System1, Inc.

Thank you for standing by and welcome to the second quarter 2022 earnings call and webcast for System One. Joining me today to discuss System One's operational and financial results are our co-founder and CEO, Michael Blend, and our chief financial officer, Tritavish Kadambi. A recording of this conference call will be available on our investor relations website at ir.systemone.com 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 operational 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 fiscal year 2021 filed on March 31, 2022, and in our Form 10-Q for the second quarter of 2022 to be filed shortly, 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 assumptions and beliefs as of the date hereof, and System 1 disclaims any obligation to update any forward-looking statements except as required by law. Our discussion today will include non-GAAP financial measures, including pro forma revenue, pro forma gross profit, and pro forma justitibida. These non-GAAP measures should be considered in addition to and not as a substitute for or in isolation from our GAAP results. Information regarding our non-GAAP financial results, including a reconciliation of our historical GAAP to non-GAAP results, may be found in our earnings release, which was furnished with our Form 8K file today with the SEC. It may also be found on our investor relations website. I would now like to turn the conference call over to System One's co-founder and chief executive officer, Michael Blend.

Thanks, Kyle. Good afternoon, everyone, and thanks for joining us on our Q2 earnings call. Together with me on this call is Triti Kadambi, our longtime CFO. We're pleased to report a good Q2, which Triti will go into in detail. I would like to begin with an overview of some of our operating priorities and then describe our view of the current digital marketing landscape. We've made considerable progress on key priorities that will enable us to triple our marketing scale over the next few years. First, let's give a quick update on Ramp, which, as you remember, is our end-to-end marketing platform and a key growth driver. While Ramp is already one of the largest marketing platforms, we have ambitious plans to 3X our scale to $2 billion of marketing spend. Handling this kind of scale entails substantial behind-the-scenes advances in our technology, particularly in the areas of automation and machine learning. We've been hard at work on these advances, and much of our engineering and product team has been focused on this since last year. We started the transition to our next generation Ramp in Q2, While we are in the early stages of migrating traffic over, the early data looks very promising. By next quarter, I should be able to point to specific improvements from these efforts. Our biggest challenge remains hiring great engineers and product managers in a competitive hiring environment. But as other tech companies slow or freeze hiring, we are starting to see the market loosen a bit. We remain focused on adding great engineers and product managers. Shifting to M&A, we've made very good progress integrating our Road Warrior, Coupon Follow, and our most recent Answers.com acquisition. On Road Warrior, we have started using RAMP to profitably acquire new subscribers, and we're in the process of integrating our CMS platform to handle all the billing and customer communication. With Coupon Follow, we recently soft-launched our brand new cashback shopping program and already have over 500 participating merchants. We also began integrating the Coupon Follow coupon data with our start page search engine, and we expect to further integrate this data throughout our network of O&O properties. And finally, on Answers.com, we fully migrated the site to our tech stack and have seen an immediate 30% monetization lift. We also have started sending paid traffic to Answers.com. Early signs are really positive. And we remain active in the M&A front and are evaluating a few interesting opportunities. As always, we're looking for strategic deals where we can inject growth into the companies via ramp. While we are not bargain hunters, we do expect that overall market conditions could lead to lower pricing for acquisitions. Now I want to move on to our business performance, where the advertising business overall was solid in Q2. Our owned and operated business was in line with expectations, including our volume of marketing spend. And our partner network, which has been flat the last couple of years as we focused on owned and operated, is showing accelerated growth. This is a result of ramp improvements we have made to support that business combined with excellent execution by our partnership team. The one negative in our advertising business was a one-time occurrence where an advertising network sent us fraudulent traffic. Beginning earlier this year, we began scaling our marketing spin with the Microsoft Bing Partner Advertising Network. However, in June, we discovered that we had been paying for fraudulent traffic that did not convert for our advertisers. The fraudulent traffic went undetected by the most sophisticated compliance programs and platforms in the world, including the largest ad networks and our own system. This was an exceedingly rare occurrence, and we have identified the publishers responsible for the traffic. Atri is going to go into details of this event during his remarks. Despite this setback, our relationship with Bing remains strong. In fact, today we're happy to announce a three-year extension of our strategic partnership with Bing that's going to go through 2025. We look forward to putting this episode behind us, scaling back up our marketing on Bing, and continuing to work very closely with