VerticalScope Holdings Inc

TSX:FORA

Earnings Call Transcript 2022-Q3

[Operator]

Hello, and welcome to the VerticalScope Holdings Inc. Third Quarter 2022 Earnings Conference Call. My name is Alex, and I'll be coordinating the call today. [Operator Instructions]

I will now hand over to your host, Diane Yu, Chief Legal Officer. Please go ahead.

[Diane Yu, executive]

Thank you, operator. Good morning, everyone, and welcome to VerticalScope Holdings Third Quarter 2022 Earnings Call. I'm joined by Rob Laidlaw, our Founder and Chief Executive Officer; Vince Bellissimo, our Chief Financial Officer; and Chris Goodridge, our President and Chief Operating Officer. We'll begin with commentary on the quarter before opening the floor to questions.

Before we, I'd like to remind everyone that today's presentation contains forward-looking information that involves known and unknown risks and uncertainties and other factors that could cause actual events to differ materially from expectations. These statements should not be read as assurances of future performance or results. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements to be materially different from those implied by such statements.

A more complete discussion of the risks and uncertainties facing the company appears in the company's management discussion and analysis for the 3- and 9-month period ended September 30, 2022, which is available under the company's profile on SEDAR, as well as on the company's website. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this presentation.

The company disclaims any intention or obligation, except to the extent required by law, to update and revise any forward-looking statements as a result of new information, future events or for any other reason. Our discussion today will include references to adjusted financial measures, including adjusted EBITDA, free cash flow, free cash flow conversion in MAU, which are non-IFRS measures. All references to currency in this presentation shall refer to USD unless otherwise specified.

Now I will turn the call over to Rob Laidlaw, Founder and CEO of VerticalScope. Rob?

[Robert Laidlaw, executive]

Thanks, Diane. Good morning, everyone, and thank you for joining us today. The third quarter started out great for our business and ended with some concerns. We performed well in July and most of August, before macroeconomic headwinds caught up with us, and we experienced a much tougher end to the quarter, which continued into October.

Overall, third quarter revenue was up 40% year-over-year to $19.6 million, a solid result, but it could have been better. We saw weakness in programmatic advertising begin around the midpoint of August and worsen in September. Similarly, our direct business, which has been growing, started to feel the effect of slower decision-making from our advertisers and resulting in delayed or reduced all advertising plans. Notably, our visibility to Q4 is less than we would prefer at this point, where things look a little more flat on a year-over-year basis versus the double-digit growth we had experienced earlier in the year and the 8% growth we experienced in Q3.

Turning to e-commerce. That is where I think there is more uncertainty. A fantastic result in Q3 with 58% growth over the same quarter last year, but I think that will probably be the peak results until we see some economic stability return and consumer confidence improve. We are seeing pullbacks from our largest spenders here, and we're seeing some of the largest e-commerce retailers in the world now calling for a soft Q4. We are being cautious, optimizing daily against our best performing partners. But ultimately, this is primarily a commission-based product where we earn revenue when consumers buy goods from our partners. It would appear that customers are either saving more of their disposable income or it's being redirected towards ever-increasing food and mortgage costs.

Regarding adjusted EBITDA, I think we survived peak tech wage inflation relatively well, recording $7 million of adjusted EBITDA in the quarter, up 40% versus last year, excluding the Paycheck Protection Loan Forgiveness in the prior year period. Now it is up to us as a leadership team to manage our costs appropriately. I highly value our free cash flow and our profitability, and those will be key factors for us as we look at 2023. We are deeply focused on ensuring that we are appropriately investing capital and properly weighting our investments towards the growth initiatives with the highest potential.

With that in mind, we have slowed a number of investments and are putting more resources towards what makes our communities special. That is the ability to find authentic perspectives from real-world owners and enthusiasts, particularly around products. We are reallocating resources towards our products and e-commerce initiatives, helping our enthusiast customers find the products and authentic reviews of those products that are best suited to them. We are also focused on getting a better mobile app for our users. It's behind schedule, but we're iterating to deliver a high-quality, high retention app. We look forward to giving you more perspectives on the results of these investments in future quarters.

