SURG - A Virtuous Cycle At SurgePays

Summary

• The company has removed bottlenecks from its already triple-rate subscriber growth of its mobile broadband business, setting it up for a significant acceleration.
• It will also use that business to expand its network of partner community shops as this is easy money for prospective shops.
• When subscribers and shops attain critical mass, the company can introduce additional products and services, reducing the dependency on the ACP, the main weakness in the business model.
• Unit economics and attrition cost are also improving with lower CAC and a higher one-time margin on tablet sales.

SurgePays (SURG) is a fintech company selling third-party services through a network of 8K partner community shops and bodegas primarily serving the underbanked.

We covered the company previously , but there are additional reasons to be bullish:

• The company is going to dramatically accelerate mobile broadband subscriptions as a recent, non-dilutive financing removes the main bottleneck, enabling the company to greatly increase the number of tablets they can pre-order.
• The company has also enabled their 8K partner community shops to sell their broadband subscriptions, a fertile ground as 75% of customers are on SNAP, automatically qualifying them for the ACP.
• The company will use its mobile broadband business to expand their network of partner shops, possibly creating a bit of a virtuous cycle and making the company less dependent on the ACP as it makes introducing additional products and services more viable.
• Pre-buying large amounts of tablets reduce their costs, thereby reducing the cost of attrition.

The company's fintech products fetch a low margin (6-8%). The company wasn't making much progress until late 2021 when it jumped on the opportunity to sell mobile broadband subscriptions.

These subscriptions come on the basis of the ACP, the Affordable Connectivity Plan that subsidizes broadband connections in order to breach the digital divide with $30/M subsidies (and a one-off $100 for a tablet).

This has changed the company's fortunes dramatically and we think the pieces are in place for the company to produce something of a virtuous cycle where its network of partner shops drive its mobile broadband business and the latter functions as leverage to grow its network of partner shops.

This will lead to a critical mass in subscribers and shops, enabling the introduction of additional products and services and reducing the dependency on the ACP, the main weakness in the business model.

Mobile broadband business

The company's mobile broadband business functions as an MVNO (mobile virtual network operator), using AT&T and T-Mobile's wireless backbones for roughly $15/M per subscriber, on average, half of the $30/M ACP subsidy.

Subscriptions rose from 30K at the start of 2022 to 220K+ at the end of the year, and this had a pretty dramatic effect on revenue:

However, the company was hamstrung by its refusal to issue shares (insiders own 34.8% of the company) in order to be able to buy more tablets and grow its subscriber base even faster.

That drag has now been removed by a $25M non-dilutive financing on the basis of government receivables (the ACP subsidies), so the company can now dramatically accelerate the growth in subscribers.

In a recent update for shareholders, management argued :

SurgePays and its partners currently has orders for over 300,000 devices (tablets and smartphones), with currently expected delivery in the first quarter of 2023. These expanded resources enable us to launch in-store Affordable Connectivity Program ((ACP)) enrollments as well as increase internet and field enrollment programs. SurgePays also offers these services on smartphones, potentially broadening overall market penetration."

It used to gain subscribers through open-air drives (tents, not unlike open enrollment for the ACA), but in another improvement that is likely to speed things up, they have enabled their community partner shops to win subscribers.

This works through connecting Shockwave, the CRM program they use (and own) for signing up customers for their mobile broadband business to the POS software they run in these partner stores. Shockwave is pretty useful (Q3CC):

we're integrated into the National Verifier and the National Accountability Database of the FCC. And it also integrates us into the AT&T and T-Mobile backbones, which is what we use to provide the wireless service and mobile broadband. So we're one of the - to my knowledge, the only company that offers ACP that owns their own CRM, now stack onto that, Ed, that we own the SurgePays platform, which does payments at the store level.

This setup has a number of benefits:

• Free internet and a tablet is a hard-to-refuse proposition for qualified customers (of which there are many visiting these shops, 75% are on food stamps, which automatically qualifies them for the ACP for instance).
• It's also a no-brainer sale for shops, earning them an easy commission.
• It's cheaper for the company to win a customer through existing shops than organizing open-air sales drives.
• No competitor can match as they don't have a similar network of shops serving the underbanked, and they have to wind down their sales drives in much of the US in the winter.

With these two changes, we can expect a dramatic rise in subscriber growth. While the official goal is to reach 500K subscribers by the end of this year, the CEO already spoke about mid-year and the 300K order of devices coming in should get us pretty close.

If these shops sell just two mobile broadband subscriptions a week on average, that would amount to 64K subscribers a month, plus what some open-air sales drives in southern states and via internet marketing come in. It quickly adds up.

The market

How many qualified households are out there? Well, only some 15.8M households have signed up for the ACP about a third of the total of some 48M households that would qualify. The FCC wasn't happy with this slow uptake and embarked on a $90M program to promote the ACP.

With just 220K subscribers (the latest figure), the company has a huge market to go after and it turns out these community shops they are now selling their subscriptions in are highly trusted by prospective customers.

Network of shops

We argued for the possibility of a virtuous cycle where the company uses its network of shops to accelerate broadband subscriber growth and uses broadband subscriptions to grow its network of shops.

