Smith Micro Has Plenty Of Room To Grow

Aug. 01, 2019 6:29 PM ETSmith Micro Software, Inc. (SMSI)S, TMUS25 Comments
Aaron Warwick profile picture
Aaron Warwick
1.64K Followers

Summary

  • Smith Micro shares have nearly quadrupled from their 52-week low, but they are still undervalued for a fast-growing, profitable company.
  • Smith's gross margin of 90%-plus and operating margin of 30%-plus allow significant portions of additional revenue to drop straight to the bottom line.
  • Smith's SafePath product has exploded with Sprint and they are well positioned to expand on that.
  • While overshadowed recently by SafePath, Smith's two other core products offer additional avenues of growth.
  • Although the Sprint/T-Mobile merger comes with risks to Smith Micro, management is clearly using this opportunity to try to expand their business.

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Smith Micro (NASDAQ:SMSI) has been on a tear. The stock has nearly quadrupled from its 52-week low of $1.62 in December 2018. However, due to a 8x earnings beat in Q2 (its fourth straight quarter of outperformance) and its operating leverage, it is clear SMSI remains underappreciated and undervalued.

The most recent earnings blowout explains why SMSI rose 67% on Friday, July 26, alone, and has risen even further since. This article will discuss the source of Smith Micro’s outperformance and why I believe the shares will deliver triple-digit returns in the year ahead.

Shareholders Unite has several good articles about Smith Micro on Seeking Alpha. Those articles give a good overview of SMSI’s basic business model and the three core products contributing to revenue. I would like to complement Shareholders Unite’s contribution by updating readers on the avenues for growth at SMSI (most especially through their SafePath platform) and discussing the company’s Q2 results. In addition, I will share important pieces from my operating model to help readers place a valuation on SMSI, as well as cover some of the possible risks of investing in the company.

SafePath – Sprint Safe & Found

Any discussion of Smith Micro’s potential has to begin with SafePath and SMSI’s relationship with Sprint (S). From the company’s most recent 10-K:

“The SafePath platform delivers a connected life experience for families and the connected devices that are part of their daily digital lifestyle inside and outside the home. The SafePath platform includes the SafePath Family – enabling mobile service providers to meet the needs of their customers for family real-time location, protection and parental controls services – and SafePath IoT – allowing service providers to deliver a connected digital life experience to their customers by bringing all of their connected devices like child and elderly wearable locators, pet trackers, car trackers, and connected home security devices under a single pane of glass.”

Currently, SafePath is white abeled with Sprint as Safe & Found. Since its introduction with Sprint in early 2018, Safe & Found has experienced explosive growth. In Q3 2018, SafePath quarterly revenue was $1.04 million. Q4 2018 showed little growth, clocking in at $1.25 million, as seen in the 10-K linked above. Although management has not explicitly stated this, I believe the reason for this slow growth was because they were working with Sprint to make the product better. Since rolling out Safe & Found, both Sprint and SMSI have shown a commitment to improving the product based on customer reviews. In late December 2018, SMSI released an app update that significantly improved the app. Then, in January 2019, Sprint began aggressively promoting Safe & Found and it’s been “off to the races.”

In Q1 2019 SafePath revenue increased 71% sequentially to $2.13 million. In the most recently released results for Q2 2019, SafePath revenue increased another 78%, sequentially to $3.8 million. In other words, from early 2018 through Q2 2019, Safe & Found went from a $0 run rate to $15.2 million. Furthermore, CFO Tim Huffmyer guided for 30% sequential SafePath growth on the company’s Q2 conference call, meaning that run rate will quickly increase to $20 million. It should be noted Mr. Huffmyer is gaining a reputation of underpromising and overdelivering.

While Safe & Found’s growth sounds impressive on its own, we should keep in mind that the company met or exceeded 90% gross margins in each of the last two quarters. Furthermore, in Q2 their operating margin was approximately 30%. Both of these margins should remain steady or even increase moving forward, allowing a significant portion of the increased revenue to drop straight to SMSI’s bottom line. I will explore this more in the valuation section below.

SafePath – Boost Mobile and Sprint Tracker

During Q2 2019, SMSI expanded their SafePath product within the Sprint network. On May 30, 2019, Boost Mobile introduced their own version of Safe & Found. Based upon data available through AppAnnie and Apptopia, Boost’s Safe & Found is gaining traction. According to the most recent Apptopia data, Boost Safe & Found has been downloaded 23,000 times in the past 30 days. Since the first month of Safe & Found is a free trial, SMSI likely reported no revenue from Boost Safe & Found in the second quarter. That will surely change going forward.