Finally, I want to talk about MAUs. They were slightly better than expected in the quarter to begin and then tailed off a bit in September to a level below our expectations. Overall, we finished at 110 million MAUs and had a slight organic decline of 2.9% compared to minus 4.4% last quarter. Through September and October, there were a number of search engine algorithm updates, perhaps one of the most volatile periods for search engine ranking that the market has ever seen. Our sites again remained extremely resilient and fared quite well against the competition. But overall, we did experience a mid-single-digit decline that could be partially attributed to macroeconomic factors and partially towards the algorithm updates.

To add some confusion to the matter, we will be changing our reporting from Google Analytics 360, our GA360, over to the newer version GA4, hopefully in the next quarter. This may cause some additional noise in the numbers in future quarters, but we will do our best to decipher the data and give you a clear picture of the trend.

I realize that I haven't been particularly forward about what Q4 and 2023 will look like for our business. But I think that is because there is a great deal of macro uncertainty and mixed messages in the market. For us, we will focus on delivering results for our shareholders. And at today's share price, I think much of what I've told you today, investors seem to have already fully built into our share price. We are long-term investors and compounders. And we think that while the near term is foggy, the medium and long term is as bright as it's ever been. We're excited about the organic growth opportunities that we are uncovering and also the potential for future M&A at accretive multiples.

I thank you for your support and confidence, and now I'll turn it over to Chris and Vince to give you some more details on the quarter.

[Christopher Goodridge, executive]

Thanks, Rob, and thanks to everyone joining today. As Rob indicated, we posted a solid top line result with our strongest third quarter in company history. Despite the mounting macro headwinds, we delivered growth across both advertising and e-commerce channels, thanks to the continued hard work of our team and the performance-driven nature of our platform.

Total revenue was up 40% over prior year in the quarter and is up 39% year-to-date. Advertising revenue grew by double digits for the seventh consecutive quarter and was up 33% over prior year and 42% year-to-date. Programmatic revenue was $8.4 million, up 52% over prior year and making up 53% of our total advertising revenue. This reflected a slight deceleration compared to the 62% growth we experienced in Q2 as we began to see signs of softness in CPMs from demand partners as the quarter progressed, which we attribute to the broader macro weakness being felt across the industry.

Our direct sales channel contributed $4.9 million and represented 37% of total advertising revenue in the quarter. This was up 8% over prior year. We saw slight improvements with automotive, power sports and insurance customers, which offset lower spending from retail and consumer electronic brands. Our intent-driven and contextually relevant audiences provide real measurable value to our partners, and we believe we are well positioned to capture spend as marketing dollars shift from brand to performance channels.

E-commerce revenue was $6.2 million in Q3, up 59% and reflecting a second consecutive quarter of double-digit growth. The acquisitions we made in Q4 last year have made a big contribution, led by the streamable.com. More broadly, however, the channel continues to experience the pullback in the consumer categories that led through the pandemic, like Fitness. Our teams are working very hard to prepare for the upcoming Black Friday and Cyber Monday shopping weekend, which is an important contributor to our Q4 results. Red Flag deals, for example, is a must-buy for Canadian retailers and brands looking to reach the largest deal hunting community in the country.

Turning briefly to M&A, we continue to take a cautious approach to capital deployment in the quarter, completing 2 tuck-in community acquisitions for total cash consideration of $400,000. Year-to-date, we've completed 13 deals for just over $4 million total purchase price. Our pace of capital deployment this year bears no relation to the number of great opportunities in our pipeline that we continue to evaluate, and valuation expectations held by sellers are improving. However, we've set a higher bar for deals given the uncertain macro environment. So we use the time to continue to improve our financial position and be ready to act on the best opportunities.

And with that, I'll turn it over to Vince to walk you through the rest of our financial results.

[Vincenzo Bellissimo, executive]

Thanks, Chris, and good early morning, everyone. Thank you for taking the time to listen in. Despite the difficult economic backdrop and the top line headwinds Rob noted above, our profitability and ability to generate free cash flow has held up better than most and positions us well to continue to invest into core product initiatives and strengthen our financial position. Excluding PPP loan forgiveness in the prior year, adjusted EBITDA grew 40% to $7 million in the quarter, and adjusted EBITDA margin was flat to last year at 36%.

