System1, Inc. (NYSE:SST) Q4 2023 Earnings Call Transcript

System1, Inc. (NYSE:SST) Q4 2023 Earnings Call Transcript March 18, 2024

System1, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning. My name is Christa, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the System1 Fourth Quarter and Full Year Conference Call and Webcast. 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 turn the conference over to Kyle Ostgaard, Vice President of Finance. Kyle, you may begin your conference.

Kyle Ostgaard: Thank you, operator. 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 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. Additionally, for all periods discussed, unless otherwise noted, the company will be referring to its results adjusted for the divestiture of the Total Security business, which closed on November 30, 2023.

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: Thanks, Kyle. Good morning, everyone, and thanks for joining us on our Q4 System1 earnings call. We have a lot to discuss today. The fourth quarter of 2023 was pretty jam packed for our company as we completed a number of important strategic shifts for System1. We believe these moves have set us up well for the future, and I’ll go into them one-by-one. First, as we previously announced, we sold our Total Security subscription business towards the end of the quarter, and I’ll talk about that in more detail in a moment. Importantly though, we also saw solid execution in our remaining advertising business on a number of fronts. As a result, we believe we are set up well for what we hope to be a secular reacceleration of spending in online advertising in 2024.

As you know if you follow System1, we sold our Total Security business during the quarter for consideration consisting of $240 million in cash, the redemption of 29 million of our outstanding shares, and the termination of certain earn out payments associated with our destock merger. I want to say a few words about our rationale behind the divestiture of that business and how it helps our remaining advertising business going forward. Now our Total Security was and remains a great business, like most subscription businesses, it has high upfront capital requirements to cover new customer acquisition costs. As the business grew under our ownership, Total Security required increasing amounts of capital to maintain a healthy new subscriber growth rate.

When System1 acquired the business in early 2022, the heavy upfront marketing costs were not really a significant concern for us. We had a low cost of capital during that low interest rate environment and spending $1 upfront to make $3 over the long-term was a great investment for our company. Things changed significantly towards the end of 2022 and heading into 2023. As interest rates and our corresponding interest expense costs rose over that period, our cost of capital to support total securities upfront marketing expense went up quite a bit. And at the same time, our advertising business suffered a downturn along with our environment generally and this lets us our overall business more highly leverage than it would like. In the current operating environment where cash is king and debt is expensive, once we received an offer for Total Security, we decided to run an extensive process.

In the end, we determined the offer from the Total Security management team combined with private equity was the best deal for System1. From a financial perspective, the sale of Total Security provided us with approximately $240 million of cash. This cash has allowed us to significantly delever our remaining business. The Total Security sale also included the redemption of 29 million shares held by the Total Security management. So going forward, we have a smaller shareholder base to realize the benefits from future growth in our remaining advertising business. Having a healthy amount of cash on our balance sheet is very important to our remaining advertising business. On the buy side of the business, access to capital gives us substantial capacity to scale our marketing spend and offer aggressive payment terms and return for buy side discounts.

On the technology front, we can continue to invest in new innovations utilizing generative AI to incorporate into our ramp platform. And finally, our improved balance sheet gives us capacity for any accretive or strategic tuck in acquisitions we may identify. Now on to the advertising business overview. I want to spend some time discussing our core advertising business in more detail. Let’s talk about the nature of our go forward business, changes and developments in the business over the past year and our plans to grow the business going forward. Our advertising business has been the core system once since we founded the company a decade ago. Except for the last few years, it was our only business. And so by divesting Total Security, we are returning to our core roots.

The advertising business has two basic components. First, our network business and second, our Owned & Operated business. Each of these in turn are organized between our paid and our organic business lines. Our paid business lines rely on paid marketing to fuel their growth and our organic business lines are primarily driven by consumers going directly to our properties or utilities. All of these components are then powered by our proprietary responsive acquisition marketing platform, which we refer to as RAMP. Our network business is the original legacy business of System1 and has historically been a very profitable business line for us. In this business, hundreds of network partners buy traffic on their own behalf and then use our RAMP platform to monetize this traffic.

In our network business, we do not take any risk on the buy side. Our partners incur all the traffic acquisition costs and then send that traffic through RAMP for System1 to monetize for them. Our paid Owned & Operated advertising business is similar to the network business I just described. The primary difference is that in our Owned & Operated business, we purchase traffic for our own digital destinations, while utilizing both the buy side monetization functionalities within RAMP. The simple way to think of this is that RAMP supports both hundreds of network partners as well as our own internal team, with our internal team being the largest customer of RAMP. Having a large Owned & Operated business also provides a lot of long-term value to our network partners.