It is more or less a no-brainer for shops to join, it doesn't really involve any cost or much effort, and selling mobile broadband subscriptions is easy money in a fertile market, much of their clientele is in the target population.

For starters, every time a customer cashes in SNAP, the sales clerk has the incentive to get him on SurgePays mobile broadband business, a free proposition for the customer.

Management has awoken to the opportunities here and has:

• Appointed a manager (Jeremy Gies) tasked with expanding the network of shops.
• Entered into a Master Service Agreement with GOP Plus, enlisting its 40+ salesforce to increase its network of shops as well as sell mobile broadband subscriptions.

On the latter from the linked PR:

to bring more stores onto the SurgePays Network, utilizing the SurgePays POS System. In addition, GPOX will sell SurgePays products to its retailers, including the Surge Wireless ACP Broadband program. GPOX will also place their proprietary products onto the SurgePays Platform reaching over 8,000 retail partners.

Management targets 50K-75K shops, although it didn't provide a timeline for that. Even simply imagine what 15K shops signing up 2 broadband subscribers a week on average would do for its broadband business (that's 120K new subscribers a month).

With broadband subscribers and additional shops driving each other in a virtuous cycle, quantity turns into quality, from the January 2023 shareholder update.

Once we hit 500,000 subscribers, we anticipate being able to offer our subscribers additional products, including the launch of our prepaid wireless brand and other financial services for the underbanked. It is important to remember that each subscriber represents a household with significant upsell revenue opportunities for the Company.

Adding shops and other products will also reduce company dependence on the ACP, which is the main weakness in the business model (and for what we can see the only reason for a fairly substantial short position in the company).

Unit economics

There are two financial metrics that are going to improve by the changes discussed above:

• The cost of the tablets are going to decline by some 30%, falling from $90 to something like $75, increasing gross margins.
• CAC (customer acquisition cost) are going to decline from $45 on average to $35 on average by selling subscriptions through their partner shops.

Ordering 300K devices at a time is also improving the price, COGS are apparently 30% lower by ordering directly from China in such large quantities, increasing gross margin on the tablets.

The gross margin on the tablets is a one-off benefit and the CAC are a one-off cost. Since the first is going to increase and the latter is going to decrease, the combined result is a dramatic reduction in the one-off net CAC (CAC minus one-time benefit on the tablets).

This used to be $35 but is now falling to just $10. That is, on a net basis, the one-off cost of adding a new subscriber is now $10. This has two additional beneficial effects:

• New subscribers are now accretive from the first month
• Reducing the cost of attrition from $35 to $10 per lost subscriber

Before the company bought the tablet for $90 and paid $45 in one-time acquisition costs and COGS, the cost of SurgePays for the mobile broadband subscription is $15 (the MVNO cost paid to the carriers).

So overall costs were $150 in month 1 while they could only bill the ACP for $130 ($100 for the tablet and $30 for the broadband subscription), in month 1, the company made a loss on new subscribers of $20.

However, in the new situation, the margin on the tablets increases to $25, and the CAC reduces to $35, the company's costs in month 1 are $75 for the tablet, $35 in CAC, and $15 in COGS, summing to $125 whilst billing the ACP for $130.

New subscribers are profitable even in the first month!

This also dramatically reduces the cost of attrition, which is around 8% per month (reduced after subscribers were explained they can use the chip in their mobile phones as well, rather than just the tablets).

But the lower CAC and increased margins on the tablets reduce the cost of attrition to just $10 ($35 CAC - $25 profit on tablets) per lost subscriber, down from $35 before ($45 CAC - $10 profit on tablets).

This is a blow to another possible reason for the substantial short position, the cost of attrition.

Profits

If the company manages to shift these 300K devices they have bought with the help of the receivables finance, they will have a run rate close to 500K. The economics of this is highly interesting:

• $180M revenue run rate.
• 50%+ gross margin for a $90M+ gross profit.
• OpEx is low ($13M a year) and the shift towards selling broadband subscriptions through its network of shops might even lower sales expenses (the salespeople in the shops are not on the company's payroll).
• So this produces $75M+ in net income on 19M shares fully diluted that's nearly $4 in EPS.

So by mid-year, the company could very well be on a $180M run rate (plus revenues from their fintech business which we haven't even included), producing nearly $4 in EPS for a stock that trades at $6.

Conclusion

We see plenty of reasons to be even more bullish than before:

• Subscriber growth for the company's ACP subsidized mobile broadband business, already in triple-digit territory, is set to accelerate further removing a financing bottleneck and selling subscriptions through its 8K partner network of community shops.
• The company is going to use its mobile broadband business (as well as a deal with GPO Plus and appointing a specialist manager) to expand its partner network of community shops, creating a virtuous cycle that is setting the company up for selling additional products and services through the network and become less dependable on the ACP, a key vulnerability.
• Unit economics are also increasing with reduced CAC and increased margins on the tablets, making new subscribers profitable from month one and greatly reducing attrition costs of attrition.
• With 300K devices already bought, the company is set to reach 500K subscribers this year, producing a $180M run rate from their mobile broadband business alone and an EPS that could be approaching $4.

The company is still very dependent on the ACP, which explains the low valuation and the substantial short position, but with subscribers and shops reaching critical mass, we see the company introducing additional products and services and the dependency on ACP decreasing.

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