Synchronoss: Another Cloud Software Company That's Profitable

Summary

Synchronoss recently reported very strong results and raised guidance for the current year.

The company is quite reasonably valued relative to its forecast growth rate.

It is not well known or well followed, which potentially affords investors an interesting opportunity.

Synchronoss' cloud offering consists of backing up and retrieving photos, videos and other personal items for customers of some of the major carriers.

A profitable software company that has cloud exposure and achieves reasonable profitability that many have never heard of.

It's amazing just how pervasive the cloud has become. Now that Amazon (NASDAQ:AMZN) has launched private-label brands for products such as diapers, can it be long before some consumer products are described as cloud-enabled? And the rapid growth of the Internet of Things (IoT) will no doubt soon enable intelligent trash cans to be controlled remotely through cloud-based software.

So, it's hardly all that surprising to find every company that can conceivably describe itself as a cloud company does so. Synchronoss (NASDAQ:SNCR) decided a few years ago that in order to continue to serve its carrier customers, the company needed to launch a product that it describes as a "personal cloud." Indeed, some of the company's traditional solutions that encompass the activation and provisioning of devices and services are now defined as SaaS, although its business model is quite far from the way I or many other readers think about SaaS.

Synchronoss is probably not a name on the lips of all that many readers or investors. It only has coverage by seven analysts, although they like the stock at the moment and have a mean price target of $50. While compared to many other names about which I have written, this company has reasonable valuation, although, as I will discuss, there are some risks that go with that valuation. It is building a new set of enterprise solutions that could significantly accelerate growth. The company will almost certainly exceed its estimates this year, as the estimates do not include any incremental revenue from the release of the new Apple iPhone. Overall, I believe the shares are attractively valued at current levels.

Synchronoss actually does things that most mobile phone users have experienced. It is a company that helps many users set up their phones when they first buy them. And it sells its Personal Cloud offering - again, through carriers - as an add-on feature. Synchronoss has little visibility, since it is a "white-label" company that allows its carrier customers to brand the service offerings it supplies as part of their own marketing package.

At the end of the day, it doesn't matter all that much if a company like this stretches word meanings in an effort to seem relevant both to its customers and investors. Some basic questions are how it will cope going forward with the decline in its legacy activation businesses, and what the future prospects for its Personal Cloud business are in a very crowded market place for the back-up and recovery of personal data.

Synchronoss currently has a valuation that might suggest investors are very dubious about the end results of the transition and even more dubious about the company's foray into the enterprise world. Even with its cloud appellation, the EV/S ratio for the current year is estimated to be about 2.4X, based on a consensus sales estimate by seven analysts of $773 million. Sales growth this year is estimated to be 16%, and is estimated to be 18% for 2018. It has a P/E of 14X based on EPS estimates for the current year and 11.3X based on 2017 estimates.

Not surprisingly, I imagine this company has had more than its share of stock price volatility. The shares were as high as $48/share in August 2015, before dropping to $24/share in the tech crash earlier this year and have now recovered to $34. Most recently, they appreciated from $28 to a high of $36 in the wake of reporting quarterly financial data that showed a significant beat on both the top and bottom lines, and which also featured significant raises in forward guidance and even in cash flow generation.

Last year, Synchronoss generated free cash flow of $57 million. The company actually does guide for free cash flow generation, and the CFO, Karen Rosenberger, is suggesting overall growth of 15-20% for the year, which would generate free cash flow of $67 million. That would result in a free cash flow yield of 4.1%, which is not an impressive number particularly given that stocked-based comp is running at about half of that figure. I would note that it seems to me, just looking at the results of Q1 and other projections made by the CFO, that an estimate of free cash flow of $67 million for 2016 seems very conservative.

What does this company really have to do with the cloud?

