SURG - After A Pause SurgePays Is Hitting The Ground Running

2023-04-14 15:15:58 ET

Summary

• A growth pause worried investors, but there is no need as the company assembled the pieces to remove the lid on growth and improve unit economics.
• A line of credit financed cheaper tablets and removes the constraint on growth as they were previously financed with cash flow.
• Selling ACP-subsidized subscriptions through their partner shop network greatly reduces CAC, and higher profits on tablets further improve the unit economics.
• ACP is used as leverage for shops to join the network, setting in motion a virtuous cycle and cementing the company's position serving the underbanked.
• This can be used to sell additional services, and we feel that little of all these prospects are priced in, for starters, the $190M revenue guidance for this year.

SurgePays (SURG) stock stumbled as Q4 revenue came in flat and the rapid rise in ACP subsidized subscribers for their mobile broadband MVNO business stalled and management communication was fairly sparse, leaving some investors wondering whether there was something amiss.

However, the company is now back on track, the reason turned out to be simple, they were simply waiting for the 300K+ tablets they ordered more cheaply in China financed by a $25M loan based on ACP receivables to arrive.

A quick recap

SurgePays has two lines of businesses, its legacy business is selling mostly third-party Fintech products through its partner network of community shops and bodegas, after the latest deal there are now 11K+ of these shops in their partner network serving the underbanked.

Their Fintech business generates low margins, at least for now. The stock really took off on the back of the ACP , the Affordable Connectivity Program as the company offers subsidized mobile broadband subscriptions through its own MVNO using the T-Mobile and AT&T networks.

The ACP offers $30 per month per qualifying household and a one-off subsidy of up to $100 for tablets. This is a good business for SurgePays, whose MVNO cost $15 per month per subscriber, and $90 per tablet.

We explained our bull case for SurgePays in several previous articles, the latest of that one can find here . In summary:

• Rapidly rising ACP subscribers, 30K at the start of 2022, 220K by October 2022.
• 50%+ gross margin business ($15 in MVNO costs on average versus $30 per subscriber).
• Large opportunity still ahead, some 18M households are on ACP whilst some 50M could qualify.

The results were pretty spectacular:

Not everything was plain sailing though:

• Cash constraints limited growth as it limited the number of tablets they could buy.
• CAC (customer acquisition cost) is high, $45M per new subscriber, partly compensated by a one-off $10 profit on the tablets.
• Substantial attrition, in the order of 8% per month.

The attrition cost per lost member is essentially $35 ($45 in CAC minus the $10 profit on the tablet).

So we also told you the company's strategy to deal with these problems but after the Q4CC we have some new information:

• Buying tablets in bulk directly in China at a lower cost, increasing the profit to $25 and financed
• Selling ACP subscriptions through their partner network shops greatly reduces CAC, by 80% (so below $10) as they don't have to hire personnel, put them in hotels, etc.

The advantages of the new model

• Growth is no longer restrained by cash flow (management refuses to dilute) with the help of the receivables based $25M line of credit . They now have 300K+ tablets to re-accelerate growth.
• Falling CAC (by selling subscriptions through their shops).
• One-time gain per tablet of $25.

Basically, if they sell enough ACP subscriptions through their shops (at $10 CAC) to bring the average CAC down to $25, these are canceled out by the $25 profit on the tablet, so attrition costs tend to zero (let alone if they would sell most of their subscriptions through the shops).

It does take 30-60 days for the ACP money to come through (hence the increasing receivables).

Additional advantages

But that's not all, there are additional advantages to selling through the shops:

• Lower attrition
• Upselling opportunities
• Increased bargaining position versus network providers

On lower attrition , these shops are trusted partners mainstays in their community with customers coming in frequently (Q4CC):

we anticipate retention will be higher if the customer knows where he can go to get help if needed, and the store owner is making a residual commission, so he has a vested interest to make sure these subscribers remain active and happy.

Simply explaining that they can take the SIM card out of the tablet and put it in their phone would often already go a long way.

It also provides upsell opportunities , from the Q4CC:

That's another significant competitive advantage that we want to take, really maximize by getting in the door through ACP. It's the -- by the way, upsell. And then, by the way, we also have a reloadable debit card, by the way, we have these other products here to help your customer the same way we helped them with the internet.

