Smith Micro Will Survive Covid-19 – Smith Micro Software, Inc. (NASDAQ:SMSI)

With the coronavirus pandemic having partially shut down the American economy, Wall Street has reacted strongly, with many small cap companies being among the hardest hit. With some investors apparently liquidating positions not seen as a “pure play” on the pandemic, Smith Micro (SMSI) has suffered from the ongoing fire sale. While the 50% drop from 52-week highs no doubt has frustrated shareholders, SMSI’s current valuation offers an amazing investment opportunity on a company that has significantly de-risked itself over the past few months.

SMSI continues to progress its core business. Since I last published on SMSI, some major, positive developments have taken place. In addition to their strong earnings report and guidance, SMSI acquired the mobile operator business of Circle Media Labs, Inc. I will discuss that acquisition and their updated progress, guidance, risks, and valuation below.

For more background on SMSI’s three main products (SafePath, CommSuite, and ViewSpot), you might find my previous articles helpful. I link to my most recent previous article in the “SafePath Leading the Way” section below. The others are here and here.

Circle Acquisition

On February 13, SMSI announced their acquisition of the mobile operator business of Circle Media Labs.

This acquisition is important for multiple reasons:

(1) Circle is the developer of T-Mobile’s (TMUS) FamilyMode. FamilyMode was a direct competitor to SMSI’s SafePath product, selected by T-Mobile for use on its platform much as SafePath was selected by Sprint (S) on its platform. FamilyMode’s adoption by TMUS users has, however, significantly underperformed SafePath’s adoption by Sprint’s users (Smith’s product is white-labeled by Sprint as Safe & Found). From what I’ve gathered speaking with industry veterans, a main reason for the poor performance by the Circle product has been Circle’s split focus. At the same time Circle was offering its FamilyMode product through Sprint, the company has been aggressively pursuing a separate direct-to-consumer “freemium” product offering. SMSI has consciously chosen to avoid the direct-to-consumer market, instead focusing exclusively on its mobile carrier opportunities and relationships. By purchasing Circle’s operator business, SMSI has expanded these relationships to TMUS, and Circle has been freed to focus on its direct-to-consumer model. In other words, Circle and SMSI saw this transaction as a win-win situation for both parties.

(2) While SMSI’s SafePath product has outperformed FamilyMode, SMSI coveted some of the parental control features of FamilyMode. In purchasing the operator business from Circle, SMSI also bought, per the press release, “a perpetual source code license to Circle’s robust parental control software.” SMSI will now be able to use this code to merge the best of Circle with the best of SafePath for a total best-in-breed product offering for mobile carriers.

(3) Finally, and perhaps most importantly, in making this acquisition, SMSI has bought out Circle’s contract with TMUS, replacing its competitor and placing SMSI front-and-center for family safety apps on both sides of the Sprint and T-Mobile merger. Furthermore, as part of this $13.5M all-cash transaction, SMSI also purchased Circle’s business with British mobile operator Sky. Between TMUS and Sky, SMSI expects to receive $4M annually in revenue from the Circle contracts. In a discussion with management after the transaction, they expect at least 30% of that revenue to become EBITDA.

I will discuss the implications and significance of this Circle acquisition in more detail below.

SafePath Leading The Way

Before continuing to discuss the implications of the Circle acquisition, we need to better understand the current status of SafePath’s relationship with Sprint. Released in early 2018, SafePath (white-labeled as Safe & Found) ended 2019 as Smith’s lead product, on a $26.6M annual run rate. This compares to the rest of SMSI’s business portfolio finishing the year on a $22.6M annual run rate. So Smith and Sprint are “rocking and rolling” and continuing to grow. Sprint continues to promote Safe & Found in various mediums and by packaging it with its popular Tracker. Please see my previous article referencing SMSI’s expanded relationship with Coolpad that began with this tracker, and will likely lead to business with additional mobile operators, such as Telus (TU), in the future.

Despite its blistering business with Sprint, investors have clearly been concerned about the implications of the upcoming Sprint-TMUS merger. This is because there was always the possibility that TMUS would eventually sunset SMSI’s SafePath product (despite its success with Sprint) in favor of FamilyMode (what T-Mobile had selected for its own network). By purchasing FamilyMode’s developer, Circle, SMSI has significantly mitigated that risk—again, by placing itself on both sides of the upcoming Sprint-TMUS merger.

During Smith’s Q4 2019 conference call, CEO Bill Smith said: “I want to note that we have spent a lot of time with both of these customers (TMUS and Sky) during the diligence process and I am pleased to say that they are excited about working with us.” After the conference call, in speaking with sources knowledgeable in this industry, I learned that TMUS’s product development team is particularly happy to be working with SMSI because SMSI knows the mobile operator business well, and they are aware the FamilyMode product was unable to gain the type of user traction that Safe & Found has achieved with Sprint. In fact, TMUS developers are so excited about this transaction that they have reportedly brought SMSI into discussions with the TMUS-S product development merger team. Clearly, this is a very bullish sign for SMSI and their future business with the New T-Mobile.