Synchronoss offers a service through its telecom partners that it calls Personal Cloud. It also offers other services that it calls Backup and Transfer to its carrier service providers. I'm going to use Personal Cloud for all cloud-based activities as the company does in its literature and its press releases. I'm not all that sure I would have called the service that, but I suppose it really doesn't matter. Overall cloud-based revenues made up 58% of the company's revenues last quarter and grew at 18% year on year. Forward guidance is based on Personal Cloud achieving 30% growth in Q2 and 27% for the full year. Since cloud revenues grew just 18% during Q1, the guidance actually implies that growth in the cloud will surpass 30% in the second half of the year. If that forecast works out, Synchronoss should at least achieve its guidance for the year, and self-evidently, if that kind of growth isn't achieved, the company will have significant issues in terms sustaining its valuation.

The company, in order to support its cloud, has been aggressive in building data centers. A couple of years' capex has been elevated by the requirement to build out data centers globally in order to effectively service its carrier customers. Capex showed signs of returning to more normalized levels during the first quarter. The purchase of fixed assets fell from $24 million during Q1 2015 to $13 million this year. Overall, capex is forecast by the CFO to be about $60-65 million, compared to $60 million last year.

The Synchronoss Personal Cloud is a service offering that allows mobile carriers to offer their customers a branded solution to protect all of the content on their connected devices. As many readers are aware, there are many solutions that provide consumers with cloud-based repositories for their photos, their contacts and their videos. This isn't all that different - it is a back-up and recovery capability that enables consumers to be certain that their treasured photos or videos are always safe regardless of what happens at their primary repository or even when they lose their phones - by far the most prevalent use case. The company offers another service called Mobile Content Transfer, which allows consumers to transfer personal content across operating systems, devices and networks. Its next-generation Personal Cloud product, which is coming later this year, is going to "allow consumers to engage with and enjoy their content in new ways." Being old-fashioned, I'm not too clear as to what consumers do with photos and videos other than looking at them, but I'm certain that they can be edited, combined and repurposed in ways that I personally have little desire to see.

The Synchronoss Personal Cloud and its ancillary Mobile Content Transfer is considered by some observers to be one of the more innovative offerings in recent years. More important than awards is the ubiquity of the service offering. Verizon (NYSE:VZ) is the flagship customer for its cloud services, but the company offers its service through many other carriers. It appears that about 50 million users are on carrier plans that make use of the Personal Cloud service for Synchronoss, and that number has apparently quadrupled in the last couple of years. Most consumers really will not use the offering unless they lose their phones, but will take for granted that their carriers will synch their photos and videos in the background.

From a business perspective, the best attribute of Personal Cloud for the carriers is that it tends to make their customers stickier and drive them to more expensive data plans. There isn't a whole lot of data supporting those attributes, but market researchers such as Mobile Cloud Era are supportive of the claim. The CEO of Synchronoss, Stephen Waldiss, commented that carriers are showcasing the capability because "it has been shown that churn rates are dramatically lower on those customers, the customers are signing up multiple connected devices. They're buying the most lucrative 4G data plans." Synchronoss tries to utilize its role in providing set-up and provisioning software to mobile operators as a mechanism by which it enhances subscriber growth. The company claims that 60% of new consumers at its carrier customers take the carrier cloud that is supplied by Synchronoss when it is part of the set-up process of newer devices.

I think that the issue that's weighing on the minds of most investors relates to competition. There are dozens of ways of storing photos and videos that are offered by companies such as Box (NYSE:BOX) and Dropbox (Private:DROPB). To be sure, they aren't quite the same, and there is some thought that photos taken from phones are more easily stored and accessed on phones, but the relatively modest valuation for a company that's forecast to grow at a 17%-plus rate for a few years reflects extreme unease about the validity of that forecast.

The biggest competitive advantage this company has - and it is by no means a moat - is the relationships it has with the carrier community and in particular with Verizon. Carriers are obviously looking for a way - almost any way - to increase revenues and retain customers. There are many people other than I who can comment authoritatively about the state of the market for wireless service. For the purpose of this discussion, all that needs to be known is that the space is intensely competitive and churn rates are high. This service is relatively far easier to sell as part of the set-up package. So, the more phones sold, the more adoption of personal cloud.

And that brings me to another point, but one that is worth noting. I think most readers are aware that the iPhone 7 is coming shortly. I think it is fascinating that there has already been a debate about the likely success or failure of the device. But the fact is that Synchronoss benefits quite directly from spikes in the sale of new phones. The company gets a fee each time a phone sold by one of its set-up partners is provisioned. And since a high proportion of iPhone customers are likely to choose the Personal Cloud Service as part of their provisioning, Synchronoss is likely to see a spike in Personal Cloud users.

