DISH - Smith Micro: The Stars May Be Aligning

2023-08-14 11:16:10 ET

Summary

• SMSI expects the launch of its SafePath 7 platform with AT&T to be successful behind a robust marketing campaign.
• SMSI is seeing interest in its ViewSpot platform and a potential new customer for its CommSuite product, which could lead to additional revenue streams.
• Gross margins are expanding and OpEx is remaining steady to slightly decreasing, which will help to grow EPS and cash generation.
• If the AT&T launch shows early signs of success, investors will likely re-rate SMSI to be a fast-growing SaaS-type company.

As my closest followers are well aware, my sentiment towards Smith Micro ( SMSI ) has changed several times over the course of the past few years, all related to my perceived progress (or lack thereof) in the company’s family safety business. After being bullish on the stock during their ramp with Sprint and initially following the Sprint-TMUS merger, I started to become more cautious on the name following the Avast mobile family safety acquisition in 2021. Eventually, I became bearish on the stock as I realized SMSI's business with T-Mobile ( TMUS ) was not going anywhere fast and that Verizon ( VZ ) seemed to be in no hurry to move to SMSI’s best-in-breed SafePath 7 platform. Of course, I became cautiously optimistic earlier this year, as I expressed in my previous article on SMSI, because I believe SMSI’s new relationship with AT&T ( T ) will likely produce some fruit. Now, I have finally come back full circle to being extremely bullish on SMSI.

So, after going from bullish to bearish, why have I come back full circle to being bullish on SMSI? I will outline the details in this article, but the short end is this: the stars seem to be aligning again for SMSI. T should soon be the first carrier to launch the SafePath 7 platform and, along with that launch, I expect a robust marketing campaign, similar to that which led to such success for SMSI with Sprint. Moreover, SafePath is not the only thing going for SMSI now. They are seeing interest from multiple parties in their ViewSpot platform, even announcing a new customer on their recent 2Q23 conference call . And last but not least, the company is even indicating a possible new customer for its CommSuite product, something that I believe surprised even SMSI executives!

All of these new possible revenue streams, combined with recent material cuts to operating expenses, lead me to believe SMSI could soon become a major compounder again.

AT&T Launch Coming

On the 2Q23 call, CEO Smith informed investors that T plans to launch the new SafePath-powered Secure Family app “this quarter” (i.e. by end of September). Based upon my research and that of my trusted colleagues, I believe the new Secure Family could be released even this week (the week of August 14). Moreover, I believe the release of this updated app will be in tandem with, or at least soon followed by, an extremely robust marketing campaign. In fact, on the call, Smith noted the marketing campaign with T will be a “template" for future SafePath launches.

This is extremely exciting for SMSI shareholders because, up to this point, the template has been SMSI's launch with Sprint's former Safe & Found app. That launch and the corresponding marketing campaigns turned SMSI into a cash cow until the Sprint-TMUS merger blunted the growth and eventually led to the demise of the Safe & Found app. So, if T becomes the new template, then I expect the marketing campaign to lead to enormous success for SMSI and its shareholders. Remember, T is approximately 2.5 times the size of Sprint in terms of its subscriber base, so the revenues could ramp even faster this time around for SMSI.

Now, I understand that SMSI cynics will note that CEO Smith is a permabull on his company, and so they may choose to wait until they see the T launch and marketing campaign before believing it. And while that approach may certainly lead to lower risk, it also will likely mean lower reward. SMSI's stock has already begun to move in anticipation of said launch, and I expect a continued upward trajectory once we see the launch of the new platform and the marketing campaign come to fruition.

Moreover, I would note that I have stayed current on my SMSI research over the years even as I was more bearish on the name, and I have been hearing for over a year that T actually provides the company with the biggest upside. T's actions certainly seem to signal that they have been the most serious carrier with SMSI since Sprint. When SMSI purchased Avast’s family safety mobile business, the primary reason for doing so was to gain and then expand the VZ business, a play that obviously did not work out, with VZ expected to shut off SMSI’s platform at EOY23. Much to everyone’s surprise, however, T became interested in the family safety space following SMSI’s acquisition. So much so that SMSI and T worked out a new contract for the SafePath 7 offering, one that is much more friendly to SMSI, but also one that benefits T by providing them with the premier SafePath 7 product.