The scale of our O&O business gives us very good insights into the challenges and opportunities faced by our network partners with respect to both buy side and monetization dynamics. We utilize these insights to continually improve RAMP and we can seamlessly test these improvements through their impact on our paid Owned & Operated business. When we are convinced that our new improvements are effective, we roll these out to our partners. In doing so, we constantly invest in the success of our network partners, attract new partners, and in turn make our RAMP platform that much stickier for our network partners. One example of the synergies derived between our paid O&O and the network businesses is the launch of our RAMP partner console, which we publicly announced last August.

The RAMP partner console provides self-serve tools that allow our partners to create and manage campaigns, just bidding strategies, access financial reporting, and get detailed analytics and reporting in near-real time. Essentially, we provide to our partners most of the tools that we use to manage our paid O&O business. As a result, both our paid O&O business and our network business experienced solid growth in Q4. Our network business grew 37% year-over-year and our paid O&O business grew 20% sequentially over Q3. While some of this growth is attributable to typical Q4 seasonality, our technology improvements and rapid incorporation of AI into our RAMP platform are having a materially positive effect on our overall business. Since first releasing the RAMP partner console to partners in late 2022, the number of active network partners has increased 50% from 135 at the end of 2022 to over 200 today.

The partner console has also allowed our partners to grow quicker. For example, in Q4 of 2023, 3 of our top 10 partners were new to the network in the year and the remaining 7 top 10 partners grew 120% collectively year-over-year in Q4. In addition to our marketing driven Owned & Operated business, we have several great organic traffic businesses such as MapQuest, Startpage and CouponFollow. These businesses are fairly distinct from our marketing driven business lines as they do not rely heavily on paid marketing. Instead, they are mostly powered by consumers direct navigating to these destinations or reaching them via non-paid organic search results. Our [indiscernible] businesses are stable sources of high gross margin revenue and in 2024 are projected to provide over 35% of our total revenue less marketing expenses.

These businesses are strong cash flow generators and have a relatively light engineering and overhead footprint within our organization. Together, our organic businesses provide a nice degree of consistent profitability and they also present opportunities for high margin growth as they seek to attract more organic users. On the technology side, we have also made substantial improvements to our RAMP platform over both the past quarter year. In addition to the launch of the RAMP partner console, we’ve also been highly focused on integrating AI in the critical aspect of RAMP in our business processes. AI is enabling us to scale the creation and distribution of our marketing campaigns at a pace we haven’t previously seen, and we believe that we are just beginning to scratch the surface on this front.

For example, in our O&O businesses, we’ve been utilizing AI machine learning tools to build optimized buy side capabilities that are directly linked to the performance of our RAMP monetization platform. To give you a sense of the impact on our ability to scale, this initiative has permitted our internal teams who are testing it to identify, launch, optimize, and monetize 5x as many campaigns per week for buying resource than we were able to achieve just 6 months ago. While we continue to refine the AI capabilities incorporated into RAMP, our ultimate goal is to be a one stop buy and sell side platform for performance marketers across the Internet. As our next step towards this goal, we are working to make our buy side capabilities available to our network partners.

These partners have historically used us only for sell side monetization and we plan to open up buy side capabilities over 2024. If we are able to successfully roll this out, our partners will be able to manage almost all of their business operations via RAMP. In addition to providing an integrated platform to our partners, we also plan to use our healthy balance sheet to help them scale their businesses. One example of System1 providing revenue guarantees across buy side channels in return for favorable pricing and then passing these savings on to our partners. In return, we can enable the partners to further scale their business on the RAMP platform. In addition to the momentum that we’ve realized from our technology improvements and stronger balance sheet, we’re anticipating some tailwinds from market changes as Google deprecates cookies within its industry leading Chrome browser.

We believe this change represents an opportunity for us given our vast amounts of first party data and our focus on contextual based advertising. We do expect there to be some disruption in the marketplaces once these changes are rolled out, so we could see some volatility in these markets during the back half of the year. However, as always, we welcome the volatility and believe RAMP is well positioned to take advantage of any choppiness in the advertising markets. We also feel well positioned to capitalize on an anticipated reacceleration in digital ad spending in the latter half of this year. Looking forward to 2024 and beyond, I believe System1 is a very rejuvenated, refocused and well capitalized company set up for a return to solid growth.

We have excellent technology, solid assets and strong relationships with our network and advertising partners. 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 as always don’t have a crystal ball about what the overall economic environment is going to look like. And after a rocky 2023, I don’t want to promise an operating performance that we aren’t confident we can meet or exceed. I encourage our shareholders to view System1 as a long-term investment opportunity and judge our success on an annual basis rather than on near-term quarter to quarter results. As a much leaner and focused digital 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 our Q1 2024 guidance. Take it away, Tridi.

