Arqit Quantum Inc. (NASDAQ:ARQQ) Q2 2023 Earnings Call Transcript May 17, 2023

Operator: Good day, ladies and gentlemen. Thank you for standing by. On today’s call, we will be referring to the press release issued this morning that details the company’s first half of fiscal year end 2023 results, which can be downloaded from the company’s website at arqit.uk. At the end of the company’s prepared remarks, there will be a question-and-answer period for selected equity research analyst. Finally, a recording of the call will be available on the Investors section of the company’s website later today. Please note that this webcast includes forward-looking statements, statements about the company’s beliefs and expectations containing words such as may, will, could, believe, expect, anticipate, and similar expressions are forward-looking statements and are based on assumptions and beliefs as of today.

The company encourages you to review the Safe Harbor statements, risk factors and other disclaimers contained in today’s press release, as well as in the company’s filings with the Securities and Exchange Commission, which identifies specific risk factors that may cause actual results or events to differ materially from those described in our forward-looking statements. The company does not undertake to publicly update or revise any forward-looking statements after this webcast. The company also notes that on this call, it may be discussing non-IFRS financial information. The company is providing that information as a supplement to information prepared in accordance with International Financial Reporting Standards or IFRS. You can find a reconciliation of these metrics to the company’s reported IFRS results in the reconciliation tables provided in today’s earnings release.

And now, I’ll turn the call over to David Williams, the company’s Founder, Chairman and Chief Executive Officer. David?

David Williams: Thank you for joining our earnings call to discuss the first half of fiscal 2023 results. The period was an important phase in the development of Arqit. While the headline revenue result is modest, the evolution in our business model, specifically going to market through major global technology channel partners, which we identified and implemented during the period, sets the foundation for the future of the company. First revenues through one of the channel partnerships that we announced in December were generated, and sales inquiries through these channels subsequently have built well. The key messages from today’s call are we believe the pivot in the go-to-market strategy was the correct step for the company.

We’re pleased with the speed of implementation of that strategy, and we’re strongly encouraged by the engagement we’re experiencing through these channels with prospective end customers. Importantly, the White House gave a lead to the world in the period by instructing national security organizations to prepare for an upgrade to new encryption and directing them to use symmetric encryption which we believe only Arqit can deliver as a scalable cloud service. It is increasingly recognized by customers that it is necessary to protect data today, well in advance of the emergence of mature quantum computers, there is strong evidence that corporation are now following that lead, and so our addressable market is favorable. The level set Arqit’s initial go-to-market strategy was focused on direct sales of QuantumCloud enterprise licenses and the sale of complete tech stack private instances which originally included satellites.

As a result of software innovation, we managed to remove the need for satellites from the tech stack of our platform as a service in 2022. The marketing approach which resulted in our target customer base took time to craft, and this had a revenue impact. But we landed with an all software tech stack which is scalable, easy to use, standards based and low cost for customers to implement. As a result, we announced several major global technology channel partners in December, and we’re in discussion with additional channel partners. Our business model is now, in our opinion, greatly improved, and just a few months after announcing those channel partners, we generated first revenues from that model. Whilst we were preparing the channel partner strategy in 2022, we promoted the sale of enterprise licenses whereby software is physically delivered onto a customer’s infrastructure for them to run with a specific volume of service for a specific price paid upfront.

This method of consumption is mainly applicable to government organizations who do not want to rely on a third party cloud infrastructure and will pay for the benefit of full control. After some early enterprise sales, we expected significant enterprise license revenue to come through. Although. we are now engaged in a number of government and defense projects, we have found the sales cycle to be very long, and it seems clear that budgetary problems in government have slowed down acquisitions of new technologies. Our focus on making the cloud PaaS easy to consume has yielded encouraging customer responses. Arqit symmetric key agreement software solves specific security needs which have been elaborated globally at government level, and the product delivers a unique solution.

Ease of consumption is crucial to rapid adoption of a completely new technology and embedding it into the architecture of existing IT infrastructure products makes it evolutionary and hence makes the buying decision simpler. Arqit focused its efforts in the first half of fiscal ‘23 to develop relationships with major global technology vendors for whom our symmetric key agreements software is complementary or additive to its product offering. We announced initial channel partners Fortinet, AWS, Dell and Traxpay in December, and we expect to announce additional partners shortly. These relationships can and should be beneficial to both Arqit and the partner, driving sales for both parties. When the Arqit PaaS is merely an integrated upgrade to a product that an end customer is already using like a firewall, the sales motion is quite frictionless.