them in the future. Looking towards the rest of 2022 in advertising, we're starting to see some of the same macro trends reported by our peers in the digital space. In our case, we're starting to see advertising demand soften towards the end of Q2, and particularly the beginning of Q3. Typically, demand is lower in the summer months, the market resets downward in July, and then bounces back towards the end of summer. This July, the drop is more pronounced than it's been in recent years, and the market is recovering more slowly than typical. We believe this is due to inflation affecting buying habits and potentially from increased summer travel. While we do have the ability to get more aggressive on the buy side during a downturn, we've decided to stay a bit cautious so far this quarter. We're keeping a close eye on the ad markets and are beginning to see things stabilize and rebound as they always do. As the market moves, we are shifting marketing to the most in-demand verticals and increasing our buy side efforts on native and social networks. And, as we are continuing to push our international expansion. Now, moving on to our subscription business, we saw a nice performance in Q2. We continue to see improved retention and upsell metrics from our flagship antivirus product, TotalAV. We added 319,000 new subscribers, including more than 100,000 from our newer Total AdBlock product. We also launched a new product, a browser booster, which is a browser extension that speeds up a user's browsing experience. and we have more products set to launch later this year. The subscription team continues to be focused on retaining existing customers, opening new customer acquisition channels, and launching new products. The team is doing a great job, and I'm really excited about our near-term and long-term opportunities in subscription. Overall, we remain very bullish. We're going to keep investing in product and engineering, and we do not expect our investing to slow down. Our management team has been through macro headwinds several times, including 2008 and, of course, the onset of COVID-19 in 2020. Each time we have invested through these cycles and each time it has paid off. Times like these are when the diversification of our business model really shines. As areas like online shopping dip a bit, other advertising verticals like consumer finance open up. And at the same time digital advertising overall is facing headwinds, we're seeing opportunities open up in our subscription business. So while we are keeping a close eye on the short-term macro trends, we are playing for the long-term. I'm confident in our technology advantage, our diversification, and our long-term growth story. I'll now hand things off to Triti to discuss this quarter's results and updated guidance.

Take it away, Trudy. Thanks, Michael. As previously mentioned, we are excited about the results we delivered in Q2. And despite any short-term headwinds we might see for the rest of this year, we remain very bullish about the business. To start, I want to provide more color on the fraudulent traffic issue Michael mentioned earlier. Since Q1, we have been significantly growing our marketing spend with Microsoft's Bing Advertising Partner Network. Late in Q2, it was identified that this network was sending System 1 material amounts of fraudulent traffic. In plain English, we were paying for clicks that were generated by bots, not humans. Our analysis shows that these fraudulent clicks originated from websites owned by two large publishers on the Bing partner network, IAC and CBS Interactive. As a result of this fraudulent traffic, our revenue was impacted by $11 million, which is the amount refunded to our advertising partners. The impact of gross profit, net of any refunds received from Microsoft in Q2 of 2022, was $6 million. In this specific event, while Microsoft has acknowledged the fraudulent traffic and issued us a credit, our analysis shows that we have not yet been made whole. This type of event is rare, and even more rare is the advertising network not providing a full refund. Our data strongly shows that we are due an incremental ad credit from Microsoft and we are committed to pursuing all avenues available to us to be made whole. As a result, we've added back the net impact of this issue in our reported adjusted gross profit and adjusted EBITDA metrics for this quarter. Before diving into the rest of our Q2 results, I wanted to start with a reminder of our operating philosophy. Gross profit dollar generation is the ultimate metric we use to measure the effectiveness of our RAMP platform. We see RAMP as the key to growth by enabling more marketing spend and driving operating leverage through optimizations. Also, when I talk about our financial performance, and specifically year-over-year results, in every case I will be referring to pro forma financial metrics inclusive of Protected.net's results in prior periods. For a reconciliation of these metrics to our GAAP financials, please refer to the reconciliation tables in the earnings release issued earlier today. Let's move on to Q2 results. Revenue was $220 million as compared to $206 million last year, a 7% year-over-year increase on a pro forma basis. Adjusted gross profit was $74 million, an increase of 31% compared to last year's pro forma gross profit of $56 million, with all segments of the business contributing to that increase. Adjusted EBITDA was $41 million versus $34 million last year, and above the high end of guidance by $3 million. In general, similar to what we've seen in moments of dislocation in the past, as advertisers pulled back overall spend, the last dollars they pull are in the pay-for-performance categories, where RAMP excels. We were able