CS Disco, Inc. (NYSE:LAW) Q3 2023 Earnings Call Transcript November 9, 2023
CS Disco, Inc. beats earnings expectations. Reported EPS is $-0.01707, expectations were $-0.12.
Operator: Ladies and gentlemen, thank you for standing by. And welcome to the to the CS Disco Third Quarter of Fiscal Year 2023 Conference Call. At this time, all participants are in listen-only mode. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] I would now like to now hand the conference over to your first speaker today, Head of Investor Relations, Aleksey Lakchakov. Please go ahead, sir.
Aleksey Lakchakov: Good afternoon, and thank you for joining us on today’s conference call to discuss the financial results for Disco’s second quarter of 2023. With me on today’s call are Scott Hill, Disco’s Chief Executive Officer and Michael Lafair, Chief Financial Officer. Today’s call will include forward looking statements within the meaning of the Safe Harbor provisions of the private securities litigation Reform Act of 1995. Including but not limited to statements regarding our financial outlook and future performance, our use of capital expenditures, market opportunity, market position, product strategy, and growth opportunities and developments in the legal technology industry. In addition to our prepared remarks, our earnings press release, SEC filings, and a replay of today’s call can be found on our Investor Relations website at ir.csDisco.com.
Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results, performance, or achievements to be materially different from those expressed or implied by the forward-looking statements. Forward-looking statements represent our management’s beliefs and assumptions only as of the date made. Information on factors that could affect the company’s financial results is included in its filings with the SEC from time-to-time, including the section titled Risk Factors in the company’s quarterly report on Form 10-Q for the quarter ended June 30, 2023, filed with the SEC on August 9, 2023 and the company’s upcoming Form 10-Q for the year ended September 30, 2023. In addition, during today’s call, we will discuss non-GAAP financial measures.
These non-GAAP financial measures are in addition to and not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A reconciliation between GAAP and non-GAAP financial measures and a discussion of the limitations of using non-GAAP measures versus their closest GAAP equivalents is available in our earnings release. And with that, I’d like to turn the call over to Scott.
Scott Hill: Thanks, Aleksey. Good afternoon, everyone, and thank you for joining us. For those of you who I have not yet met, I’m Scott Hill. I assumed the role of Chief Executive Officer about two months ago. Before we dive into the results, I would like to briefly introduce myself. I was the CFO of a company called Intercontinental Exchange, better known as ICE, from 2007 until 2021. I joined ICE not long after its IPO and helped lead a company that uses innovative technology to fundamentally transform commodity and financial markets and generate strong growth and investor returns. I met Disco just after I retired from ICE and saw a company similarly poised to use technology to transform the legal industry and generate strong growth and returns.
I jumped at the chance to join Disco’s Board of Directors in June of 2021, shortly before we went public. More recently, the Board asked me to step into the CEO role on an interim basis while we conduct the search for a permanent CEO. We are focused on finding a leader with demonstrated experience scaling businesses, leading high-functioning organization and building, enhancing and maintaining a strong cultural foundation. Once we find our new CEO, I look forward to remaining on Disco’s Board of Directors. Until then, I will strive every day to make a meaningful and positive contribution to the company, its employees, its customers and its shareholders. There’s a lot of work to be done. We’ve gone through a difficult couple of months, but we remain steadfast and focused on building the leading legal technology company.
I’m here to enable that strategic vision by removing obstacles and making decisions that propel the business forward. I’m excited to be a bridge to Disco’s next chapter. Although, I’ve been here only a short while as CEO, and I’m still very much diving into the core of our operations, I’ve already spent considerable time speaking to our leadership team across all functions meeting with our customers around the country and listening to our employees. The magic that makes Disco unique continues to permeate our company. Before diving into the quarter, I wanted to share some of my initial observations. First, I’m very impressed with the employees and talent we have at Disco across all functional areas. Our team continues to work incredibly hard to build the best company possible.
Their commitment and dedication in the face of numerous challenges is inspiring. Disco’s ability to succeed is not dependent upon a single person but a collective team focused on innovation and customer service. That is the DNA of the company. And that is what will help us regain our footing and enable our future success. Second, Disco has extraordinary products. Our customers love them. Having gone on several trips to visit our largest and most sophisticated users, the anecdotes I’ve been hearing are eye-opening, and I see the beauty of our platform in a lot more detail. I’ve heard firsthand from general counsels and law firm partners and associates about the time savings and simplicity Disco has brought to their legal operations. And when we showcasing demo, our upcoming AI-focused products like Cecelia Q&A or Cecilia time line, their eyes light up.
