System1, Inc. — Q3 2022 Form 10-Q
Business context and reporting period
For the three months ended September 30, 2022, System1 operated an omnichannel customer-acquisition and advertising platform and sold antivirus and related subscription software through Protected.net. The company reported three segments: Owned and Operated, Partner Network, and Subscription. Protected.net had more than 2.3 million active subscribers at quarter-end.
System1 completed its merger on January 27, 2022, acquiring S1 Holdco and Protected.net, and also acquired CouponFollow, RoadWarrior, and Answers during 2022. The filing separates “Successor” and “Predecessor” accounting periods because the merger established a new accounting basis. Accordingly, reported comparisons with 2021 are not fully comparable, and 2022 includes businesses absent from the prior-year period.
Financial results and liquidity
| Metric | Q3 2022 | Q3 2021 |
|---|---|---|
| Revenue | $201.2 million | $171.4 million |
| Cost of revenue | $137.7 million | $128.9 million |
| Gross profit / margin, calculated | $63.5 million / 31.6% | $42.6 million / 24.8% |
| Operating income (loss) | $(42.3) million | $16.0 million |
| Net income (loss) | $(37.6) million | $11.4 million |
| Net loss attributable to System1 | $(31.6) million; $(0.35) per share | Not applicable to predecessor per-share reporting |
Q3 revenue increased 17% year over year. Owned and Operated revenue declined 10% to $146.9 million; Partner Network revenue rose 13% to $10.0 million; Subscription contributed $44.3 million following the Protected.net acquisition. Management attributed lower Owned and Operated revenue primarily to reduced revenue per session and lower advertising spend directed to the segment.
Segment adjusted gross margin, a company-defined measure, was $72.9 million, up 62% from $45.0 million. It represented approximately 36.2% of revenue, versus 26.3% in Q3 2021. This non-GAAP-style segment measure is not directly comparable to GAAP gross profit.
For the Successor period from January 27 through September 30, 2022, revenue was $587.1 million and net loss was $109.7 million. Net cash provided by operating activities was only $0.5 million; investing activities used $453.4 million, primarily for acquisitions. These Successor-period figures do not represent a directly comparable nine-month period.
At September 30, 2022, cash and cash equivalents were $31.9 million, with an additional $10.1 million in restricted cash. Current assets were $126.9 million and current liabilities $207.1 million. Debt carrying value was approximately $417.2 million, including $15.0 million current and $402.3 million long-term; scheduled principal payments totaled $439.0 million. The term loan bears interest at adjusted Term SOFR plus 4.75%; the revolving facility bears adjusted Term SOFR plus 2.5%. The company borrowed the remaining $1.0 million available on the revolver in October.
Material changes, outlook, and risks
- Revenue growth reflects the addition of subscription operations and acquisitions; Owned and Operated revenue weakened in Q3 even as Partner Network grew.
- Operating expenses rose sharply, including $33.4 million of depreciation and amortization in Q3, largely due to acquired intangible assets, and $55.9 million of salaries, commissions, and benefits. Q3 share-based compensation was $30.6 million.
- Interest expense increased to $10.0 million in Q3 amid higher borrowings. A $4.5 million Q3 expense from changes in warrant fair value also reduced results.
- Management said expected operating cash flows, cash balances, and financing arrangements should fund anticipated working-capital and capital needs for the next 12 months, and stated it expected to meet scheduled debt payments. The company reported compliance with borrowing covenants at September 30.
- Advertising-partner concentration is significant: Google accounted for 67% of Q3 revenue; Google and Microsoft together accounted for 70%. Google and Yahoo represented 64% and 12% of receivables, respectively. Google contracts were due to expire in February and July 2023, subject to their terms; partners may terminate under specified circumstances.
- Disclosure controls were not effective at quarter-end because material weaknesses in financial reporting controls remained unremediated. Weaknesses include staffing and segregation of duties, acquisition accounting, accrued liabilities and stock compensation, financial close and reporting controls, and IT general controls. Management described remediation efforts as ongoing.
- A U.S. trademark-infringement lawsuit concerning the “SYSTEM1” name remained pending; the company said it intended to defend itself. Management stated ordinary-course legal matters were not expected to be material, while acknowledging outcomes cannot be assured.
- On August 30, the company changed a Protected.net incentive award into a $40.0 million cash payment in four quarterly installments; it recognized $18.3 million of related Q3 expense. It also considered a separate $50.0 million 2024 award probable of achievement and recorded expense. CouponFollow’s performance-based incentive targets were not considered probable at quarter-end.
- No specific revenue or earnings guidance was provided. The filing also reports a $25.0 million share repurchase authorization; in October, the company repurchased shares for $1.1 million.
Important facts for investors to verify
- How much reported growth and segment margin performance is sustainable after separating acquired businesses from comparable organic trends.
- Whether Owned and Operated revenue per session and advertising economics recover, and whether subscription renewals and subscriber levels hold up.
- Cash generation, revolver usage, variable-rate interest exposure, debt covenant headroom, and capacity to meet scheduled principal payments.
- Exposure to Google and other major advertising partners, including contract renewal terms and termination rights.
- Progress in remediating material weaknesses and the accuracy of acquisition valuations, incentive-plan liabilities, and related disclosures.
- Potential cash costs from incentive plans, the trademark litigation, acquisition commitments, and the company’s related-party arrangements.