Management, during the course of the last conference call on May 5th, went out of its way to say that whatever benefits the company might get from the introduction of the new iPhone, or for that matter any other popular device, are not factored into its forecasts. At the current time, analyst consensus estimates for the December quarter do not show any potential from the introduction of the new iPhone. The estimates for the December quarter of $.75 show only normal seasonal trends.

I hardly think the introduction of a new iPhone is reason to make or not make an investment in SNCR, but it is a bit of tailwind that's likely to lead to a couple of earnings surprises and EPS forecast revisions.

While this company is dramatically benefiting from the development of the cloud and its adoption by many consumers as a repository for their personal data, its success or failure going forward is most nearly going to be related to the success of its carrier customers, particularly Verizon. There are many reasons I think to consider a position in these shares, but one of the most salient is the relationship this company has with its carrier customers. Synchronoss is basically agnostic in terms of operating systems and platforms, but its marketing is a function of the marketing done by carriers for its add-on services.

A new initiative and its possibilities and pitfalls.

One thing this management realizes is that it needs to put more legs under its stool. While Synchronoss' activation solutions aren't doomed for extinction, they are certainly not going to be a growth driver in the future. The company is under-penetrated in Asia/Pac and in most international markets overall. It has made customer acquisition in those areas a priority, and it describes that potential as part of an additional leg.

But the company's initiative, being developed in collaboration with Verizon and Goldman Sachs (NYSE:GS), is going to really determine the success of its third leg strategy. Synchronoss recently created its Enterprise Mobility Unit (EMU), which is targeted at the financial services, life sciences and healthcare verticals. It also announced a relationship with PwC to identify enterprise pain points and to specify deliverables. Its new solutions are going to be in the areas of identity, access management and security.

We really do not know all that much about the partnerships other than which companies they are with and what they plan to accomplish. It hasn't yet been made too clear exactly how the two ventures will function and interrelate. I assume Verizon is going to OEM the products that are developed by EMU. That kind of partnership has worked well for SNCR, and it makes sense to expand it. Verizon has expertise in selling solutions to businesses and consumers, and Synchronoss has none.

The Synchronoss partnership includes IP that GS has internally developed some solutions, including Lagoon and Orbit, to ensure that it can provide its clients and employees with secure access to data across multiple platform and devices. Synchronoss is contributing one of its products called WorkSpace, which is a "device and operating system agnostic mobility content management solution." I'm not sure if I have ever before found, and I hope never in the future will I find a phrase with quite as high a proportion of buzzwords. I wonder who edited this press release.

I think many readers are going to identify the deliverables Synchronoss is intending to launch as belonging to one of the most competitive spaces known in enterprise software. If I know that, I have every confidence that the management of SNCR is well aware of what else is out there. In any event, the company recently recruited Dan Ives as senior VP of Finance and Corporate Development, who will also oversee Investor Relations. Dan comes from FBR, where he worked as a well-known analyst who followed companies emerging in the cloud as well as companies in the cybersecurity space. I assume part of the rationale for the hire was to ensure that Synchronoss doesn't introduce a "me-too" product.

Management said it had literally spent thousands of man hours commercializing the next generation of BYOD (Bring Your Own Device) software. The company plans to put the product in GA less than a month from now, and it will have, it says, several significant customer wins to announce at that point.

The market space for authentication and identity management is likely significantly greater than the current markets addressed by Synchronoss, although that is a little difficult to determine given the available data. The space is known colloquially as BYOD, but I doubt the users who do bring their own devices will be as happy with the results as consumers who brought their own bottles (BYOB). I realize that is a very sick and very stretched joke. Synchronoss has suggested in a tweet that the BYOD market will have grown from $67 billion to $181 billion by next year. How the calculation was made I really do not know, and I'm reasonably sure the figure is far, far greater than the market space that SNCR's new product sets will really address. A far better analysis, I think, is that worldwide EMM revenues are growing from $1.5 billion last year to $4.5 billion this year. This analysis was put together by the Radicati Group, which specializes in Technology Market Research. Still, adding a real TAM of $4.5 billion to SNCR's potential is quite meaningful in the context of the current revenues of this company, and the fact that it intends to focus on the BYOD space shows that it is at least cognizant of the major market trend that is animating user buying decisions.