I will discuss a particular hurdle that still exists between SMSI and the New TMUS in the “Risks” section below. But here I will conclude by highlighting that SMSI and TMUS seem to have overlapping product plans, especially as 5G is unveiled. According to the New T-Mobile website homepage, the New TMUS plans to be the 4th largest internet service provider by 2021, competing for business in the home against cable companies.

New TMobile ISP

This plan fits nicely with SMSI’s ultimate SafePath Home solution, a product that will expand on their current SafePath product with Sprint, bringing parental controls, device connectivity, and other features into the consumer’s home. Interestingly, Sky already has a router with a Circle product on it, a product that SMSI has now taken over. So although there has been an understandable focus on the Sprint-TMUS merger, we should not overlook what SMSI could possibly do long-term with Sky.

Speaking of not overlooking other carriers, we should also be aware of two additional developments. First, the Sprint-TMUS merger will bring DISH Network (DISH) into play as an SMSI customer. DISH will be receiving the Sprint pre-paid Boost business, and Boost and SMSI maintain a good relationship. Furthermore, DISH is already “in the home,” so this fits well with SMSI’s ultimate goal. On the Q42019 call, CEO Smith mentioned: “We also remain very optimistic about DISH Network’s ascension as the fourth U.S. Tier 1 carrier. Their acquisition of Boost should position DISH well for strong growth in the wireless carrier market. We welcome the opportunity to serve at both the new T-Mobile and DISH moving forward.” In addition to this opportunity with DISH, I mentioned the strong possibility of SMSI adding Canadian mobile operator, Telus, to their stable in my previous article linked above.

CommSuite And ViewSpot Update

SafePath is clearly the focus of the SMSI story going forward, but the company’s CommSuite and ViewSpot offerings should not be forgotten. While the CommSuite business disappointed in Q3, SMSI CFO Tim Huffmyer guided for some stabilization on the Q4 2019 call, with the business still expected to bring in over $17M in revenue in 2020, at high margins. In addition, I have been told that CommSuite continues to be “part of the discussion” with mobile operators when SMSI and the operators discuss possible future business partnerships. For perspective, CommSuite had not seen much engagement from carriers outside Sprint until around Q3 2019. As with SafePath, the Sprint-TMUS merger will provide an opportunity for SMSI to work with DISH on CommSuite.

As for ViewSpot, SMSI continues to implement upgrades to the product to both impress possible carrier customers and to help fit into their dynamic business model. Most specifically, both SMSI and multiple prospective customers are looking to make the product more user-accessible. When SMSI purchased ViewSpot in early 2019, the product required a significant number of consulting services for it to operate properly. SMSI continues to automate these processes and remains hopeful it will eventually lead to new business. In fact, concluding his prepared remarks for ViewSpot on the Q4 2019 call, CEO Smith said: “Overall, I am pleased with the progress made on [the ViewSpot] development side addressing market needs. We expect to announce new ViewSpot wins throughout 2020.”

CommSuite and ViewSpot provide potential additional upside to SMSI’s business. Still, even if they perform according to the status quo, they provide relatively stable, high margin revenue to SMSI.

Operating Expenses

So far I have discussed the many benefits of the Circle acquisition – and I believe these benefits far outweigh any initial headwinds. Still, I must note that the integration of Circle and SafePath will create additional operating expenses for SMSI. Based on research I have conducted, I believe SMSI’s operating expenses in Q1 2020 will likely be much higher than normal (I am modeling $800,000 higher than normal in my personal operating model). A good portion of that is related to new hiring and other expenses related to the ongoing software integration. These expenses will likely continue in Q2 and Q3 2020 to the tune of around an additional $500,000 per quarter. I expect the return on investment over the next year or two will more than justify this short-term jolt to OpEx.

Fortunately, the expected increase in SafePath revenue should more than offset higher expenses, with this possible even in the short term. SMSI will receive an extra $500,000 for SafePath in Q1 2020 from inheriting a half-quarter of revenue from the purchased Circle operator business. Starting in Q2 2020, SMSI step up to the full $1M per quarter provided by the contract. So even in the unlikely event SMSI does not grow SafePath at all organically, they will still cover these additional expenses with the increased revenue from the Circle deal. Moreover, it is possible SMSI will be able to deploy its current version of SafePath on TMUS’s network prior to the full integration of SafePath and Circle.

Most importantly, SMSI is investing in its future. If these increased expenses lead to winning the New TMUS business, the 2020 OpEx will provide an impressive return on investment for years to come. While my research in this area resulted in me slightly lowering my 2020 EPS estimate, I have simultaneously become more optimistic about SMSI’s 2021 (and beyond) revenue and earnings potential. I will discuss that below in more detail in the “Valuation” section.

Risks

I will outline three risks associated with investing in SMSI in order of my perceived importance, while also discussing why I think these risks can and will be mitigated.