Tridivesh Kidambi: Thanks, Michael. Thank you everyone for joining us today. I wanted to start by echoing Michael’s comments on the recently completed Total Security transaction. While we remain believers in the opportunity for RAMP to power Owned & Operated subscription businesses at significant scale, the Total Security business in particular was characterized by high upfront customer acquisition capital requirements and in turn required an increasing amount of our available capital to maintain its healthy growth rate. Given the increased interest rate environment compared to when we acquired the business, when combined with the secular headwinds we faced in our advertising business over the past 18 months, the divestiture was an important step in rightsizing our capital structure and improving our balance sheet.

As a result of the transaction, we used a portion of the cash proceeds to pay down approximately $155 million of notional debt, in addition to our scheduled mandatory amortization of $5 million per quarter. And we still retain substantial liquidity on the balance sheet to grow our core advertising business, which we believe to be at or nearing a secular trough. Now, on to our operating results. Q4 revenue was $96.1 million, representing a 31% year-over-year decline, which was narrower as compared to the 44% decline that we saw in Q3. This also represents growth of 9% sequentially compared to an 11% sequential decline from Q3 to Q4 of 2022. This comes in above the top end of our implied Q4 revenue guidance range that we provided in December.

Owned & Operated advertising revenue was $79.4 million representing a 38% year-over-year decline, also narrower than the 54% decline that we saw in Q3, a sequential growth of 20%. Last year, Owned & Operated advertising declined quarter over quarter from Q3 to Q4 by 11%. Network advertising revenue was $16.7 million, up 37% year-over-year. As Michael mentioned during his remarks, we remain incredibly bullish about the growth potential of our network advertising business, especially given the investments in additional features and tools for our RAMP platform that we are now making available to our partners. Adjusted gross profit was $37.6 million, down 12% year-over-year versus 18% year-over-year decline in Q3 of 2023 and comes in above the high-end of the implied Q4 adjusted gross profit guidance range previously provided.

Revenue less advertising spend for our Owned & Operated advertising segment declined 24% to $26.6 million versus a 36% decline in Q3 of 2023. Network revenue less agency fees was up 35% to $13.1 million versus $9.7 million in the prior year quarter. Owned & Operated cost per session and revenue per session were both flat sequentially at $0.05 to $0.07 respectively, with the spread also flat sequentially at $0.025. On the network advertising business, RPS was $0.02 per session. Most importantly, total sessions processed by RAMP in the most recent quarter was $1.85 billion, up 4% sequentially and 31% year-over-year. Operating expenses net of add backs were $27.6 million, down 3% year-over-year and down 5% sequentially. Adjusted EBITDA was $10 million versus $14.4 million last year, down 31% year-over-year, but up 24% quarter-over-quarter.

This represents a margin on adjusted gross profit of 26.6% versus 21.8% in Q3 of ’23 and came in above the high end of the implied Q4 guidance range. With respect to liquidity, we ended the year with $135.3 million of unrestricted cash on our balance sheet and a balance of $365 million of term loans under our credit agreement. Taking into account the modified Dutch auction to repurchase term loan debt under our credit agreement that we completed in mid-January we had $94.4 million of unrestricted cash and a balance of $301.3 million of term loan under our credit agreement. Our implied net leverage at year end pro forma for the impact of the completed modified Dutch auction is slightly above 7x. On a run rate basis, after giving effect to the operating expense cuts we made throughout 2023, as well as the increased professional services costs that we incurred to assist in the restatement of our Q1 through Q3 ’22 financial statements, our pro forma net leverage would be approximately 4.8x.

While we are comfortable that our current capital structure, 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 continuing to delever in a prudent matter in the current market, including through further attractive and opportunistic debt repurchases, accretive M&A, and most importantly through the organic growth of our core advertising business. And our entire team is now singularly focused on execution to achieve this organic growth. We remain cautiously optimistic about macro trends in digital advertising generally. We are also bullish on our identified near-term opportunities, as well as our team’s ability to continue to improve and optimize our RAMP platform, including offering both greater sell side and buy side functionality to our partners.

That being said, an upturn in macro trends is unproven at this point. For example, to date in Q1 of ’24, we are not seeing evidence of a comparable rebound to what we experienced in the first half of 2023, much less the first half of 2022. Moreover, while we view Google’s anticipated cookie deprecation on its Chrome web browser, currently anticipated in or around late 2024 as a net positive for our overall business, the change does create a significant amount of uncertainty in the online advertising environment in which we operate. As a result, at this time, we will not be providing full year guidance for 2024. We are estimating Q1 revenue to come in between $82 million and $84 million representing a 31% year-over-year decline at the midpoint.