They see the power of our solutions and how it will positively impact the future of legal work. Third, I’m confident in our product road map and strategy. We have world-class talent on the product and engineering side of the house and the capabilities to build innovative solutions that can transform the legal industry and the pace and quality of that product development has never been better. Fourth, we’ve made progress within our go-to-market organization. We had our best revenue quarter as a company in Q3 and that momentum carried into October. However, there’s more work to be done. We are operating in a market with embedded legacy software providers and displacing those entrenched competitors takes time and requires great focus and execution.
In particular, we are investing to enhance our approach to enterprise clients, both corporate legal functions and large law firms. Fifth, we need to engage with and invest in our most important asset, our people. There are cultural elements at Disco that need to be improved, and that is one of my top priorities. Building a great company culture takes time and we are committed to promoting a constructive and supportive work environment that will enable our team to realize their full potential to the benefit of our customers and shareholders. We are already taking the important first steps of this journey. With that, let’s dive into our performance during the third quarter. Revenues for Q3 2023 was a record $34.9 million, adjusted EBITDA was negative $4.5 million, a sequential improvement from the second quarter.
We ended the quarter with $158 million of cash, no debt and 1,449 customers, 10% more than a year ago. Michael will provide more details about the quarter shortly. Within our core eDiscovery business, we have continued to make progress. We have seen a reacceleration in usage over the last several months, which continued in October. We saw quarter-over-quarter growth in both active and early case assessment usage, which is very encouraging. Although ECA is still the fastest-growing data segment, we are also seeing growth in active. This is attributed to the hard work our sales team is doing to attract new matters and gigabytes to our platform in addition to usage expansion among our existing customer base. Our product and engineering teams released some important new eDiscovery features during the third quarter.
We introduced self-service capabilities for Slack, which is by far the fastest-growing data set among our customers. This new capability will allow customers to upload documents in the eDiscovery without needing DISCO support, considerably reducing total NGS time for Slack data. Our team also released eDiscovery annotation which allows much more intuitive and flexible collaboration between team members within DISCO eDiscovery. Customers can now annotate specific documents, alert their team and start comment threads creating a richer workflow for the legal team. We also added a witness management module to our case builder product, a task that has been historically performed in Excel and Word can now efficiently be conducted in a central contextually rich interface.
Finally, we continue to enhance our facility Q&A capabilities to match how our users work with the addition of scoping. Scoping allows users additional control over the content being reviewed, such as documents related to a specific custodian. This allows our customers to find answers faster within specific document sets. This was the single most requested product enhancement to Cecilia, based upon early customer trials. In addition to delivering a solid third quarter and a fast start in October, our sales team has been busy introducing our customers to our new DISCO AI platform, Cecilia. We’ve embarked upon a nationwide customer road show where we have been showcasing Cecelia Q&A, an integrated AI chatbot for large-scale eDiscovery as well as Cecilia time line which automatically generates time line from re-existing legal documents.
We are also previewing several other Cecilia skills on our product road map. Importantly, Cecilia is running in beta in support of over 20 active customer matters. Those customers are using Cecilia to rapidly understand critical facts in opposing productions, prepare for depositions and gain insights in the critical case strategy question. I’ve had the opportunity to join dozens of our AI roadshow events in my first few weeks and the power of this technology to help our customers deliver better legal outcomes for their clients is clear. We’ve heard customers talk about how Cecilia can help minimize the time required for tedious tasks such as building a time line. A must have for any case but also time consuming and expensive from a billing perspective.
Customers also appreciate the efficiencies of document interrogation using Cecilia Q&A. In fact, one customer highlighted some critical documents their prior review had missed but with Cecelia helped surface. We believe that the risks and costs associated with not using technology like Cecilia to augment lawyer capabilities is odd. We are focused on continuing to build customer interest in generating financial returns on this important investment. We also continue to invest in our long-term strategy to become an end-to-end legal technology provider. You saw us announce yesterday that we’ve licensed fast cases comprehensive US primary law data. This will give us and our customer’s access to all federal and state laws, regulations and court rules.
Integrating facts and evidence with primary law into a single platform will further our ability to enable legal professionals to deliver optimal outcomes for their client by leveraging our leading innovation around AI and intelligent workflow solutions. We look forward to sharing additional aspects of our strategy over the coming quarters. With regards to the path to profitability, we have made impressive progress. Then we have much lower operating expenses now than in Q3 of last year. My early observation though is that the way, in which we have allocated resources may have swung too far and too fast from a growth-only focus to cost cutting. We have to make sure we have a balance between cost efficiency and growth investments. I believe a balanced approach to profitability that combines prudent expense and resource management, along with investments in our people, products and sales will result in a more sustainable, profitable and growing company.
Two months into this role, I strongly believe we have the people, the products and the customer relationships to reenergize our top line. We will have more concrete full year 2024 guidance on our fourth quarter earnings call in February. With that, I’ll hand it over to Michael.