Margin compression in the quarter was driven by softening top line trends, while our costs remained stable. Though these compressed margins fall outside of our historical norms, we are comfortable navigating through this difficult macro environment at these levels while continuing to invest in key organic growth initiatives that will position us well and drive long-term value for our employees, users and shareholders.

Free cash flow generated in the quarter was $4.6 million, up 24% when excluding PPP loan forgiveness recognized in the prior year, resulting in a 66% free cash flow conversion for the period. The quarter-over-quarter decrease in conversion was driven by income tax payments in the quarter relating to current period installments and 2021 filings.

Operating expenses in the quarter increased by 67% or $10.3 million compared to last year. This increase was driven by an incremental $4.8 million amortization relating to acquired intangible assets, $2.3 million in incremental wages and consulting costs onboarded from Q4 acquisitions, and the $900,000 in PPP loan forgiveness recognized in the prior year. The remaining year-over-year variance consists of increased cloud hosting and ad serving costs relative to our audience and digital advertising growth, increased travel costs, wage inflation and increased headcount. We pride ourselves in our ability to optimize operations relative to market conditions, and we continue to explore automation and rationalizations that will drive cost savings within our business.

We finished the quarter with $7.8 million in unrestricted free cash and total liquidity of $72 million, including $64 million available to be drawn on our revolving credit facility. Between scheduled and voluntary payments, we have paid down over $20 million in debt year-to-date, bringing our net debt position, including contingent considerations to $72 million and a net leverage ratio of just over 2x as defined by our credit agreement. We have accrued $22.4 million in contingent considerations relating to Q4 acquisitions, including the maximum current portion owing of $15 million. With the rise of cost to capital, our goal will be to continue to delever while strengthening our financial position and building a reserve of dry powder that can be deployed towards M&A.

Our net loss in the quarter was $6 million which was $3.9 million less favorable when compared to prior year. Amortization related to acquired intangibles are the primary driver of the loss in both periods with $8.3 million in amortization recognized in the quarter versus $3.5 million recognized in the prior year. Excluding amortization related to acquired intangibles, the quarter would have generated earnings of $2.3 million and a basic and diluted earnings per share of $0.11.

And now I will pass it back to Rob to wrap things up. Rob?

[Robert Laidlaw, executive]

Thanks, Vince. We'll now open it up for questions.

[Operator]

[Operator Instructions] Our first question for today comes from Max Ingram from Canaccord.

[Max Ingram, analyst]

This is Max on for Aravinda. I just have a couple of questions, if that's okay. So my first question is surrounding the underlying organic outlook as we head into Q4, just given the trends that you were seeing in the second half of Q3. And then my second question is about the streamable. Any upside you see coming from any new licensing arrangements? And also how would FIFA World Cup sort of help bolster Q4?

[Robert Laidlaw, executive]

Thanks, Max. I'll take the first one, and I'll let Chris take the second one. Underlying organic outlook I think is foggy. It's tough to kind of see. But definitely we're seeing pressure on advertising, and we think commerce is where the most uncertainty lives. So I would say that if we were able -- when I talked about direct, direct is often kind of a bit of a bellwether for how our organic is looking, and that felt pretty flat. I would say flat would be tough to achieve in commerce in particular. And we'll see how programmatic goes. But yes, overall I think there's just a lot of uncertainty here. So it's kind of tough to pin it down.

[Max Ingram, analyst]

Yes. Fair enough. That's helpful.

[Christopher Goodridge, executive]

Max, and it sounded like your -- just if you could repeat your question on the streamable, I got the part about the World Cup, but there was -- it seems like there was a first part.

[Max Ingram, analyst]

Yes. Sorry about that. Can you hear me okay now?

[Christopher Goodridge, executive]

Yes, I got you.

[Max Ingram, analyst]

Yes. So the second question was about the streamable. Any upside you see coming from, if there's any new licensing arrangements? And then the second part was how would FIFA cup also help Q4?

