Investing in small-cap stocks can be a tricky task. As much as there are massive growth opportunities in small-cap, under-covered, under-appreciated stocks, the inherent risks of investing in small-cap stocks make it challenging for a novice investor to get the better of investing in small-cap stocks on a consistent basis.
Small-cap tech stocks have time and time again drawn the attention of investors as some of the so-called small-cap stocks at the beginning of this century have grown into multi-billion dollar companies today.
Smith Micro Software (NASDAQ:SMSI) is a promising but small company that is benefiting from the secular trend of embracing digitized products and services. The stellar financial performance in the most recent quarters has helped the stock price appreciate a staggering 240% from year-to-date, which has certainly caught the attention of investors.
The YTD performance of SMSI
(Source – Morningstar)
Considering the growth opportunities present in the industry represented by Smith Micro, and the management initiatives to capitalize on these trends, SMSI is still attractively priced. However, investors need to weigh the inherent risks of investing in small-cap stocks before making an investment decision. An investment in Smith Micro represents a long-term investment that requires being patient when the market turns volatile, especially considering the not-so-promising macroeconomic outlook on a global basis.
Smith Micro Software Inc. is a company that provides software solutions to a wide range of clients. The company develops and markets wireless solutions for wireless service providers, mobile device and chipset manufacturers, and enterprise businesses. In addition to wireless solutions, Smith Micro develops graphics software for animators, illustrators, graphic designers, and students.
Smith Micro primarily conducts business operations under 2 segments.
The below table illustrates some of the software products developed and marketed under each of these 2 segments. We will discuss some of these products in detail in the remaining sections of this analysis to provide color as to which products are driving the earnings growth of the company.
Wireless business segment
Graphics business segment
(Source – Smith Micro Software)
SafePath, the primary contributor to the recent success of Smith Micro, is focused on digitizing the lifestyle of its users. SafePath distributes 3 products under its brand name.
Collectively, these software products provide an all-in-one solution for family members to stay connected, both to each other and to their most-loved devices.
(Source – Smith Micro)
CommSuite is a comprehensive voice messaging platform that promises to go far beyond that of basic voicemail features supported by handsets, and ViewSpot is an extension of a carrier/retailer’s sales team that interacts and engages with customers while serving as a platform to store and use customer data.
The primary business strategy of the company is to make hay while the sun is shining. To put it in different terms, Smith Micro is focused on capitalizing on the secular growth trend of internet-related concepts such as the Internet of Things ((IoT)). The company management has taken various measures to develop software that addresses the growing needs of its target consumer base, which has been instrumental to the recent success of Smith Micro Software.
Another business strategy of the company is to form lucrative partnerships with third-party companies to develop and market software products. The success of SafePath can be directly attributed to the partnership with Sprint.
By 25th July, SMSI had already appreciated close to 100% on a year-to-date basis. The release of Q2 earnings on July 25 triggered a significant rally in SMSI. The primary reason behind this was the significant improvements in Smith Micro’s financials in comparison to the corresponding period in 2018.
Q2 earnings results indicated growth across all wireless product segments of Smith Micro, which confirms the rapid market penetration of company products. The topline growth in comparison to Q2 2018 reported revenues was one of the drivers of SMSI price since the release of Q2 2019 earnings results.
Smith Micro revenues grew a staggering 56% over Q2 2018 figures
(Source – Form 10-Q)
Breaking down into revenue sources, it’s evident that SafePath is leading from the front in taking Smith Micro to the next level. As highlighted earlier, there was growth across all major software products but SafePath has essentially become the crown jewel of the company by securing robust growth.
SafePath brought in $3.78 million to the company in Q2 2019, in comparison to the meager $0.76 million of revenue reported in the corresponding period in 2018. CommSuite and Netwise sales grew modestly by 8.3% in Q2. Considering that these products account for over 80% of company revenues, it came as no surprise that Smith Micro reported net earnings of $3.4 million in Q2 against a loss of $0.11 million in Q2 2018.
Smith Micro’s Q2 bottom line received a boost from the divestiture of Poser as well, which was reported as a gain of $483,000 in other income. Even after excluding this one-time, non-operating income, Smith Micro’s Q2 results look stellar and promising.
Another important development over the years is improving gross profit margins. This is to be expected with a software developer and the gross profit margin of Smith Micro has consistently improved over the last 5 years.
(Source – Company filings)
The same has not been the case with operating margins. Smith Micro has failed to turn up an operating profit since 2010, but this is finally set to change in fiscal 2019. At the halfway stage, Smith Micro had returned to profitability in style and reported an operating margin of 12% for the first half of 2019. Staying by the management opinion, it’s not difficult to conclude that Smith Micro will finally break the buck and report an operating profit for the current fiscal year, which could be the start of many to come if things go according to plan.