to take advantage of this trend in Q2, ahead of the larger macro pullback for the back half of the year, and it lends further validation to our business model and the platform in the long term. On the advertising front, we acquired over a billion sessions to our owned and operated advertising properties in the quarter, reflecting a 32% increase year over year. Our cost per session was $0.12, with corresponding monetization of $0.16 per session, which maintains our spread of $0.04 sequentially and represents a spread of 35%. Excluding the impact of the fraudulent ad traffic issue, our cost per session was 11 cents, and our spread would have been 42%. Our network advertising business also delivered a strong quarter, with revenue up 52%, network RPS up 41%, and network sessions up 8% year over year. Overall, advertising revenue less advertising spend was up 21% year over year. The subscription business performed well with revenue up 19% and segment profit up 26% year over year. We continue to benefit from the shift to renewing customers and our ability to retain and upsell the large total AV user base. Subscriber ARPU was $20.17 in the quarter versus 1876 last year. Total subscribers were up 1% sequentially and 5% year over year. Change in deferred revenue, which represents the delta between gap subscription revenue and billings, was $3.5 million in the quarter. In our guidance for the year, we assume change in deferred revenue remains flat, with a similar seasonal spread through the quarters as last year. Operating expenses, net of add-backs, were $32.5 million for the second quarter of 2022, compared to $21.7 million last year. The year-over-year increase is reflective of our continued investment in RAMP, increased headcount from our transition to a public company, and increased public company costs. Operating expenses as a percentage of adjusted gross profit was 44% for the second quarter of 2022, compared to 50% last quarter. With respect to liquidity, we ended the quarter with $37 million of cash on the balance. Gross debt was $444 million, which includes the $49 million Revolver drawdown to finance the coupon follow acquisition. As of June 30th, LTM Billings-Based EBITDA, as defined by our credit facility, was $159 million, resulting in a net leverage ratio of 2.55 times. We plan to actively pay down the Revolver via our operating cash flow in the second half of the year. Now, onto guidance. Through the first six weeks of Q3, and consistent with the earnings announcements of our peers, we have seen a significant softening in the advertising market, driven by the macroeconomic environment. Despite the choppy start to the quarter, we believe the current trends are temporary. We expect advertising dollars and volume to come back to the market, and consistent with historic trends, we expect those dollars to come back first to performance-based advertising platforms. As we've seen in the past, when ad markets rebound, we've historically seen acceleration in our business. Our overall views on our business model remain unchanged. Our management team has been through many of these cycles in the past. Our guidance also reflects the financial impact of the marketing we previously had planned to do with Bing. Due to the fraudulent traffic issues I discussed earlier, we currently have materially reduced our advertising spend with Bing. Because this is a higher volume but lower margin business for us, the result is substantially lower gross revenue combined with higher gross margins. Additionally, we are seeing several pockets of new subscriber growth in our subscription business. While this is very positive, the short-term effect of increased customer acquisition is upfront marketing spend ahead of increased renewals and profitability next year. As a result of the combination of these internal trends, coupled with macroeconomic trends we discussed earlier, we have determined it is more appropriate to provide full year guidance versus specific Q3 guidance. This gives us the flexibility to pull acquisition levers as we deem necessary to take advantage of new sources of subscriber growth. We will provide an update on both of these trends during our next earnings announcement. For the full year, we expect revenue to be between 900 million and 930 million, representing 10% growth at the midpoint. adjusted gross profit to be between 285 and 295 million, representing 36% growth at the midpoint, and adjusted EBITDA to be between 155 and 165 million, representing 26% year-over-year growth at the midpoint. Our lower revenue guidance reflects our currently reduced marketing send with Bing, as well as our conservative view on buy-side spending as ad markets stabilize. The adjusted EBITDA guidance reflects a forecast of limited recovery in the macro environment, as well as our desire to maintain optionality to increase customer acquisition spend through the end of the year. Finally, I'm excited to announce that our board of directors has approved a repurchase program for both common shares and public warrants of up to $25 million. This program reflects both the company's and the board's confidence in our business model and platform. I want to reiterate that while the macro conditions have caused us to reduce our full year outlook, we view this as a temporary change as markets stabilize. Ultimately, this is a business that's going to conservatively grow gross profit by more than 35% and EBITDA by more than 20% at the low end of the range. We have a proven platform that thrives in these environments and a plethora of opportunities in front of us, both organic and via M&A. We are excited about our prospects and bullish about the opportunity. Thank you for joining us today, and now let's go to questions.