Since the announcement of our channel partners in December, we focused our time and resources on activating those relationships. That includes any refinements from an integration standpoint, salesforce education and commencing end customer engagement. We saw the first results of our channel partnerships realized in the sale to the first customers shortly before the closing of the financial period. Since the end of our half year, we’ve received further purchase orders through additional channel partners. Crucially, we made significant progress in making our product easy to consume through the launch of new applications. The Quantum Cloud platform as a service has been available to use on a cloud fulfilled basis through our partners since December.

This makes it relatively simple and scalable to use as opposed to enterprise licenses which are more complex. It does still require specialist IT resources by a customer to integrate the pads into their architectures. In answer to specific customer opportunities, we built two specialized applications which now require virtually no specialized skills or integration for the customer to use. The first application, NetworkSecure adapts the PaaS so that it can be used via a standardized connector to integrate into most vendors firewalls or other styles of network devices to create a quantum safe network boundary. We already have this product operating with several vendors’ products. The second, TradeSecure, embeds the PaaS into digital assets.

There is a significant trend now for regulated financial services companies to use digital assets which are evolutions of blockchain technologies designed for regulated use. The first opportunity for Arqit came with the new M⁠L⁠E⁠T⁠R laws which make it lawful for trade finance markets to use digital assets to represent trade finance documents. By the first partnership with Traxpay in Germany, Arqit took the TradeSecure product to market and has identified interest from a number of banks and importers. According to McKinsey, an electronic bill of lading alone could save $6.5 billion in direct annual costs and enable $40 billion in new global trade. So the entire digital trade document market is large. Arqit believes its product is a world first in delivering compliance with MLETR rules, as we said recently in a press release with government partners.

As a result of joint sales and marketing efforts with our channel partners, in the last two months, we’ve generated a significant number of new end user sales leads for the various product integrations. The level of inquiry demonstrates the power and symbiotic nature of a channel partner relationship. As I said earlier, we’re pleased by the speed of implementation of these partnerships and encouraged by the prospective customer engagement. We are seeing clearly the pivot in go-to-market strategy in 2022 impacted revenue generation during the period, as we did not emphasize the pursuit of direct enterprise license sales to better focus our resources on the new strategy, but we do regard the pivot as one step back to take many steps forward. That said, we did sign a modest direct enterprise license in the period with a US Defense and government customer, and we will continue to pursue selective enterprise price opportunities in the government market.

We also announced in December that as a result of innovation in our technology, Arqit no longer requires satellite hardware in the technology stack. Arqit took the decision to monetize through partnership or licensing or sell its satellites under construction. There is a market for quantum satellite services. However, the product requires a level of working capital, resourcing, and access to government space users, which is more likely to be found in a larger specialized defense or space company. As announced today, based on feedback generated in the partner search initiated in December, there is appetite from potential partners to perhaps buy the entire satellite business. While a transaction cannot be certain, disposal of the business would result in better focus for both that satellite business and the software business that Arqit will retain.

Arqit has hired an advisor to assist in the process of potentially selling the satellite business. The satellite business includes satellite assets under construction, patents, customer contracts, and an engineering team. Mindful of global macro conditions and the pace of revenue development, we took actions during the period to appropriately scale our cost structure and capitalization. As Nick Pointon will highlight, following the end of the financial period, we implemented a cost reduction program to align our operating expenses with our operational focus on the channel partner strategy and the newly branded applications NetworkSecure and TradeSecure. The cost reduction program included the elimination of 20 positions. Striking the right balance in terms of operational scale is difficult, but it’s necessary for the future of the business.

We also raised $20 million of capital in the period to provide funding to support the implementation of our go-to-market strategy. While dilution is never welcome, our cash balance coupled with our cost reduction program provides us with sufficient runway to focus on our channel partnership strategy. With a monthly budgeted cost base of $3.2 million commencing in July and a cash balance of $41.5 million, we put ourselves in a reasonable position to focus on the growth of our channel partner revenues, which began in the first half. We made an important strategic decision to change our go-to-market strategy. The first half of fiscal 2023 reflects the effects of that decision. However, we exited the period with the strategy in place, partnerships activated and first revenues from that strategy on the books.