Smith Micro has not made a positive free cash flow since fiscal 2010 but is not burning cash as it did at the beginning of this decade. As the company grows in stature and gains traction, I expect Smith Micro to achieve positive free cash flow in the long term. However, this likely won't occur in the short term as the execution of growth plans will continue to have a negative impact on free cash flow, which should not be a concern as long as Smith Micro services its debt repayments in a timely manner.
One of the primary challenges of investing in small or micro-cap companies is identifying companies that are not knee-deep in debt. As is often the case with small-cap companies, the debt burden eventually takes its toll, resulting in unrecoverable losses for investors. As such, it’s important to analyze the balance sheet trends of a small-cap company thoroughly before making an investment decision.
Smith Micro’s balance sheet position has improved in the last couple of years, which is well-supported by the warrant conversions that have boosted the cash balance.
The improving debt-to-equity ratio confirms the financial strength of the company at present, especially considering the recent earnings growth that will further strengthen the finances of Smith Micro in the future.
(Source – Zacks)
Smith Micro has so far focused its time and effort on securing contracts with North American carriers and little has been said and done about expanding on a global scale. As a result, the Americas account for more than 99% of the revenues earned by Smith Micro at the moment. There’s a real opportunity for Smith Micro to expand beyond borders, but so far, it seems like the company will continue to focus on the Americas to deliver growth.
The management guided for 30% sequential growth from SafePath in the next quarter and if Smith Micro secures a topline growth of anywhere close to that figure, shares could be in for another breakout from the current price level. Investors should carefully monitor the development of the proposed merger between Sprint and T-Mobile as this could have a material impact on Smith Micro’s ability to remain an attractive growth play. In fact, the most significant growth opportunity for Smith Micro on the horizon is the possibility of securing a contract with this combined entity. The management is presumably in talks with T-Mobile to secure a contract, which would be an important step in determining the future profitability of Smith Micro.
It’s evident that the company management is searching for new avenues to propel the company forward. The recently announced partnership with Boost Mobile is an example of this. Even though the partnership with Boost might not end up leaving the same effect as the partnership with Sprint, these partnerships with carriers will be key to Smith Micro’s long-term success. On the other hand, it’s important to divert from concentrating on one partnership to generate the bulk of company revenues. Even though the proposed divestiture of Boost to DISH is a risk, this provides a new opportunity for Smith Micro to form a new partnership with DISH, which should open up new growth avenues for the company in the long run.
In addition to the growth opportunities available for SafePath, there are opportunities available for other software products developed and marketed by Smith Micro as well. Boost Mobile has deployed the CommSuite messaging platform to its subscriber base, and these subscribers currently account for nearly 30% of CommSuite revenues. As the possibility of regulators creating a fourth Tier 1 wireless carrier in the U.S. is high with the proposed merger between Sprint and T-Mobile, Smith Micro would be in a good position to accelerate its growth plans for CommSuite. On the back of 7 consecutive quarters in which CommSuite subscriber base grew, the management expects the CommSuite subscriber base to grow at low single digits sequentially. Growth in the subscriber base will help Smith Micro earn higher advertising revenue as well. The management is positive about introducing new product features to engage the users more with the CommSuite platform.
ViewSpot provides Smith Micro with another growth opportunity and the company management is focused on investing in enhancing the product features of ViewSpot. The shift by retailers to focus on delivering a more connected experience to their in-store customers provides an opportunity for Smith Micro to cash in on. In the coming quarters, Smith Micro plans to roll out significant upgrades to the ViewSpot platform to enable its users to access real-time data, advanced device monitoring, AI-driven anomaly detection, and improved dashboards. It would certainly take some time for Smith Micro to roll out these features but investing to improve the ViewSpot platform will yield attractive results under these prevailing macroeconomic conditions. The management is positive that the ongoing ViewSpot trials will be fruitful.
We are in all the company-owned store locations for both of our Tier 1 carriers. We're not in the other locations. Beyond that, that's something that we're in discussions with. We are very excited by the number of proof-of-concept trials that are ongoing. It looks like we will have approximately 11 trials between now and the end of 2019 and hope to grow that. So -- but that gives you some idea of the level of sales activity that's ongoing with ViewSpot. We think it has some real legs.– William Smith, CEO
There’s an abundance of growth opportunities available for Smith Micro all across the board. In the short term, the success of Smith Micro will largely depend on the continued growth of SafePath. However, within a couple of years, I expect ViewSpot and CommSuite to contribute meaningfully to Smith Micro’s revenue, which is a good thing for investors.
Smith Micro is planning to increase its headcount in the next few quarters, which is an indication of higher operating expenses in the near future. These new hires will focus on developing new features for SafePath and on servicing existing clients of the firm. However, a decision to ramp up hiring is a clear indication of the management believing in the growth opportunities available for the company.
