founder and CEO

Yes. Well, thanks, everybody, for joining us today. If you've been following us at System1 closely, you know it's been a choppy few quarters for us. But the team has been really heads down executing, and it feels like we're starting to see all that hard work paying off. I'd say we're getting increasingly optimistic about our trajectory here at the company, and so we look forward to speaking with all of you at our Q2 earnings call. Thank you very much. Thanks for joining.

Operator, Operator

This concludes today's conference. Thank you for joining. You may now disconnect your lines.