[Christopher Goodridge, executive]

Yes. Okay. Great question. So we are seeing the emergence of some new streaming platforms. In the States, Valley sports is one that we're keeping an eye on as it kind of gets its programs off the ground. It's still -- it's a new entrant, right? So it takes time for that to scale up. We think there's potential there. Probably won't have an impact on Q4 results. But we think going forward it will be a nice alternative for sports. And sports, of course, is a key driver of those -- that seasonal performance we see in the streamable. And then, yes, there'll be a little bit of a benefit from FIFA World Cup. But given the predominantly U.S. audience and the fact that FIFA is generally, I think, available over the air -- on over-the-air channels as opposed to through kind of some streaming or pay packages, it probably won't have a material impact on the quarter.

[Max Ingram, analyst]

Okay. And if I can just ask one last quick question. Are you guys able to provide any color or commentary on the EBITDA margin outlook, just given the pressure on the top line. I know you're continuing the growth initiatives and then the current inflationary environment.

[Robert Laidlaw, executive]

Vince, do you want to take that one?

[Vincenzo Bellissimo, executive]

Yes. Yes, I can take that one, Max. Thanks for the question. So yes, from an EBITDA outlook, as I indicated, we're comfortable sort of operating at these levels to the mid-30s. And that's simply because we think the size of our business is optimized right now to continue to deliver on these organic initiatives. We feel that any change there or shift would greatly hamper our ability to deliver on those and drive that long-term value. So with the top line headwinds and sort of a consistent cost base, so to speak, margins will likely trend and continue based on what you're seeing now in the mid-30s.

[Operator]

Our next question comes from Ahmed Abdullah from National Bank of America -- National Bank of Canada, my apologies.

[Ahmed Abdullah, analyst]

With regards to the advertising trends offering that was highlighted, can you just give us a bit of more color as to which verticals you're seeing were most effective?

[Christopher Goodridge, executive]

Yes. So from a direct perspective, we've seen a bit of softness in the retail -- some of our retail partners compared to last year, right, where we saw a bit of a ramp as we kind of got towards the end of Q3 and then certainly into Q4, we're not seeing that same ramp. Automotive, we mentioned the last quarter had come back, started to come back a little bit. It's there, but it's not making a material impact to our overall direct results. And it's relatively steady in categories like insurance. So it would be really more retail where we're seeing a bit of that softness. And programmatic, I'd say that's more just a broad macro observation we're seeing. We're not really attributing it to any one kind of content type or vertical type.

[Ahmed Abdullah, analyst]

Okay. I appreciate the color. And on the consumers pulling back on spending in the next few quarters, do you see that impacting user engagement in terms of reigniting engagement maybe as a bounce back happens in the macroeconomics?

[Robert Laidlaw, executive]

Yes, it's an interesting question. User engagement, depending on kind of what happens on a macro level, and usually what we would see is that people are spending more time at home. So they're actually on the forums, in the communities more often. We haven't seen that yet at this point. So generally, I guess, probably depends on how much the consumers pull back. I would say if anything, right now, there's just a lot of noise going on in the traffic numbers that it's kind of hard to decipher what's macro, what's Google algorithm. And generally I think most online platforms and publishers are reporting kind of softer traffic numbers.

So that's why we're kind of at this point saying probably half macro and maybe a little bit of algo. But our hope is that what we've seen in past kind of consumer pullbacks or recessionary periods is that user engagement increases, people just have more time at home and they're going online and kind of doing things that take their mind off of the world economic situation and spending more time on their hobbies and doing more DIY projects and that sort of thing. So there tends to be a bit of a shift from -- I'm going to buy everything too. I'm going to do my own oil change or change my own tires and all that kind of stuff. So we haven't seen that shift yet, but that might be a few quarters out.

[Ahmed Abdullah, analyst]

Okay. And I appreciate that. And just one last one for me. I know you mentioned the mobile app is a bit delayed. Can you maybe give us a sense as to when it could be launched? And also, can you talk about new product initiatives that are in the works?

[Robert Laidlaw, executive]

Yes. So the mobile app is later than we'd like, but that's simply because we're holding ourselves to a higher bar on retention. We want to launch something that we kind of feel like if people download it, you've got like one chance to make sure they -- once they download it, that they really love it and they keep it and they put it somewhere, hopefully on the home screen of their phone and go back to it often. So we've been experimenting with it. We've got it actually live on one of our larger communities, and that's how we really test out some of those retention figures.