Smith Micro’s balance sheet received a boost with the cash injection that was a result of the recent conversion of warrants. This, coupled with the expected conversion of the remaining warrants, will leave a sizable cash balance in Smith Micro’s books. The improving cash balance will support the decision to hire new employees, and on the other hand, provides the opportunity for Smith Micro to pursue more growth opportunities by investing in product development. However, investors need to consider the ownership dilution of warrant conversion as well.
The growth story of Smith Micro depends primarily on the continued penetration of connected devices on a global basis. Worldwide technology spending on the Internet of Things is expected to reach $1.2 trillion by 2022, growing at a CAGR of 13.6% through 2017 to 2022, as revealed in the latest Worldwide Semiannual Internet of Things Spending Guide by the International Data Corporation.
The robust growth of spending for devices and software related to the Internet of Things provides a clear growth path for Smith Micro and a platform to launch new products and software to meet the growing demands of consumers in this space.
The adoption of IoT is gaining momentum and is expected to remain so through 2030, which confirms the positive macroeconomic outlook for companies operating in this industry.
(Source – Forbes)
Even though the macroeconomic outlook is supportive of exponential growth for companies representing this industry, the competition will be a major threat to the survival of smaller players. It’s important to develop products and software that have a lasting effect on consumers to ensure that a company in this industry does not get swooped up by the increasing competition. Multi-billion dollar companies including Amazon, Apple, and Facebook are eyeing this industry as a candidate for their future growth plans, which brings an added layer of risk to the existing small players of the industry, including Smith Micro.
Even with the looming threat of increased competition, Smith Micro is in a good position to benefit from the robust growth of the industry, given that the company would be able to secure a contract with the combined entity of Sprint and T-Mobile and the short-term profitability of Smith Micro lies solely on such a contract.
The median consensus analyst estimate for SMSI is $7.50, which represents an upside of 13% from the current market price. In fact, from a risk-return perspective using analyst estimates, SMSI is trading at an attractive price level. The low end of the analyst estimate indicates a marginal downside whereas the median estimate represents an upside of 13%.
(Source – CNN Money)
SMSI is currently trading at a forward P/E of 33, and as Aaron Warwick points out, at an annualized EPS of $0.32 and a hypothetical P/E of 20, shares should trade at $6.40. This, in my opinion, is a very conservative estimate.
Considering the growth opportunities available for Smith Micro across the spectrum of its products, it’s likely that Smith Micro will form new partnerships to distribute its software products within the next couple of years. As a result, Smith Micro would be in a better position to earn much higher revenues that translate into record earnings for the company. This will boost SMSI to new highs.
Going by the guidance provided by the management of 30% sequential growth for SafePath, earnings should grow at a stellar rate in fiscal 2020. During the last 12 months, Smith Micro has secured a return on capital of above 21%. Even if Smith Micro operates at a return on capital of close to 15%, the company should be able to earn economic profits.
Smith Micro is certainly enjoying a nice ride along with the growth of internet-based concepts but there are new developments that could bring the growth story to an abrupt end. SafePath accounts for the bulk of company revenues and product sales are entirely dependent on the partnership of Smith Micro with Sprint. The proposed merger between T-Mobile and Sprint could turn out to be an adverse development for the company, especially considering the fact that the combined entity might cease to remain in partnership with Smith Micro. SMSI will take a plunge in this event as the concentration on SafePath revenue is very high and is an important determinant of the growth prospects in the next few years. Taking this into account, investors need to look for a healthy margin of safety before investing in Smith Micro based on the recent positive performance.
Another inherent risk of investing in Smith Micro is the competition in the industry. The market is highly fragmented and it’s difficult, especially for a small company, to build an economic moat around its products. Alternatives are widely available for Smith Micro’s key products, which poses a prominent threat to the ability of Smith Micro to earn economic profits for a prolonged period of time.
SMSI has had a nice run over the last couple of weeks, supported by a stellar Q2 performance. Now that the company has returned to profitability, investors are optimistic about further growth in the future as the 3 major wireless products of the company (SafePath, ViewSpot, and CommmSuite) are poised to deliver strong results. The proposed merger between Sprint and T-Mobile poses a threat to the continued success of SafePath but is a major opportunity for the firm to distribute the platform across an even larger subscriber base. The high concentration of revenue on SafePath will likely diminish within the next couple of years as the prospects for the other 2 major products look promising. Despite the recent breakout of SMSI's share price, shares are still trading at an attractive price range and small-cap investors should find this an intriguing offer.
This article was written by
I am an investment analyst with 7 years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities. Please click the "Follow" button to get timely updates on new articles.
I am the founder of Leads From Gurus, a Marketplace service on Seeking Alpha that focuses on uncovering alpha-generating opportunities.
I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, and GuruFocus.
I'm a CFA level 3 candidate, an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK), and a candidate in the Chartered Wealth Manager program.
During my free time, I enjoy reading.
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.