Smith Micro Software Has A SafePath Forward

Smith Micro Software (SMSI) shares have been stuck in neutral for most of 2020. Although the shares rallied early in the year, reaching an intra-day high of $7.15 in mid-February, they were quickly battered with most of the rest of the market during the Covid drop in mid-March, with shares dipping as low as $3.28. Although shares eventually rallied above $5 in mid-April, they have since been stuck in the $4.00/share range, give or take. To me, the question is, knowing what we now know: do the shares really deserve this $4.00/share valuation?

Followers of SMSI know why the stock dropped from its September 2019 highs in the mid-$6/share range: the uncertainty surrounding the company's largest customer, Sprint. With the merger between Sprint and T-Mobile (TMUS) on the horizon, and the possibility that TMUS might discard SMSI as a provider for its family safety products, investors placed little value on SMSI's impressive, SaaS-like margins and positive cash flow, focusing instead on the longer-term risk of SMSI losing its largest customer. And undoubtedly, this was the risk of owning SMSI. Their revenue from other customers would not be able to sustain the company for long. On top of that, during the Covid-19 pandemic, SMSI operating expenses have ballooned, while revenue has moderately declined.

In this article, I will show why I believe this risk of losing TMUS is now, all but formally, in the rearview mirror, providing SMSI with a "SafePath" forward. In addition, I will explain why SMSI's positive EPS and operating cash flows during this challenging time bode extremely well for the company in 2021. Yet, even with the risk of losing TMUS business significantly mitigated, investors are still able to purchase SMSI shares for around the $4/share price. I believe this continued depressed valuation will lead to a once-in-a-generation opportunity for investors, with the very real possibility of SMSI shares quintupling within 18-24 months.

Sprint/T-Mobile Merger

Before dealing with SMSI's future possibilities, I want to briefly cover their recent past. In early 2018, Sprint introduced SMSI's family safety/location tracking product, SafePath, under its own white-label name, Safe & Found. By the summer of 2019, this product was SMSI's biggest hit, producing more revenue than any other Smith product. After a blowout earnings report in mid-July, shares rallied the next day by 67%. However, beginning in mid-October 2019, SMSI shares took a precipitous decline. Why?

The only reasonable explanation was the merger between Sprint and TMUS, and the possibility that TMUS might not continue offering a SafePath product. In addition to that, the merger brought concern that another Smith product, their visual voicemail service, CommSuite, might also fall by the wayside during the merger. Since CommSuite was the second-highest revenue generator, investors were reasonably concerned about these possibilities.

I have written several articles about SMSI since these developments, each time recognizing this risk, but pointing out why I believe it was unlikely TMUS would walk away from SMSI. Making the possibility of TMUS walking away from SMSI even more unlikely, SMSI purchased the operator business of Circle Media Labs in February 2020. The significance of this was that Circle provided TMUS with a competing family safety app, FamilyMode. After this acquisition, as I pointed out, the possibility of TMUS leaving SMSI behind became unlikely.

But recently, based on SMSI's Q3 conference call, I believe it is now all but certain that TMUS and SMSI will be partnering in 2021, with SMSI providing TMUS a white-label SafePath product. Following the conference call, I checked with people who are familiar with TMUS and SMSI's relationship, and they confirmed my understanding of the situation. Based on this new information, I believe SMSI is now significantly de-risked, and shares should be much more highly valued.

SMSI Significantly De-Risked

On past SMSI conference calls, CEO Bill Smith presented a hopeful picture of the company's relationship with TMUS. However, Smith also made it clear that they did not have any contract with TMUS and that general merger issues, coupled with Covid-19 problems, had delayed the timeline SMSI hoped to follow to introduce a new SafePath app for TMUS. On the Q3 conference call, Smith struck a subtly different tone, one that indicated the company is now working closely with TMUS on marketing efforts for a unified product.

While indicating a contract for the new product has not yet been signed (normally, the last thing that happens after SMSI demonstrates it can provide what the carrier needs and wants), CEO Smith noted:

As far as the actual launch of the new product, obviously that will be driven by T-Mobile as they move forward. We are working very closely with them on a lot of their marketing plans and things like that."

This is clearly a subtle, yet extremely positive development. Normally, carriers do not work on marketing plans with companies for new products they do not fully intend to adopt.

In addition to that clue, Smith specifically referenced TMUS on the call when describing plans to unite the legacy Sprint users and the legacy TMUS users on one new product. This new product would be the recently-completed SafePath 7, which combines the best of SMSI's SafePath and the acquired Circle Media coding, to create a best-in-breed product. For the first time, on that Q3 call, CEO Smith commented on their plan with TMUS:

The good news is there will be a single family safety product that can be marketed to all T-Mobile customers going forward, whether they are original T-Mobile users, or acquired Sprint customers."

Sometime between SMSI's Q2 call and last week's Q3 call, something transpired between the two companies to the extent that CEO Smith is now publicly notifying investors that: (A) the plan at TMUS is to have a new, unified offering that would allow TMUS users and Sprint acquired customers to use the same SMSI white-labeled product on the New TMUS network and (B) SMSI is now discussing the actual marketing plan with TMUS for such a launch, which according to Smith on the call, is slated for the first half of 2021.