We changed a bit of strategy around it. So we did kind of pull back some features and even some of the native functionality just to really focus around how do we get that retention number up. So it's not so much about necessarily saying it's not ready right now. It's just we're aiming higher before we roll it out fully, and we're being very careful to make sure that when we get that one chance for a user to download it, that in fact, the retention is going to be very, very high.

And again, that's, I think a bit of a -- a bit of the beauty of our business in that -- while it's a nice to have, it's not driving our model. It's not really changing a whole bunch of stuff for us. So we can wait and get it right and be long-term thinkers here as opposed to having a significant amount of pressure to get it out this month or this quarter. So from that perspective, we're feeling good about the improvements we're making. It's just not quite where we want it to be before it kind of showtime.

And then as we talk about the product initiatives, really, this is -- there's a number of initiatives within this, and I don't want to get into all of them because I'm sure there's competitors listening to, but this is really around how do we get those authentic perspectives that are being shared in our communities around products and product purchase decisions, just easier to access available to more people and really becoming more concise. Sometimes it's a challenge for our users, particularly the new users to come in and read a 20-page spread about a product and hear all these different opinions.

So how do we make that content easier to digest. So -- and then likewise, how do we help our existing users kind of show what products they own and develop expertise, even be able to kind of have Q&A at the products they own. So it's this whole life cycle of product ownership resulting in people posting reviews and then making those reviews very easy to digest. So that's kind of the overall playbook. But -- there's still many different experiments that we're running there right now. And frankly, a lot of them are working. So we're just kind of trying to bring it all together into a pretty cohesive launch and something we can share more broadly and launch across all the communities.

[Operator]

Our next question comes from Towaki Dojima from TD Securities.

[Towaki Dojima, analyst]

Towaki here for Vince Valentini. So I guess a few of my questions have been asked really, but to kind of move the topic to capital allocation. You talked a little bit about M&A, how the pace of development, about the pipeline being light and our valuations are coming down. But should we expect that the pace of acquisitions are going to remain slow until this macro environment improves? Or is it more about the valuations coming down to a level you're more comfortable with?

[Robert Laidlaw, executive]

Yes, I can take that one. Look, I think there's been -- if you look at the interest rate rise just since the beginning of the year, cost of capital is rising and how you think about 2023 and beyond earnings for what some of these acquisitions are and what their owners are looking to sell for, I think there's just a lot of uncertainty. So we've set the bar higher for these deals. We need a more certain and a greater level of confidence to do a deal. And therefore, yes, I think it will be slower. But when we move, it will be with a lot of conviction. And I think on deals that will be highly accretive.

So I think seller expectations are coming down. I think likely our sellers will start to feel a lot of this kind of macro uncertainty, weakness in some of the programmatic channels, et cetera. And there will be a readjustment and hopefully an alignment that will allow us to be opportunistic. But I think we expect it to be slow until either we have a little more certainty in our own business and the businesses we're buying or the sellers start to kind of readjust their expectations from 2019 or 2020 type valuations to where kind of risk capital lies today.

[Towaki Dojima, analyst]

Perfect. And that makes sense. And I guess to tack on to that. So if acquisition spend is expected to be modest, what are your thoughts around the buyback, especially with the shares trading at well under 10x EBITDA?

[Robert Laidlaw, executive]

Yes. We think the stock is priced very attractively. But in this market and with the uncertainty, we think the most important thing right now is our balance sheet. So we have the NCIB in place. We haven't been particularly aggressive with it, and frankly have the opportunity to be particularly aggressive because there's just not a lot of stock to buy. But it is a tool that we have available and we'll use it as we feel necessary or where it makes sense for us. But I think likely result is it will continue to be very slow or very measured on the NCIB.

[Operator]

Our next question comes from Adhir Kadve from Eight Capital.

[Adhir Kadve, analyst]

So it's been kind of like a year since the Threadloom acquisition and maybe call it 6 months since Paul was named a Chief Product Officer. I think it would be great if you can kind of give us an update on the progress of Threadloom and bringing the Threadloom tech into the For a ecosystem. Any initiatives you see that Paul is leading that really has you excited for the future?