Another avenue of growth within Sprint was the introduction in Q2 of Sprint’s Tracker + Safe & Found. Sprint Tracker is a small device customers can attach to or place within almost any item (e.g., backpack, dog collar, car keys). The software used to track this device is Safe & Found. On the Q2 conference call linked above, SMSI management indicated this device is selling better than expected. Based on these comments, the device provides another opportunity for SMSI to expand its relationship with and revenue from Sprint.

SafePath – Future Opportunities and Risk

In my valuation section below, I will conservatively value SMSI based only on their current relationship with Sprint. But I would be remiss not to mention some of the risks and the future opportunities with the SafePath platform.

Ironically, the biggest risk to SMSI also is its biggest opportunity. Sprint and T-Mobile (TMUS) recently received DOJ approval for their proposed merger. As part of the merger, Boost Mobile is being sold to DISH. The risk here is, of course, DISH and/or TMUS could decide to minimize or eventually end the relationship Sprint has with SMSI. While this scenario is possible, it's not probable. SMSI CEO William Smith addressed this situation head on in the most recent Q2 conference call:

“We see this as an excellent opportunity for Smith Micro that could result in a very strategic upside for us. The merger of T-Mobile and Sprint presents risk, but it also provides immense opportunity for growth and expansion of Smith Micro. The entire team is focused on ensuring a successful outcome should the merger be approved. This prospect combined with the opportunity to serve a new fourth Tier 1 carrier presents an exciting time for the company.”

Even more encouraging, later in the call, Mr. Smith stated:

“Well, obviously, on the merger front, we can't have any meaningful discussions or disclose the discussions that we are having around that as far as Boost. I mean, we can only look at what the media reports are that they would be acquired by DISH. We have a good relationship with the Boost team, which soon would go over to DISH. And so, we continue to work heavily in both Kansas City and Seattle and we have a lot of meetings and a lot of discussions and planning ongoing and that's really all I can say about that subject.”

The fact Mr. Smith mentioned Seattle seems to be a reference to SMSI having discussions with TMUS (headquartered in the Seattle suburb of Bellevue). Of course, the CEO can say whatever he wants on the call. What's more telling is what the CEO is actually doing. And to that end, SMSI is on a hiring frenzy. On the Q2 call, management emphasized hiring 18 employees in Q2. In addition, a recent review of LinkedIn indicates SMSI is trying to hire approximately 20 more employees, primarily in development. I asked management on the Q2 conference call if all this hiring was due to their growth with Sprint, or if it was related to expected growth based upon their current pipeline. Mr. Smith’s response was telling:

“I would say that it's both. We're looking at headcount to help service our existing customers, but we're also looking at headcount to service new opportunities that we believe are on their way. So, yes, it's - this is a pretty exciting time.”

Again, while Mr. Smith can say anything, he is “putting his money where his mouth is” by hiring additional employees. Although this is no guarantee of future business, it certainly highlights management’s optimism and provides insight into future possibilities.

Other Avenues of Growth

In addition to the SafePath product, Smith Micro offers two other products that together with SafePath comprise more than 90% of revenue. These products are called CommSuite and ViewSpot.

CommSuite supports visual voicemail and voice to text. According to the company’s most recent 10-K, CommSuite is installed on more than 18 million mobile handsets. In their most recent conference call management highlighted that base revenue from this product has grown sequentially for seven consecutive quarters. According to CFO Huffmyer on the Q2 conference call, they expect continued sequential growth in the low single digits, with $200,000 to $400,000 swings per quarter related to ad revenue in addition to the basic subscription revenue.

ViewSpot was acquired in January 2019. According to the 10-K, ViewSpot is a smart retail platform providing wireless carriers and retailers a way to bring on-screen, interactive demos to life. These engaging demos deliver consistent, secure and targeted content that showcases the features of the devices that consumers want to see and learn more about. The ViewSpot platform also offers analytics capabilities for carriers to gain valuable insights into their consumer base and its buying behavior as well as their retail operations. ViewSpot has been a nice addition to Smith Micro’s offering and management has guided for 10%-20% annual growth in ViewSpot revenues.

The final note related to SMSI revenue growth relates to their participation earlier this year at Mobile World Congress. On the Q2 call, management has conveyed they have a robust pipeline for all three of their main products from their participation at that event and hope to close some deals to expand their relationships over the next two years.