Following the conference call, I contacted someone familiar with discussions between the two companies. While this contact has always been confident that SMSI and TMUS would work out a solution that was beneficial to both companies, they affirmed that my reading of the progress was correct, with the roadmap becoming more clear, and the discussion moving more to the logistics of a product launch and marketing efforts. In my opinion, this recent development has significantly de-risked SMSI shares. While my contact correctly noted that nothing is 100% certain in life or in business, it is now highly probable that TMUS and SMSI team together to offer New TMUS customers a white-labeled SMSI SafePath product in 2021.

Quite frankly, SMSI and TMUS seem like natural business partners with the introduction of 5G. In fact, just recently, TMUS announced its new effort to compete in the home with cable companies, offering a new TVision service. In addition to its SafePath Family platform, SMSI offers a SafePath Home product that extends its family safety/parental controls into a home's router. TMUS could conceivably combine SafePath Family - the traditional product used with cell phones - with SafePath Home to provide TMUS subscribers with protections that extend into the home. When I pointed out this natural fit between TMUS's new TVision and SMSI's capabilities, my contact noted it would certainly make sense for TMUS and SMSI to be discussing SafePath Home since it fits within SMSI's "wheelhouse."

New Customers on the Horizon

As I noted in my most recent previous article on SMSI, the company is no longer only about Sprint/New TMUS. Within the past year, SMSI has seen high interest from many other carriers for both its SafePath and ViewSpot products. In fact, on the Q3 call, management was quite clear that their drastically increased operating expenses in 2020 were due to high demand for its products. We should note that the sales cycle for SMSI begins with them developing the product to carrier specifications and showing that they can provide what the carrier needs. Subsequently, most product development expenses come up-front, with high-margin revenue resulting on the back-end. This will be important to keep in mind when we later review SMSI's valuation.

In any case, on the call, CFO Tim Huffmyer stated the company plans to hire 12-15 more people in the 4th quarter of 2020. The reason cited by Huffmyer for all the additional hiring in 2020 is that the expenses "are necessary to accelerate the SafePath roadmap by adding features and functionality, sooner than originally expected to support the pursuit of new customers." He further elaborated: "We are currently pursuing multiple opportunities to sell our SafePath platform for both Family and IoT." He concluded by saying: "We are optimistic enough to make the investment and pursue the win."

What exactly is the opportunity SMSI is pursuing? Well, there are multiple opportunities, to be sure. Based on my research and that of my research partners, we believe there is a strong possibility that SMSI is working to close a major deal with a Tier-1 US carrier besides TMUS. Certain signs that we have found based on publicly-available data lead us to believe the possible partner is Verizon (VZ), but we have been unable to confirm that with the precision we prefer. When I spoke to someone in the industry familiar with SMSI's situation, they noted whatever SMSI is working on right now is clearly "something big," given the size of the investment as reflected in the recent increased operating expenses.

In the meantime, this possible US Tier-1 new customer is not the only customer SMSI expects to win. In fact, Lake Street Capital analyst Eric Martinuzzi asked CEO Bill Smith directly on the Q3 call:

You've talked pretty confidently about at least a couple [new contracts] in the next 30 days, perhaps a third one by year end. Do you recommit to that same number of new customer signings in 2020?"

CEO Bill Smith responded quite simply

That's our game plan."

My research leads me to believe that at least one of the expected three wins by year-end will be for the SafePath product. At least one is also expected for ViewSpot. But that is just talking about the next seven weeks. In 2021, I expect even more SafePath (and ViewSpot) wins. My research partners and I have been able to identify no fewer than seven carriers who seem to be exploring SMSI's SafePath product. These include TMUS, DISH Network Corporation (DISH), and possibly another US Tier-1 carrier. But they also include some large prepaid and international carriers, as well as at least one mid-size US carrier. In short, SMSI is not lacking for opportunities to sell its SafePath product.

DISH Possibilities

While all of the developments I mentioned above are exciting, they can often cause investors to overlook the massive potential SMSI has with DISH. DISH, of course, purchased Sprint's prepaid business, Boost Mobile, as part of the merger deal between Sprint and TMUS, which stipulated that DISH would be purchasing not only Boost but also the spectrum to eventually become the US's fourth Tier-1 carrier.

For the same reasons I highlighted with TMUS's move into the home, DISH and SMSI seem to be natural business partners. Add to this the fact that SMSI has always maintained a positive and productive relationship with Boost Mobile, even while Boost was part of Sprint. All of this puts SMSI in the driver's seat to partner with DISH as they begin to launch their postpaid service, likely in mid-2021.

Unlike TMUS, or any other carriers SMSI works with, DISH is starting from the ground up on the postpaid side. As they look at add-on services like visual voicemail, family safety, and parental controls, they will almost certainly rely on SMSI's expertise in these areas, "boosted" by Boost's existing and positive relationship with SMSI. I am told that SMSI believes they are "well positioned" to capitalize on these opportunities with DISH in 2021 and beyond.