[Robert Laidlaw, executive]

Yes. Thanks, Adhir, for the question. That's a great one. And Paul has come in, as you mentioned, become a Chief Product Officer, and we've really integrated the Threadloom team now throughout VerticalScope. So there's really one VerticalScope as we move forward. And that team, in particular, really, really excited about some of those product initiatives. I think Paul has been instrumental in kind of helping us rethink some of the mobile app strategy, especially around really focusing on that retention number?

And then I think some of the product initiatives that I spoke about earlier are highly driven by Paul and his team. So I think it's really just that focus on how do we make this content, these authentic perspectives on products that enthusiasts and hobbyists are looking to buy. How do we make them more easy to access, more digestible, and in fact, get more MAUs eyes on those reviews and help people understand the value that's kind of sometimes feels like it's hidden deep within these forums. How do we make that more of a first-class citizen.

[Adhir Kadve, analyst]

Okay. Great. And then I'd like to ask the capital allocation question maybe a different way. You've kind of mentioned that M&A will be a little bit slow, maybe a little bit slower on the NCIB. So is it kind of -- would the priority then as we head into fiscal '23, would it just kind of be to delever? Or how are you guys kind of thinking about those 3 buckets from a hierarchy perspective?

[Robert Laidlaw, executive]

Yes. I think you can think of it in 2 ways. It's either delever or build up our war chest for a transaction where we have high conviction. Look, we're looking to build this company bigger. We're long-term growers, long-term compounders, big shareholders ourselves. So ultimately, here, we're very, very aligned with shareholders. And if those transactions aren't coming through and we're gaining confidence in kind of the macro situation than the NCIB could be a great tool for us. But ultimately we think there's some really important goals ahead of us, like achieving $50 million of EBITDA, unlocking some of these organic growth opportunities. So we're going to continue investing in the business. And I think right now it's prudent to delever and build up that war chest. And hopefully the opportunities will come, and they'll be at really high returns for our shareholders.

[Operator]

[Operator Instructions] Our next question comes from David McFadgen from Cormark Securities.

[David McFadgen, analyst]

So you talked about the MAUs being a bit lower than your expectations for the quarter. I was just wondering what those expectations were? And then also, you said you're not sure if they're down due to the changes in the search algorithm impacts? Or is it just due to the macroeconomic environment. I was wondering if you could talk to what the impact is from the changes in the search algorithms? And when do you think you will know what is actually driving the decline here in the MAUs?

[Robert Laidlaw, executive]

David. I can take the MAU question. Our expectations is that we're still looking at probably a single-digit decline. So I think where there is some question is that more than 5%, less than 5%. I'm not 100% sure where that shakes out. And I can tell you that the honest reason why we're not quite sure where that shakes out is we've got some big days ahead of us; Black Friday, Cyber Monday are huge. And if shoppers are just uninterested and not shopping, that will weigh on MAUs because those days are just really important days across our ecosystem. So I think it's within that range. But again, it's going to be kind of probably a single-digit year-over-year decline. And that's really one of those numbers where I think in 2023 we're looking to kind of turn the tide.

Regarding the algorithms, it's tricky to figure out because there's a lot of stuff happening at once. The algorithms don't hit you in 1 day anymore. It happens over 2, 3 weeks as they roll out. So it's a little hard to say what is macro and what's Algo. But generally, I would say half of it might be macro has as it might be algo.

[David McFadgen, analyst]

Okay. And when would you know what it is for certain it's going to take a while, I guess, to know for sure or maybe you'll never know for sure, I don't know. Just curious.

[Robert Laidlaw, executive]

Yes. Unfortunately, the users coming in won't tell us why they're not coming in or why they are. So I don't think there's ever certainty. I think we'll get a better sense of it. But again, whether it's 40%, 50% of it is algo, putting a finer point on it, it's going to be pretty hard, and that's just kind of a bit of a black box of trying to figure out the actual search engine algorithms and how that kind of plays into your analytics numbers. So I don't think we'll ever have like great, great certainty, but we'll certainly have a better directional feel.

[Operator]

Thank you. We have no further questions for today, so I'll hand back to Robert Laidlaw for any further remarks.

[Robert Laidlaw, executive]

Great. Thank you, everybody, for joining today. As always, we appreciate your trust, your support, your questions. Look forward to seeing you again next quarter. Thank you.

[Operator]

Thank you for joining today's call. You may now disconnect.