We also took important decisions regarding our cost structure and capitalization. The market has moved to embrace our product, demand signals are evident and we found major channel partners to take it to market at scale with a more appropriate cost base, we look forward to a period of focused growth. With that, let me turn the call over to Nick Pointon, our CFO, for a few remarks on our financials. Nick?

Nick Pointon: Thank you, David. For the six month period ended March 31, 2023, we generated $2.6 million in revenue and other operating income from new QuantumCloud contracts and other activities. For the comparable period in 2022, we generated $12.3 million. Our QuantumCloud revenue totaled $19,000 for the periods generated by two contracts. While the magnitude of QuantumCloud revenue is not significant, the important fact to note is one of the contracts represents first revenue from our architect NetworkSecure firewall product sold through our new channel partnership. Revenue from the channel was recognized late in the period as the new channel became fully activated .We expect to recognize additional revenue under the contract in the second half of our fiscal year.

The other contract in the period was with a major US. Government and defense contractor which licensed to evaluate our symmetric key agreement software for specific use cases. QuantumCloud revenue for the period for the comparable period in 2022 was $5.3 million from two enterprise licenses. As mentioned in our press release and in David’s remarks, our pivot in go-to-market strategy resulted in a shift away from direct sales of enterprise licenses to implementing and activating our channel partnerships. This is responsible for the negative variance between reporting periods. Other operating income for the six month period was $2.6 million, primarily resulting from Arqit’s ongoing project contract with the European Space Agency associated with the development of our Arc satellite.

Despite the announced innovation in our technology infrastructure, which no longer requires the satellite element, we expect to continue to perform going forward under our contract with ESA realizing future other operating income. Should we sell our satellite business, we will no longer realize other operating income from our contract with ESA. Our administrative expenses equate to operating costs for those more familiar with US GAAP, for the period, our administrative expenses were $25 million versus $26.6 million for the comparable period in fiscal year 2022. High employee costs during the period were primarily offset by favorable movements in foreign exchange rates. Headcount increased to 170 from 145 at September 30, 2022. Administrative expenses for the period included a $9 million noncash charge for share based compensation versus a $10 million charge for the comparable period in 2023.

Earlier this month, we actioned a significant cost reduction initiative across all business functions to better align our cost structure with our stage for revenue development and operational focus. The cost reduction initiative included the elimination of 20 positions in the company. These cost reductions actions have been implemented pro forma for the cost reduction initiative market has 150 employees as compared to 170 at the end of the reporting period. The cost reduction initiative resulted in a 30% decrease in monthly budgeted operating costs commencing July to approximately $3.2 million from a previously budgeted monthly operating cost of approximately $4.6 million. Operating loss for the period was $34.6 million versus a loss of $14.3 million for the first half of fiscal year 2022.

The variance in operating loss between periods primarily affects the lower revenue and other operating income, combined with a $12.2 million impairment on trade receivables and contracts assets associated with the Virgin Orbit bankruptcy. We generated a loss before tax of $21.8 million. However, we generated an adjusted loss before tax of $34.7 million, which in management’s view reflects the underlying business performance once non-cash change in warrant value is deducted from loss before tax. In February, we raised $20 million in gross proceeds from the issuance of 10 million ordinary shares. As a result, we entered the period with a cash balance of $41.5 million versus a cash balance of $48.9 million as of Arqit’s fiscal year end 30th September 2022.

As noted in our earnings release market is presently the largest unsecured creditor to Virgin Orbit which filed for bankruptcy. We have approximately a $10 million claim and have taken a full provision for the claim. The Virgin Orbit bankruptcy process is moving at pace and some clarity as to the possibility of potential recovery of some or all of our claim should be forthcoming in the weeks ahead. Regardless, we do not believe Virgin Orbit bankruptcy will have a material impact on the operations of our business going forward. With that, I turn the call back to David.

David Williams: Thank you, Nick. I noted at the end of our fiscal year earnings call in December, there was a probe in symmetric key agreement product and major global technology vendor channel partners through which to go-to-market. 2023 would be about execution. In the brief three months since we announced the new go-to-market strategy, we’ve successfully activated our channel partnerships as evidenced by first revenues. We’re pleased with the speed with which this was achieved. A significant work and partner coordination was required. We’re focused on increasing the momentum of the sales activity through our current and expected new channel partnerships and are currently working with a number of additional channel partners and are encouraged by the engagement we’re seeing with prospective end customers. I now hand the call back over to the operator for Q&A.