Michael Lafair: Thank you, Scott. In Q3 2023, revenue was $34.9 million, although year-over-year revenue was up only 1%, we are starting to see a pickup in eDiscovery usage. As Scott mentioned, we are seeing growth in both ECA and active data on our platform. Within review, revenue came in below where it was in Q2 due to $1 million review that ended offset somewhat by the growth of our eDiscovery business. In discussing the remainder of the income statement, please note that unless otherwise specified, all references to our gross margin, operating expenses and net loss are on a non-GAAP basis. Adjusted EBITDA is also a non-GAAP financial measure. Our gross margin in Q3 was 75%, as we mentioned before, our gross margins fluctuate from period to period based on the nature of our customers’ usage, for example, email and types of data ingested and managed on our platform.
Sales and marketing expense for Q3 was $15.4 million or 44% of revenue compared to 54% of revenue in Q3 of the prior year. This represents a decrease of over $3.1 million in the quarter year-on-year. The decrease was primarily driven by a decrease in sales and marketing personnel costs. Research and development expense for Q3 was $10.1 million or 29% of revenue compared to 40% of revenue in Q3 of the prior year. This represents a decrease of approximately $3.7 million in the quarter year-on-year. This decrease was primarily driven by a reduction in research and development personnel costs. General and administrative expense in Q3 was $6.6 million, or 19% of revenue compared to 23% of revenue in Q3 of the prior year. This represents a decrease of approximately $1.3 million in the quarter year-on-year.
The majority of the decrease was driven by a reduction in general and administrative personnel costs. Operating loss in Q3 was negative $5.8 million, representing an operating margin of negative 17% compared to negative 41% in Q3 of the prior year. In total, our Q3 operating expenses were over $8.1 million lower than Q3 of the prior year, representing an approximate 20% reduction in operating expenses. Adjusted EBITDA was negative $4.5 million in Q3, representing an adjusted EBITDA margin of negative 13% compared to adjusted EBITDA margin of negative 38% in Q3 of the prior year. These results represented an adjusted EBITDA improvement of $8.5 million from Q3 of last year, bringing us closer to profitability. Net loss in Q3 was $3.9 million or negative 11% of revenue compared to a net loss of $14.1 million or negative 41% of revenue in Q3 of the prior year.
Net loss per share for Q3 was negative $0.06 per share compared to negative $0.24 per share in Q3 of the prior year. Turning to the balance sheet and cash flow statement. We ended Q3 with $157.7 million in cash and cash equivalents and no debt. Operating cash flow in the first three quarters of 2023 was negative $28.7 million ompared to negative $36.7 million in the same period of the year prior. Now turning to the outlook. For Q4 2023, we are providing revenue guidance in the range of $34 million to $36 million and adjusted EBITDA guidance in the range of negative $7 million to negative $5 million. For fiscal year 2023, we are providing revenue guidance in the range of $136.3 million to $138.3 million and adjusted EBITDA guidance in the range of negative $31.9 million to negative $29.9 million.
As Scott mentioned, we will provide our 2024 revenue and adjusted EBITDA targets on our next earnings call. At this point, we are not planning to significantly increase spending from current levels. However, we do expect to make some additional investments to set the company up for success in 2024 and beyond. Now I would like to turn the call over to the operator to open up the line for Q&A. Operator?
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Q&A Session
Follow Cs Disco Inc.
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Operator: Thank you, sir. [Operator Instructions] Our first question comes from the line of Derrick Wood from TD Cowen. Please go ahead with your question.
Unidentified Analyst: Hey guys. This is Cole on for Derrick. Just want to get a better picture of kind of how sales rep productivity has been trending in the quarter. I know that last quarter, you talked enablement initiatives. But can you just give us an update on that.
Scott Hill: Thanks for the question. So we’re really pleased about the performance in Q3. It was a record quarter, the best quarter in the history of the company. And so in terms of rep productivity, we’re pleased with the direction of the business. And as we mentioned in our prepared remarks, we’re very, very pleased with the pace of where the business is going and how the usage on the platform, in particular, with respect to eDiscovery has picked up into October. So we’re pleased with how things are going.
Unidentified Analyst: Great. Thanks. And then just one more, on the net new customer number, that was lower than it’s been in the past couple of quarters, kind of impaired with the sales rep productivity, has that productivity shifted to more of a focus on existing customers and kind of selling into that more? Or what are you seeing on the new customer front?
Scott Hill : Yes. It’s Scott, and I’ll take this. And it’s interesting the way you phrased the question. It’s not a focus on existing or a focus on new, it’s a focus on both. And that’s one of the things in the couple of months that I’ve been here that I think we need to do a better job of — from a sales standpoint is it’s not corporate or transactional, it’s not corporate or a law, it’s all of that. And so I was pleased to see the customer count up again 10% year-over-year. Pleased to see that it’s trended up as we’ve moved through the year. And I think that’s a great opportunity for us. It gives us a larger customer base to sell into. But it’s also the case that we’ve got this great existing set of customers that I think we can do a better job of selling into as well.