Risks

As is always the case, investing in a company comes with risks. I’ve identified three risks related to SMSI. The first is a short-term risk: Recent share price appreciation. After nearly quadrupling in seven months and 67% in one day, some shareholders may sell to lock in profits. Especially after the most recent one day move, SMSI became more visible in trading communities and some of them have tried to short SMSI after such a large move, expecting people to take gains. I'm not a technical analyst or swing trader, so these are not major concerns with me. But I would warn anyone looking to jump in to SMSI that they should be prepared for some volatility along the way. As my fundamental valuation below will show, I believe investors today will be handsomely rewarded if they are patient.

The second, more long-term concern could be characterized as a customer concentration risk. Sprint represents the vast majority of SMSI’s current business, and effectively 100% of their current SafePath revenue. This risk is perhaps heightened even more than normal due to Sprint’s upcoming (likely) merger with T-Mobile. As stated above, it’s possible T-Mobile will sideline SMSI after the merger, even though that would still likely take years. Nonetheless, it is a real concern.

However, as I highlighted above, SMSI itself sounds bullish and is behaving as though they believe they will win the New T-Mobile business. Furthermore, it should be pointed out that SMSI has a multi-year contract with Sprint that the New T-Mobile would still have to recognize. Add on to that the fact that SMSI’s SafePath product is clearly superior to what T-Mobile currently offers and you have a recipe for a winning formula with the New T-Mobile.

The third and final risk I wish to highlight is an even broader concern. Namely, SMSI has a history of boom and bust. A quick look at their stock chart shows just how volatile the stock has been because of this. While this history remains a concern, it should be noted SMSI’s SafePath product is likely more “sticky” than their previous business ventures since they are selling a SaaS product. Furthermore, with their IoT capabilities, they are likely on the cutting edge of what mobile operators are seeking to provide in the future.

Valuation

In Q2, SMSI earned $0.08 non-GAAP EPS. This blew away analyst expectations of $0.01 EPS. This $0.08 EPS on an annualized basis equals $0.32 EPS. Even putting a 20 P/E target on SMSI — a P/E much too small for most high growth SaaS vendors, but used as a midpoint to counteract their customer concentration risk — you get to a share price of $6.40. Again, this is assuming $0.08 EPS per quarter. As I will show below, that number is far too small.

On the Q2 call, management guided for an increase in operating expenses due to increased headcount for Q3. In my operating model, to remain conservative, I assumed the company would add approximately 40 employees, all in Q3. This led to increasing R&D costs by 17%. Holding revenue from their other products even (despite some relatively small expected growth) and increasing SafePath revenue by 30% per management’s guidance, SMSI should easily meet or exceed $0.09 EPS in Q3. Again, putting a 20 P/E on that has the share price at $7.20.

Looking forward to 2020, you see where SMSI has the opportunity — with the current Sprint business alone — to explode once again. In an attempt to be conservative, in my operating model I used the following assumptions: (1) 20% growth per Q for Safe & Found after Q3 2019; (2) 10% growth annually for other main sources of revenue (CommSuite and ViewSpot); (3) 10% growth in operating expenses (unlikely to be that high, but I want to be conservative). Based upon those assumptions, my target 2020 EPS for SMSI is $0.71. Again, a basic 20 P/E would lead to a $14.20 share price.

The above assumptions include only current business. If SMSI adds another Tier 1 or even mid-sized carrier for SafePath, or adds an additional customer for CommSuite or ViewPath, then these numbers would obviously be low. Moreover, if SMSI lands another Tier 1 carrier for SafePath, or simply wins the New T-Mobile business, the current customer concentration risk is significantly mitigated and a much higher P/E can be applied, one more in line with other high-growth SaaS vendors. In any case, a conservative projection still leads to the conclusion that SMSI remains undervalued.

Conclusion

Despite its recent near quadrupling in share price, I believe SMSI is still significantly undervalued. Smith management is clearly preparing for the Sprint/T-Mobile merger, and this event, while introducing some risk, also offers a potential huge reward. Based upon their current business and expected growth, SMSI should easily beat the Wall Street Q3 estimates of $0.04 EPS (I estimated at least $0.09 EPS in Q3 above). Furthermore, they should be able to produce $0.71 EPS in 2020, rewarding current shareholders who are willing to brave some possible temporary volatility after SMSI’s recent share price appreciation.

This article was written by

Aaron Warwick profile picture
1.64K Followers
I collaborate with other "Breakout Investors" at app.breakoutinvestors.com as we try to be ahead of the curve, looking for opportunities where the market has not yet figured out or appreciated a company's fundamental business or upcoming catalysts. I have an accounting degree from Creighton University and a Masters in Philanthropy and Nonprofit Development from the University of Northern Iowa. I invest for retirement and as a hobby. I primarily engage in fundamental analysis and look for large discrepancies in what I believe a company is worth and their current share price.

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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