Smith Micro: A Safe Haven Producing 65% Growth With 91% Gross Margins

Summary

• Smith Micro's SafePath is likely to benefit from the T-Mobile/Sprint merger, as it made a smart acquisition to increase its chances of becoming the preferred solution for both.
• It has exciting opportunities with other carriers and for its Home version.
• The company's other two products generate less excitement, but winning new customers could change that.

If you are looking for a stock to invest that can escape the economic fallout from the coronavirus, we have a suggestion. Smith Micro Software (NASDAQ:SMSI) just produced another good quarter in which its main product, SafePath, is also its fastest-growing, and the risks that were associated earlier with it seem to have greatly reduced.

Apart from strong growth (65% for the year), the company enjoys gross margins in the 90s and strong operational leverage, and it generates considerable amounts of cash flow.

T-Mobile-Sprint Merger

This is, of course, a main item for the company, as SafePath, as well as the tracker it addresses, are going gangbusters at Sprint (S), and the risk is that T-Mobile will impose its own solution.

Well, the merger is going ahead, so that risk looks to be on, but as far as we are concerned, it is rapidly receding behind the horizon due to:

• Sprint's success and marketing efforts for SafePath (Safe & Found under Sprint's branding) and the tracker.
• Smith Micro's acquisition of the carrier business from Circle Labs.

With respect to Sprint's marketing efforts (from the Q4CC):

The growth of new subscribers continues to be driven by several marketing initiatives already underway by Sprint. With new efforts plan to roll out shortly such as online advertising, in app messaging, social media campaigns and strong in-store promotions, all with a set goal of adding new subscribers onto the platform.

These marketing efforts are ongoing, and even accelerating. That's no surprise - you don't usually get 28% sequential growth out of thin air. Would Sprint engage in such effort if it were under the impression that T-Mobile was going to kick Safe & Found out? Not likely.

Acquisition of the carrier business from Circle Labs

The company bought the assets and customer contracts of Circle Labs' carrier business, as the latter is concentrating on selling directly to consumers. This $13.5 million acquisition has numerous advantages, which are nicely summed up in a single quote from the CEO (from the Q4CC):

First, it diversifies our customer base by adding two new key customers, T-Mobile USA and Sky in the United Kingdom. In addition, it de-risked the Sprint T-Mobile merger by putting us on both sides of the consolidation. Second, it brings us significant technology gap fillers by providing us with robust parental controls on both iOS and Android and provides a powerful in-router implementation to extend mobile parental controls into the home on the same platform.

We had the inclination to put the whole quote in bold, because basically everything is important and pregnant with big implications. First is, of course, what the CEO says about de-risking the merger. This was a major market worry.

It was already seen as diminishing on the basis of the continuing marketing efforts of Sprint both for Safe & Found (carriers can put their own brand on SafePath, and this is how Sprint calls it) and the tracker it supports.

Second, there will be a SafePath/Circle Labs merged product coming out in Q3 which is a strong contender to be the unified product for the new T-Mobile/Sprint combination (from the Q4CC):

you have a very large installed base coming over to the new T-Mobile from Sprint. You have an installed base coming over to the new T-Mobile from the Circle side as well at T-Mobile. But the Sprint size is large. So there will be a need to reconcile these two products, I expect that there will be a strong need to come up with a single product that meets the needs of the new T-Mobile going forward.

It would be rather surprising if they went for a third-party solution, given the fact that Smith Micro now has a foothold in both Sprint and T-Mobile. Sky UK, which is a customer of Circle Labs, also has a strong likelihood to be a customer of the combined product.

Given the strength of such a combined SafePath/Circle Labs solution, the market is wider than just T-Mobile/Sprint and Sky UK. There are other carriers to go after, one of which is another strong contender (see below).

SafePath Home

But the other implication is also very significant - it's about the vision that the company is trying to build as a gateway to the smart home, running on 5G routers.

We described these efforts at some length in an earlier article from August last year. With respect to this also put forward the strategic licensing deal, and it might be a good idea to refresh memories here (from the company PR):

Smith Micro Software, Inc. (“Smith Micro” or the “Company”) today announced it has signed an exclusive strategic license agreement with Gryphon Online Safety, Inc., providing a software solution that offers simple, yet powerful integration of home routers, including future in-home 5G routers, with the SafePath^® platform. Known as SafePath Home, this new capability continues the vision for SafePath, making it possible to add all in-home devices to the digital family lifestyle. Family life includes time inside and outside the home. SafePath provides a single pane of glass through which the family can manage and secure their digital lifestyle no matter where they happen to be.

Now, there will be a lot of competition for providing the platform for the smart home, but Smith has the good fortune here that mobile telecom carriers have been presented an enormous market opening getting to the home through 5G routers (which is one reason we are bullish on another company in the SHU portfolio, Inseego Corp. (INSG)).