Trying to forecast the success or failure of a product that has yet to be released, and especially one that is based in part on contributed technology and is going to be sold by a third party (I think), is a fraught exercise. I'm sure there are internal targets for the revenue and gross profit ramps of the new unit, but I surely do not have them, and those forecasts are likely to be a little better than random chance. If the strategy works, then the EMU that this company is building could easily drive growth rates well beyond expected levels. If it doesn't... well, at the moment no one is forecasting any revenues for the unit in the current year.

As might be anticipated, Gartner has a piece on what it calls Enterprise Mobility Management. Its commentary was essentially focused on what it describes as suite players. Gartner's Magic Quadrant chart and ensuing commentary focused on 12 vendors. Leaders included IBM Corp. (NYSE:IBM), VMware (NYSE:VMW) and Citrix (NASDAQ:CTXS), as well as a private vendor called Good Technology and Mobiletron (NASDAQ:MOBL), a fairly recent IPO.

A very little bit about the company's legacy business.

Transitions can always be messy. This transition has another complexity in that this company's fortunes, to a lesser or greater extent, are tied to the mobile phone business. No one is going to like that, but that's what SNCR used to do until the cloud came along. I think, without belaboring the point, that activations for mobile phones - the business that Synchronoss is in - are going to track the sales of mobile phones. SNCR has a long-time relationship in the activation field with AT&T (NYSE:T) and now DirecTV. At one point, revenues from the AT&T relationship were in the range of 30-40% of total revenues, but that has long since changed. The company's current AT&T contract runs through the end of 2018. AT&T also offers SNCR's Personal Cloud, and SNCR's technology powers the company's Locker offering. At the moment, in the cloud, AT&T's revenue contribution is smaller than that of Verizon. Other significant customers include Time Warner Cable (TWC), BT Group (NYSE:BT), Orange (NYSE:ORAN), America Movil (NYSE:AMX) and Telstra (OTCPK:TLSYY).

As mentioned above, this company has not, and will not, forecast the bump it is likely to get from the introduction of the new iPhone. It is sure to be visible and equally sure that the bump will certainly recede. Overall, Synchronoss has forecast a further 3% decline in activation revenue in Q2, but still believes it can achieve 4% growth for the year as a whole. Synchronoss doesn't identify sector profitability, but it is likely that its activation suite has been, and will remain, a cash cow for the company.

Wrapping up

This is one of those less-followed software companies that has been around doing less interesting things. A few years ago, however, management recognized that the business of providing software to activate cellphones would no longer be a growth driver and it entered into an adjunct space. The company describes the new business as Personal Cloud, and it allows the carriers, that are actually its customers, to take the Synchronoss white-label solution and sell it to the carriers, who offer it as an extra-priced feature. This new business is now 58% of revenues and is forecast to grow 30% this year. Obviously, there are many, many competitors to this Personal Cloud, and I haven't tried to analyze winners and losers. The most important attribute this company has is that it has partnerships with many major carriers, and in particular with Verizon, that have been quite successful and are likely to remain so.

Synchronoss has a major new business in an offering in the identity management and security space for the enterprise, which is forecast to be in GA in the middle of June. It is a very high-profile undertaking with partners including GS and Verizon. The EMM space as a whole, which is the area in which this new offering will compete, is very crowded, with some strong participants. On the other hand, the BYOD sector - to which this company's offerings are specifically targeted - is growing more than 30% a year, according to market research data. I do expect this company will be successful in building the third leg to its stool.

Synchronoss has a relatively reasonable valuation in terms of both P/E and EV/S. It's improving net cash flow significantly as profits rise and capex falls. EV/S of 2.5 or less and P/E on current-year earnings of 14X are very reasonable valuation metrics for a company that is thought to be growing at 17%. I like the shares at these levels.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.