And so I’d like to see the customer count grow. We’re clearly focused on continuing that trend. But we — again, we want to do both. And I think in the quarter, we did a pretty good job of that. We saw some growth and existing customers, we saw growth in new customers, and that’s a trend that I’m really working hard with Luke and the sales team to focus on it as we move forward and to take the steps that we can do to enable that team to be able to not do either or but to do both.
Unidentified Analyst : Great. Appreciate the color. Thanks.
Operator: Thank you. Our next question comes from the line of Scott Berg from Needham & Company. Please go ahead with your question.
Unidentified Analyst : This is Ron Morelli [ph] off from Scott Berg. Thanks for taking the question. Your 4Q revenue guidance is a touch life on the implied guide last quarter. Is this a difference based on less new customers signing 3Q or our existing customers, I guess, using — is usage less than what was previously expected?
Scott Hill : Yes. So we feel good about the usage and in particular, on ediscovery into October into the beginning of Q4. We — in terms of the guidance, we have provided guidance based on what we believe the number will land based on all the information we have as of today, and we feel good about that number. Obviously, we would like to beat the guidance. But the number that we provided is the number based on all the facts we have today that we believe we’re going to land based on where we are now.
Unidentified Analyst : Got it. And then with the addition of primary law, what does that do for the Disco platform competitively? And also how do the economics work for Disco? Thanks.
Scott Hill : Yes. So I’ll start, and then I’ll let Michael walk you through the financial aspects of it. But I think the way that I would think about it is we’ve built an amazing platform that today helps lawyers understand all of the facts and the evidence in their case. And so whether it’s in our ediscovery platform today or using Case Builder or we’ve been demoing Cecilia and basically interrogating Cecilia on all your facts and evidence, makes the workload of understanding your facts far more efficient than it has historically been. What the primary law does is allow us to go from what are my facts to what law is relevant to those facts? How do the facts and law intersect? And again, I think that’s a really big step forward on our overall goal strategically to be an end-to-end platform, a place where lawyers can come in and work with their facts and evidence come in and understand the relevant laws and use all of that information to determine what the best path forward is with their clients.
And so I think that’s the great opportunity. Imagine so in a world where Cecelia becomes an expert on 100% of your documents and your facts. Imagine if that witness also knew 100% of the relevant law, how powerful that can be. And so I think for what’s a relatively small investment, we have the opportunity to create an incredibly powerful offering for our customers. Mike, do you want to talk a little bit about the financial
Michael Lafair: Again, in terms of the financial impact of this, I mean, we spend — it’s a $14 million investment that gives us access to all of primary law, as we described in the release that went out yesterday for five years as well as regular updates of that law. So when I go back from almost six years ago when I joined the business, this has been a vision of the business from, I believe, the inception and especially from — since when I joined. And as Scott mentioned, the concept that we have the evidence and we have our technology to help review that evidence and then we also have the law at the same time that we’re going to build into the product. It’s very, very powerful. And we also have an option to renew for another five years.
And then we have additional options to renew beyond that. So it’s a really exciting opportunity for not a large investment from a cash perspective to build it into our product and give our customers really the full spectrum from the eDiscovery piece to what is the law.
Unidentified Analyst: Got it. That’s helpful. I guess with that option, is it another $14 million investment after five years? Or is there describes
Michael Lafair: We haven’t disclosed what the option price is but it’s — we just haven’t disclosed that.
Unidentified Analyst: Got it. Thanks for the color.
Operator: Thank you. Our next question comes from the line of Mark Schappel from Loop Capital Markets. Please go ahead with your question.
Mark Schappel: Hi. Thank you for my questions. Michael, I was wondering if you could just provide some additional details on your activity around your view product. For instance, are you expecting any additional legal matters to kind of wind down on the platform in the next quarter or two?
Scott Hill: Yes, I mean, so all of our business, as you know, is usage-based or most of our business is usage-based. So matters will end when a case ends or when a case may settle or a judge may make a decision in one way or another that could cause the customer to actually have to load up a whole bunch of new data on the system or in the alternative if the case settles remove data from the system. So it’s the review piece, and we mentioned this in the script, there was a large review that ended in the prior quarter in Q2 that was a significant amount of — it was a $1 million-plus review. That review ended and had an impact on our Q3 numbers. And in terms of the guidance we’ve provided and we’ve provided some color on October, we feel really good about eDiscovery and the usage on eDiscovery that’s kind of happened over the last couple of months and into October.