What's more, selling their own prepaid MVNO service through their shops gives them another competitive advantage (Q4CC):

A lot of us watched what Mobile just sold to Verizon for, and they had pretty slim margins. We're very familiar with most of the MVNOs out there. We take payments for most of the MVNOs out there. To have an ability to be an MVNO that has your own brand that's paid for by the customer with family plans and very aggressive rates to help folks out and then be able to do the transaction over our own platform. So we're not paying a third party, 8%, 9%, 10%, 15% to do the transaction.

Expanding partner shop network

We told you in our last article that it can work both ways, using the shops to increase ACP subscriptions, as well as using ACP to increase their partner network.

The company has hired dedicated experienced people for this and they had the first success with the addition of 3K+ shops from Capital Candy (which as 3K+ community shops in the New England area) in February.

So that's 11K+ shops in the network, management expects 13K shops by yearend but it could be more (Q4CC our emphasis):

we recently added another 20-year veteran to the team as VP of Sales, directly reporting to Jeremy to assist in working through a funnel of over 35 more partnerships, integrations and similar agreements with several of those being 10 times the number of convenience stores .

The ambition is to have a network of tens of thousands of shops, which would enable the company to:

• Become a very attractive partner for selling third-party goods and services to this demographic.
• Introduce higher-margin services, like telehealth.
• Become much less dependent on the ACP.

We explained that the company already sees an opportunity in prepaid cards for their own MVNO. They could use the ACP to build a pretty commanding position serving the large underbanked segment and become less dependent on the ACP, which might not exist forever in this form.

So what's new?

• No reason for investors to worry, nothing nefarious. The two-quarters of stagnation are simply the results of arranging the loan, ordering the tablets, and waiting for these to arrive
• The tablets (17 shipments in total by sea, which is why it took so long but they saved $35K per shipment versus airfare) have started to arrive by the end of March.
• We know the CAC of selling subscriptions through the shops is really a LOT cheaper, an 80% lower CAC.
• Management provided guidance, 500K ACP subscribers, $190M in revenue (up from $121.5M in FY22), and 13K partner shops by year-end and positive operational cash flow for the year.

There are already early signs things are taking off, from the 10-K :

SurgePhone and Torch Wireless provide subsidized mobile broadband to over 250,000 low-income subscribers nationwide.

Given that Q4/22 revenues were flat from Q3/22 and management guided Q1/23 revenues also flat sequentially, most of those additional 30K subscribers must have come very late in the quarter, too late for revenue to be recognized in Q1, as one of our investment group members pointed out.

While revenue growth stagnated in Q4/22 and Q1/23, taking their foot off the gas has done wonders for cash flow:

With lower CAC and higher profits on tablets, we expect this to continue.

Valuation

There are 14.1M shares outstanding, 5.68M warrants (exercise price of $4.85), and 6K options for a fully diluted share count of 19.68M shares. At $4.5, this produces a market cap of $88.5M or an EV of $81.5M, which makes a mockery of the guided $190M in sales this year at an EV/S of 0.43x.

The warrants will expire in October 2024 and would bring in another $27.5M in cash (or expire worthless). Analysts expect an EPS of $0.40 this year and $0.67 the next, which would also make the shares very cheap.

Risk

While the ACP business is very good and the company has some unique benefits, being able to sell subscriptions through its shop and order tablets cheaper in bulk at the factory, the ACP itself might not be around forever, despite bilateral support at its inception.

The company has a compelling vision of using the ACP as leverage to build out its network of community shops for underbanked households, building a commanding position that can be used to sell a whole host of additional goods and services.

While essential pieces of that vision are already in place, it remains to be seen whether the company can add higher margin goods and services selling through its network of shops, like its prepaid MVNO cards.

Conclusion

We think the case is stronger now for the shares compared to our last take, all the elements are now in place for growth to resume with new vigor, and improving unit economics while the stock price is lower.

After a two-quarter pause waiting for the receivables credit and huge shipments of tablets to arrive the company is set to accelerate growth once more as the barrier to growth is removed and the increased profit on the tablets compensates the CAC. There are already signs this is happening.

We expect that this will enable the company to get to 500K ACP subscribers, 13K partner shops, and $190M in revenues while being cash flow positive.

Selling ACP subscriptions through the shops will bring multiple benefits, among which are much lower CAC, better retention, upselling opportunities, and the ability to leverage ACP to expand its network of partner shops.

We think this ultimately sets the company up for a commanding position in serving the underbanked, a position that can be leveraged for selling all kinds of products and services and making the company less dependent on the ACP, which is its main weakness.

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