(1) The Circle carrier business came with less than favorable contracts, likely because TMUS invested significant money in Circle prior to their deployment of Circle’s FamilyMode. Under the contract with TMUS, Circle received a flat annual rate. SMSI, on the other hand, receives a variable rate from Sprint. Specifically, with the combination of the purchased contracts of TMUS and Sky from Circle, SMSI will receive an annual flat rate of $4M of revenue. On the other hand, under the variable terms with S, SMSI earned over $6.6M in quarterly revenue in Q4 2019 from S’s Safe & Found, or an annualized amount of $26.6M (nearly seven times as much the annual amount SMSI will currently receive from TMUS).

For SMSI to be successful long-term with new TMUS business, the contract SMSI purchased from Circle will need to be replaced or restructured for more favorable terms. I believe this will happen for several reasons: (A) as noted above, SMSI indicated TMUS was aware of their purchase of the Circle operator business and TMUS is “excited” about that; (B) related, TMUS understands the contract with SMSI will need to be restructured; (C) a restructured contract – one more aligned with the terms of the S variable contract – is actually better for both parties; although TMUS will pay significantly more to SMSI than they were to Circle, they will get more in return, not just in the way of a better product, but in terms of their own revenue from add-on services.

Still, investors should be aware of this contract situation and subsequent risk, and should factor that into their analysis of SMSI.

(2) As with most companies, there is some new uncertainty created by the novel coronavirus and the related fallout.

Covid-19

Already, both Sprint and TMUS have restricted store hours and even closed some of their stores nationwide. This will almost certainly have a negative impact on SMSI, but the degree to which it impacts them could vary significantly. I will outline how that impacts my valuation in the “Valuation” section below. Here, I will simply say I think the COVID-19 selloff has more than “priced in” the most dire situation SMSI would face. In addition, I should note that SMSI, even after the Circle acquisition, has around $20M of cash on hand, giving them flexibility to weather a storm. So even with the current uncertainty around COVID-19, I believe this risk has already been priced in at current share price levels.

(3) CommSuite disappointed in 2019, especially in the second half of the year. There is still clearly some uncertainty surrounding CommSuite as it relates to what happens with the product at the New TMUS. My best guess is that CommSuite would, at the very least, continue to be available to current subscribers. In terms of company guidance on the Q4 2019 conference call, SMSI expects CommSuite to be between stable and down in the single-digit percentage. Nevertheless, the complete, or significant, loss of CommSuite business represents a real risk for SMSI. If that happens, however, I think the business would likely “trickle” away and not immediately cease altogether. In such a scenario, it is likely that additional SafePath revenue would start offsetting (and eventually exceed) the CommSuite loss.

Valuation

Previously, I predicted SMSI’s EPS for FY 2020 to be $0.53/share. I have modified that for the most updated information, most especially the expected increase in operating expenses. Below are some key assumptions I made in my model, in addition to the details I provided already above (note that all of these assumptions are conservative in nature):

(1) No new material customer wins that positively impact 2020 revenue.

(2) All outstanding warrants will be exercised by EOY 2020.

(3) The SafePath sequential growth (measured by absolute dollar amounts) slows to an average of $500,000 per quarter. Note that the average absolute dollar sequential growth in 2019 was almost triple that amount.

(4) CommSuite and ViewSpot decrease in the higher single-digit percentage range (i.e. the lower end of management guidance).

(5) Operating expenses rise slightly higher than my current base-case expectation.

Taking into account all of these factors, I now estimate SMSI to earn $0.43/share in 2020.

SMSI 2020 EPS

Using a basic 20 P/E multiple for simple purposes, that would value SMSI at $8.60/share, well over 100% above the current share price.

Again, note that my valuation includes no new material customer wins that result in revenue for 2020. However, if SMSI announces a favorable contract win with the New T-Mobile, this will obviously favorably impact the share price. In fact, my initial estimate of 2021 EPS with a full year of New TMUS SafePath revenue leads me to believe SMSI could earn as much as $1/share. That could lead to a reasonable valuation of $20/share, especially considering the company would be expected to continue growing for several more years.

Given the uncertainty related to COVID-19 as outlined in the “Risks” section above, I also decided to run my operating model assuming no organic SafePath growth beyond the first part of Q1 2020. In this model, I also lowered CommSuite and ViewSpot beyond management’s current lower-end guidance. In this model, I still ended up at $6/share, well more than a 50% increase from current prices.

Finally, as I have noted in previous articles, it is a near certainty now that SMSI is added to the Russell 2000 index (they are currently 25-30% above the expected market cap required). This addition should create a nice tailwind of forced institutional buying by those who track the index, likely leading to a nice bump in share price.

Conclusion

Smith Micro’s SafePath product offers investors a “safe path” to outsized returns for their 2020 portfolio. Simply put, SafePath has been on fire with Sprint. Now that SMSI owns TMUS’s previously competing product, they are highly likely to win an exclusive deal with the New T-Mobile after the TMUS/S merger. With additional mobile operators and devices in the pipeline, SMSI is set to have an outstanding 2020.

Disclosure: I am/we are long SMSI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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