So carriers will get their 5G routers in homes, there is no doubt about it. Whether SafePath will be a driving platform on these remains to be seen, but when they are already on mobile phones though carrier selection, addressing stuff like trackers and other upcoming IoT electronic gear like watches, addressing smart stuff in the home is the next step up (called SafePath Home).

And the acquisition of Circle Labs has made the solution more complete (from the Q4CC):

We have spoken about the in-home strategy and SafePath Home that we have planned on licensing, but now we own the complete technology. This significantly accelerates our roadmap position us with a killer platform for the market.

As a side note, SafePath is doing such a good job with these IoT devices that Coolpad, a maker of consumer electronics (among which the tracker Sprint sells), selected SafePath as its platform for IoT devices. For other ramifications of this deal, we refer you to the excellent recent article of our fellow SA contributor Aaron Warwick (for instance, Coolpad's trusted relationship with T-Mobile - another reason why we're not worrying about the merger anymore).

The idea is to combine some features (most notably the parental control code) from Circle Labs with SafePath 6.0 into SafePath 7.0, which (from the Q4CC):

will be the most powerful Connected Life Platform in the market for white-labeled solutions, for cable, mobile and satellite operators that will launch in the second half of 2020.

Management has been in extensive contact with the two clients of Circle Labs (T-Mobile and Sky UK), and these clients are "excited" to work with Smith. There will be some changes in contract format, to bring these in alignment with Smith's customary per user license or revenue sharing arrangement, but this isn't a surprise for these customers.

Dish/Boost

Another consequence of the T-Mobile/Sprint merger is that Dish is likely to become the fourth Tier 1 carrier in the US, by acquiring Sprint's prepaid business Boost.

Boost already uses SafePath, the tracker, as well as CommSuite, so there are considerable expansion opportunities as a result - especially given the fact that Dish isn't in the carrier business, so it doesn't have its own solutions to protect or favor.

ViewSpot and CommmSuite

Compared to the excitement and opportunities about SafePath, the company's other products are almost becoming an afterthought.

The company has invested a lot in its acquisition ViewSpot, in order to bring its capabilities up to date according to customer requests. This is an ongoing process, although it has introduced features like dynamic pricing already.

While ViewSpot's revenue increased and it has Verizon (VZ) as a customer, it is guiding flat to down for this year - although that is excluding any new wins, which management does expect. The company lost a Tier 1 customer, but it also won one (T-Mobile Mexico).

CommSuite also increased revenue a bit (3% to $4.3 million in Q4 and 15% to $17 million in FY 2019 with the variable ad income falling from $2 million to $1 million in 2019.

There is an opportunity to win T-Mobile customers under the merger, as T-Mobile's solution isn't as strong (according to Bill Smith). But he also said that T-Mobile tends to have a younger customer base that might be less interested in the visual voicemail solution in the first place.

Dish is another expansion opportunity, as the company will buy existing CommSuite customer Boost. Guidance is flat to slightly down for the year though, based on its present customer base.

Financials

The company grew revenues by 67% in Q4 to $12.3 million generating 92% gross margins (the company has little S&M, as it sells to carriers only). SafePath revenue grew by 28% sequentially to $6.7 million, way beyond the 10-20% guidance. It will grow another 10-20% sequentially in Q1, but this includes some $500K from Circle Labs.

The company produced free cash flow of $4.3 million in Q4 and $8.3 million for the year. It sat on $28.3 million of cash at the end of last year, but $13.5 million of that will have been spend on the Circle Labs acquisition in February.

With revenues growing at 67% (or 65% for the year), there is considerable operating leverage, as operating cost grew only by 33%, or half the growth rate of revenue, to $7.6 million in Q4. For the year, the growth in operating cost was even lower, just 27% to $29.3 million.

The company is aggressively hiring, but it can clearly afford to do so considering gross margins of 92%. Non-GAAP net income was $3.8 million in Q4, or an EPS of $0.08. For the year, it was $9.8 million, or $0.26 per diluted share, versus a loss of $67K in 2018. Quite a turnaround.

Valuation

The $0.29 per share in earnings gives it an earnings multiple of 20, which we think isn't expensive for the growth opportunities, gross margin, operational leverage, cash flow and balance sheet strength.

Conclusion

While the shares are quite volatile and not risk-free, we think that the main risk - SafePath losing Sprint as customer as a result of the T-Mobile/Sprint merger - has changed into an opportunity to gain the T-Mobile and/or Dish customers, and there is always the opportunity to gain other carriers.

SafePath is already growing explosively, but even just at Sprint it has a long way to go still, especially given the likelihood of new IoT introductions after the successful tracker.

The other products are in need of a new impetus through new customers. This is always a possibility, but it has become clear that SafePath has become the main show, and the introduction of SafePath Home is only accentuating that.

Given the inherent leverage in the business model, we think this is still an exciting investment opportunity at these levels.

Analyst’s 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.