Valuation

Valuing SMSI right now is somewhat difficult because of the uncertainty related to the timing and size of their new deals. I have, therefore, tried to be realistic, if not conservative, in my valuation. Below are the assumptions I used with an explanation for each assumption.

(1) SafePath revenues: I assumed a 10% sequential reduction for Q4 2020, per guidance. In Q1 2021, I estimate flat sequential revenue. Beginning in Q2 2021, because I expect some of these new deals to be launched and to start producing revenue, I estimated a 10% sequential increase each quarter through Q4 2022. Ultimately, investors should note this could be extremely conservative. For example, if SMSI ends up signing New TMUS and another Tier 1 carrier, or even DISH, then by Q4 2022, they should blow away my estimate. And then on top of those huge potential opportunities, you can also add some mid-size carrier/international deals. Regardless, my assumption is 10% sequential growth from Q2 2021 through Q4 2022.

(2) CommSuite revenues: Similar to SafePath, I assumed fairly flat revenue, up through Q2 2021. Then, beginning in Q3 2021, I expect a 10% increase each quarter through Q4 2022. The reason for this is that I expect DISH to start selling CommSuite by mid-2021 on its post-paid network. There is potential downside to CommSuite as well, of course, depending on how New TMUS handles the product. But I assume that between any negatives on CommSuite and upside potential on SafePath, my assumptions here will, at worst, net out.

(3) ViewSpot revenue: I expect 1H 2021 revenue to be slightly down sequentially from 2H 2020 due to some one-time consulting deals surrounding the new Apple iPhone release in 2H 2020. Following that, I assume once again a 10% sequential increase as SMSI scales ViewSpot and signs more customers. I believe this assumption is quite conservative, but as a small part of current revenues, it does not make a huge difference through Q4 2022.

(4) Operating expenses: I assume that R&D expenses will hit the high-water mark, as mentioned on the Q3 call, in Q4 2020. After that, I expect a slight decline in R&D, but I taper that off so that it does not fall below $5M per quarter. For other operating expenses, I assume a modest increase sequentially through Q4 2022.

Based on these assumptions, I model SMSI's non-GAAP EPS at $0.23/share in 2021, with almost half of that, $0.10/share, coming in Q4 2021. For that full year, I model $0.72/share.

Now, to show how quickly SMSI can scale EPS with incremental revenue, I ran my numbers assuming that both SafePath and ViewSpot see sequential growth at 15% beginning at the timeframes I previously mentioned them moving to 10% sequential growth. That would lead to 2022 EPS of $1.01/share. Moving SafePath to 20% sequential growth-remember, with just Sprint, by far the smallest of US Tier 1 carriers, SMSI had several quarters of 70%+ sequential growth with SafePath-I show $1.32/share of EPS in 2022.

For simplicity, I will slap a 20 P/E multiple on those numbers-a quick and, I believe, fair number to use when speaking of a growing, high-margin, recurring revenue business. At my most conservative number, in 2022 you are looking at $14.40/share (240% upside); at the 15% growth rate $20.20/share (380% upside); at 20% growth rate $26.40/share (525% upside). Keep in mind, as well, that SMSI currently has ~$0.60/share of cash on its books, and generated $3.9M in cash flow from operations last quarter alone. This cash flow from operations number will also grow by multiples as revenue ramps up through new deals.

Risks

The biggest risk for SMSI is that they are unable to reach an agreement with New TMUS on its SafePath product. Failing to reach a deal could be disastrous for SMSI, especially in the short-term, as it could lead to a loss of its highest revenue deal. However, as I discussed extensively above, I now believe it is almost certain that SMSI and TMUS will reach a mutually beneficial deal. It simply makes too much sense for the two companies to partner together. It is a win-win situation.

The second-biggest risk is that SMSI fails to sign any additional customers. While no additional customers would not be disastrous if a deal is reached with New TMUS, it would still mean that SMSI faces a concentration risk. By signing additional customers, SMSI will drastically decrease this risk, which I expect them to do by the end of the year and throughout 2021.

The final risk I will mention here is that of another destructive wave of Covid-19. With the pandemic picking back up in several states, and with several cold months still ahead for much of the United States, an uptick in cases could lead to additional lockdowns and/or carrier store closures and economic fallout that could lead to a reduction in/churn of SMSI's subscriber base. While I believe any such scenario would merely lead to temporary headwinds, it remains a risk to SMSI and investor sentiment in general.

Conclusion

SMSI shares have been stuck in the $4/share range due to the uncertainty surrounding the Sprint/TMUS merger, Covid-19 headwinds, and R&D expenses needed upfront to win high-margin business on the back end. With SMSI subtly hinting on their most recent call that their relationship with New TMUS is strong-so strong that they are already planning marketing efforts for 1H 2021-their business is now significantly de-risked. With three possible deals to be announced by EOY 2020, and with high-margin revenue starting to drop to the bottom line by mid-2021, investors now have the chance to buy a beaten down, but de-risked, stock with explosive growth opportunities and a "SafePath" forward.

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.