Business context and reporting period
System1 operates an omnichannel customer-acquisition and advertising platform (RAMP), owned and operated websites, a partner network, and antivirus subscriptions through Protected.net. This unaudited Form 10-Q covers the quarter ended June 30, 2022.
System1 completed its merger on January 26, 2022. The 2022 “Successor” results include the combined company from January 27 onward, while earlier 2022 and 2021 “Predecessor” results primarily reflect S1 Holdco. As a result, year-to-date comparisons are not directly comparable; Q2 2022 also includes businesses, including Protected, not present in the Q2 2021 comparison.
Financial performance and position
Unless noted otherwise, amounts below are in millions of dollars. The filing presents financial statements in thousands.
| Metric | Q2 2022 | Q2 2021 |
|---|---|---|
| Revenue | $219.8 | $169.6 |
| Operating income (loss) | $(27.9) | $16.3 |
| Net income (loss) | $(34.1) | $11.8 |
| Net income (loss) attributable to System1 | $(29.2) | $11.8 |
| Basic and diluted EPS | $(0.33) | Not presented on a comparable share basis |
| Adjusted gross profit, company-defined | $78.8 | $46.3 |
Revenue increased 30% year over year. Approximate operating margin was (12.7)% versus 9.6%; cost of revenue was 69% of revenue versus 74%. Adjusted gross margin, calculated as company-defined adjusted gross profit divided by revenue, was approximately 35.8% versus 27.3%. These adjusted gross profit figures are non-GAAP segment measures and may not be comparable with similarly titled measures at other companies.
Q2 revenue by segment was $163.7 million Owned and Operated (+2%), $13.3 million Partner Network (+52%), and $42.8 million Subscription. Subscription revenue reflects the acquired Protected business. Management attributed Owned and Operated growth to international traffic, acquisitions and RAMP improvements; Partner Network growth to continued investment and partner contributions.
Q2 cost of revenue rose 21% to $152.6 million. Salaries, commissions and benefits rose 157% to $45.6 million, including increased headcount and substantial share-based compensation; selling, general and administrative expense was $16.2 million, up from $6.3 million. Depreciation and amortization increased to $33.4 million, primarily from acquisition-related intangible assets. Interest expense rose 64% to $7.3 million following increased borrowing. The quarter included a $4.1 million gain from the change in fair value of warrant liabilities.
For the Successor period January 27–June 30, 2022, revenue was $385.9 million and net loss was $72.1 million ($59.2 million attributable to System1). Cash used in operating activities was $6.2 million, investing activities $451.1 million, and financing activities $15.5 million. The filing cautions against treating this partial-year Successor period as directly comparable with the six months ended June 30, 2021.
At June 30, 2022, cash and cash equivalents were $37.4 million and restricted cash was $7.3 million. Current assets were $146.3 million and current liabilities $200.4 million. Notes payable were $420.9 million on the balance sheet; disclosed future principal payments totaled $444.0 million, including $49.0 million outstanding under the revolver. The term loan and revolver carry floating rates based on Term SOFR. Management reported covenant compliance and said it expected to make scheduled principal and interest payments on time.
Total assets were $1.62 billion, including $907.2 million of goodwill and $537.9 million of net intangible assets. Total equity was $827.1 million, including $184.3 million of non-controlling interest. Deferred revenue was $68.4 million.
Material changes, outlook, and risks
- Merger and acquisitions: The January merger and acquisitions of Protected, CouponFollow, RoadWarrior and Answers expanded the business and materially changed the asset, debt and revenue profile. Acquisition accounting remained preliminary. Merger and acquisition activity also drove substantial amortization and integration-related expenses.
- Compensation and unusual items: Q2 share-based compensation expense was $22.1 million. System1 recorded an $18.2 million liability for the Protected incentive plan after judging its performance targets probable of achievement; the plan can provide up to $100 million in shares if specified EBITDA targets are met. The company disclosed that the plan terms had been omitted from its prior-quarter disclosures, but said the omission did not materially misstate those financial statements.
- Liquidity and financing: The company’s post-merger cash use included acquisition spending and transaction-related financing flows. Management noted that continued ability to meet obligations depends on operating cash generation and that additional debt or equity financing might be needed if existing resources and sales growth prove insufficient; such financing may not be available on favorable terms or at all.
- Revenue concentration: Google represented 69% of Q2 revenue and Microsoft 3%. Advertising partners may terminate their contracts immediately or with limited notice under certain circumstances. Google agreements ran through February and July 2023; Microsoft was renewed through June 2025.
- Controls and reporting: Management concluded disclosure controls were not effective at June 30 because material weaknesses in internal control over financial reporting remained. Weaknesses included staffing and segregation of duties, acquisition accounting, accrued liabilities, period-end reporting and IT controls. The company described a remediation plan, but remediation requires sustained testing and validation.
- Contingencies and other risks: A U.S. trademark infringement lawsuit concerning the System1 name remained pending; the company intended to defend itself. Management noted continuing uncertainty around COVID-19 effects and foreign-exchange exposure, which it does not hedge. No material changes to previously disclosed risk factors were reported.
- Outlook: The filing provides no quantitative revenue or earnings guidance. Management expected salaries and benefits and selling, general and administrative expense to increase in absolute dollars as it invests in infrastructure. In August 2022, the board authorized up to $25 million for repurchases of Class A shares and public warrants.
Most important facts for investors to verify
- How much of reported revenue and growth reflects acquired businesses versus underlying organic performance, given the merger-related comparability limitations.
- Whether operating cash flow can improve enough to support floating-rate debt service, scheduled principal payments and ongoing business needs.
- The trend in Google-dependent revenue and the status and renewal terms of major advertising-partner contracts.
- Progress in remediating material weaknesses and the accuracy of acquisition valuations, accrued liabilities and share-based compensation estimates.
- Whether Protected’s EBITDA incentive targets become probable or are achieved, and the resulting share issuance and dilution.
- Developments in the trademark lawsuit and the intended use and execution of the $25 million repurchase authorization.