We are estimating adjusted gross profit to come in between $28 million and $30 million representing a 24% decline at the midpoint. We estimate Q1 adjusted EBITDA to come in between negative $1 million and negative $2 million which is reflective of some seasonality in operating expenses where we see higher professional services expenses primarily related to our fiscal year audit as well as higher beginning of the year accruals for payroll and bonus related expenses. I want to reiterate that we are cautiously optimistic about macro trends in digital advertising for this current year, I’m bullish about our abilities to execute against our near-term opportunities. Thank you for joining us today.

See also 20 Countries that Export the Most Rum in the World and 22 Best Whiskeys Under $50 in 2024.

Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Dan Kurnos from The Benchmark Company.

Dan Kurnos: Michael, Tridi, just how do we think is there any way to get some incremental thoughts around the integration and streamlining? I mean, this is the year for ad tech in general of streamlining businesses. I’d like what you guys are doing in terms of sort of the enhanced offerings. Can we just maybe even just get some cadence or timing thoughts on how that could impact the business? And if there’s any way to kind of, I know you won’t maybe put numbers around it, although it would be great if you did, but just any way to kind of think about the size of the impact that could have?

Michael Blend: So as far as streamlining the business, I can answer on a couple of fronts. So first of all, we on the OpEx side, we took a bunch of calls out of the business over kind of the latter half of 2022 and 2023. So we’re operating off of a reduced cost base and we don’t expect that to grow much on a go forward basis. As far as kind of a growth on the business, I’ve mentioned AI and incorporation of it into our overall platform. And what that is allowing us to do is essentially scale a lot of the processes that typically would have done by employees of the company. And we’re automating and scaling. And so the growth of ramp going forward is going to be largely driven by AI. And we don’t expect to hire much headcount to really support that growth. So on a go forward basis, the business is scaling. It’s going to be dropping cash to the bottom-line. Tridi, you want to kind of extrapolate on that?

Tridivesh Kidambi: Yes. I think just on that point, I mentioned in our prepared remarks that the specifically the Q1 OpEx and per the guidance, kind of implied between $30 million and $31 million should be the high point in terms of OpEx. And to Michael’s point, that’s going to kind of drop throughout the year as we get through some of the Q1 accruals. And, also, we’ve said this on previous calls as well, but, we do continue to plan streamlining, continue to take kind of cost out of OpEx going forward throughout the year. And so, again, as we think about just the ad market and ad demand coming back, all of that gross profit growth, that we’re expecting throughout this year, knocking on wood here, will flow down to EBITDA profitability.

Dan Kurnos: Let me maybe rephrase a little bit. I guess I was thinking more just in terms of integration and buy side simplification of the process. And when we found out that ad buyers are frankly need a lot more handholding than I think a lot of people thought. And so to the extent, Michael, that you’ve sort of made the process easier to access, you’ve given them all the tools, they can now be walked through at AI, can explain a lot of the more complex components to them. Just how do we think about sort of the growth opportunity from a revenue perspective?

Michael Blend: Yes. So the way to think about our business on the Owned & Operated side, and this is more of the marketing driven part of our business, would be, we have thousands of marketing campaigns that we put out there across hundreds of different advertising verticals, and they don’t all work. So in aggregate, they’re profitable, but as we’re launching new campaigns, they’re not all going to be profitable out of the gate. And some of them are going to be negative, and when we kind of cut them off as quickly as possible. And so what AI has allowed us to do is essentially scale pretty dramatically. And I’m talking if you look at a year ago, we’re up over, I believe, 5x the number of campaigns we can we can roll out on a weekly, monthly basis.

And so we can basically put more lines in the water. And the more we do that, the more we find the profitable campaigns. We can then use AI to optimize our bid pricing on those. And so we and once things are optimizing, a campaign is kind of profitable for us on a on a regular basis, and we stopped seeing volatility in the campaign. We kind of leave it out there running. And, so it’s essentially allowed us to scale that buy side of our business, pretty dramatically as I mentioned. And so when you talk about RAMP and opening up the buy side to our network partners, what we’re doing is pretty difficult. We’re one of the largest our Owned & Operated business, one of the largest advertising buyers out there. And, we run this process through a bunch of different marketing channels, everything from native to social to search buy side.

And it’s quite difficult to do if you’re a smaller average size shop. So on the network side of our business, as we open up those capabilities, we expect we’re going to enable, a fair number of our partners to scale their business on us substantially just by incorporating what we’re already doing. Does that answer your question, Dan?

Dan Kurnos: Yes. No, that’s helpful. I’m just trying to get sort of directionally how we should think about the impact of that decision, but obviously very early, most of the adoption is. One other kind of, let’s just call it, two parter. You’ve been unwilling to really get into CTV before. It feels like we’re having a dead cat balance in CPMs. I don’t know if there’s any incremental appetite to get into that side. And we’re also seeing some green shoots in international too, Michael. So if you want to address both of those topics, love to hear it.