Q&A Session

Operator: And our first question coming from the line of Scott Buck with H.C. Wainwright.

Scott Buck: Hi. Good afternoon, everyone. Thank you for taking my questions. David, can you give us a little bit more color around how and when you expect some of these channel partners to begin to really ramp revenue?

David Williams: Yes. Hi, Scott. The channel partners that we announced for the platform as a service in December and others that have subsequently committed have already generated first revenues and the revenues have increased since the period end with multiple purchase orders coming from multiple partners. So momentum is growing and we’re pleased with the speed of activation of these channel partnership relationships. I think getting first revenues through a channel partner just three months from signature is a sign that the product is easy to implement. And we’re seeing multiple purchase orders coming through from several channel partners. So I feel that there’s a good sign of momentum.

Scott Buck: Great, that’s helpful. With those additional purchase orders. And what the visibility you do have in revenue. How are you thinking about cash runway here, given the $40 or so million you have on the balance sheet?

David Williams: I’ll let Nick answer that one.

Nick Pointon: Well, we had $41.5 million of cash on hand at the end of the fiscal period and we’ve indicated that in our earnings release that our recent monthly cash burn was at $4.6 million. We also indicated that our monthly cash cost should be about $3.2 million from July onwards. So that would suggest that on cost alone, we have operating cash well into 2024. Obviously, revenue generation will only work to extend that. And finally, I guess on this point, the monetization of the satellite business could result in a meaningful additional cash injection. So bringing that all together, I think we have reasonable cash position.

Scott Buck: Nick, that’s really helpful. On the satellite, how should we think about what the potential value is for that operating unit?

David Williams: So we’re not in a position to know precisely what potential bidders may apply or whether a transaction will close. However, the bidders that have completed data room access may well now consider that we’ve invested approximately $53 million of cash in the satellite assets under construction. Also, as previously announced, we have binding contracts for the receipt over the lifetime of the project and subject to performance worth tens of millions of dollars from commercial and R&D funding customers. We also think that we’ve got world leading patented technologies and a very strong engineering team. And a number of governments around the world have finally, a little later than we expected, announced procurements of Quantum Satellite systems.

Which includes the European Union IRISS project, which is worth apparently EUR 600 million. So it seems that there is demand for this technology. It’ll be better delivered by a company which has got the right balance sheet and resources to serve those government customers. But the value that we’ve invested is evident to those partners and they themselves see the demand.

Scott Buck: Great, David. That’s helpful. And a quick follow up there. What is the potential additional cost savings if you’re able to sell that satellite operating unit?

David Williams: The engineering team amounts to 40 people out of the current headcount base, and so it would represent a material reduction further in operating costs were that satellite division to go.

Operator: And our next question coming from the line of Jim Shelton with Deutsche Bank.

Jim Shelton: Hey, guys, thanks for taking my question. Just given the current uncertainty around the satellite business, I mean it’s good to see the cost reduction initiatives. But with regards to the satellite CapEx, I’m just trying to help square that up with investors in terms of the kind of ramping top line and I guess cash burn and the potential for further dilution in the future if that top line doesn’t pick up as quick as you expect. Thanks.

David Williams: We don’t expect to make any material CapEx on the satellite project. It’s our intention to sell the satellite business, and we’ve been conducting that process now for some months. And you’ll see from the appointment of an advisor, which we’ve announced today, that there are a number of parties who’ve expressed interest in it. So we have some reasonable reason for optimism in making a sale for value. Even if the sale were not to proceed, we would not expect to make any material CapEx on the satellite business in addition. Therefore, our view, expressed on the cash resources we have, should be considered only in the context of the operational costs that we’ve announced today that we’ve reduced to, which is $3.2 million per month.

Operator: And I’m sure we have no further questions at this time. Now I’ll turn the call back over to David Williams for closing remarks. David?

David Williams: Thank you very much, operator. And thank you all investors and analysts for following us closely this year. We appreciate your interest in the company and your support as fellow shareholders. Thank you.

Operator: Thank you. Ladies and gentlemen, this concludes today’s conference. Thank you for participating. You may now disconnect.