Ultimately, my conclusion is that T has come to “play ball.” They are absolutely serious about becoming the leader in family safety in the carrier space, which they believe will not only earn them a much higher ARPU (average revenue per user), but will lure customers away from their competition. My sources indicate that this attitude infiltrates all levels of T’s business and that various business units within the carrier approach SMSI on a regular basis with ideas for marketing and product integrations for the SafePath platform. In short, I expect SMSI to be able to do things with T that they have not previously done with other carriers. T has massive marketing capabilities and the IoT space is now developed enough to take advantage of SMSI’s platform integration capabilities. I would be shocked to see anything less than a replication of SMSI’s success with Sprint.

T-Mobile Continues Along

It seems to be anyone’s guess when TMUS will show any sort of unified, sensible plan for its family safety offerings. At present, my estimation is that TMUS is simply cobbling together multiple different strategies and products in this space. Of course, this is not a criticism per se, as I realize TMUS had bigger near-term concerns of integrating its Sprint acquisition. As a former Sprint and now TMUS subscriber, I can attest that process has been long and, at times, rough for TMUS. In order to worry about a unified plan for “add-on” services such as family safety offerings, TMUS first has to unify its various networks.

In the meantime, SMSI continues to work closely with TMUS. Thankfully, the company seems to be entering a new phase in that relationship. On the conference call, Smith referred to the recent updates with the TMUS products as being “compliance” related. By that, I believe he means that SMSI and TMUS needed to ensure the multiple current product offerings with TMUS simply work for the end users.

Now, based upon what I am hearing from trusted sources, SMSI is finally starting to engage with TMUS beyond the mere compliance phase, shifting to a feature-focused approach. While this may not lead to immediate revenue and earnings opportunities for SMSI, the change in approach should lead to longer-term success. At the least, this shift indicates that TMUS is still interested in SMSI’s products and offerings. My own hunch is that a successful launch with T is likely to light a fire inside TMUS as the carrier sees T profiting from SMSI’s capabilities and realizing it can do something similar to increase its own ARPU.

ViewSpot Gaining Traction

SMSI acquired ViewSpot in early 2019. Since then, the company has seen minimal success in growing the product’s revenue base. To be fair, the Covid-19 pandemic certainly created a mighty headwind in this respect. However, SMSI has recently seen a surge in interest, even announcing they landed a new customer with material potential on this most recent earnings call. In addition, CEO Smith noted he expects to announce additional new customer wins “over the coming quarters.”

While ViewSpot revenue tends to be much smaller per customer than the SafePath or CommSuite products, its revenue is still material to the company, most especially if they land multiple new customers. The recent, increased interest in ViewSpot seems to be attributable to a new sales team/sales approach. Smith alluded to this on the earnings call and my own interviews with those close to the company indicate SMSI is absolutely “fired up” about this new ViewSpot success.

CommSuite? CommSuite?

The CommSuite product was a big success with Sprint, but was ultimately dumped by TMUS in favor of its comparable TMUS incumbent offering. However, CommSuite revenue is not completely lost as Boost Mobile, now owned by the DISH Network ( DISH ), continues to use the product. I believe SMSI maintains a fantastic working relationship with the former Boost team, which they have been able to parlay into DISH. The issue here, of course, is that DISH is trying to start a postpaid mobile service from scratch, which is taking time. That said, if and when DISH is able to become the fourth major carrier in the US, SMSI and the CommSuite product should benefit materially. Up until about a month ago, that was the extent of the CommSuite opportunity.

Fortunately, however, SMSI has now gained serious interest from another potential customer. The company is extremely (and understandably) tight-lipped about the identity of this prospect, but they are equally excited about the potential. This development seems to have surprised even company executives, who themselves probably believed CommSuite was mostly a product in its past. But, when it rains, it pours. And as SMSI is turning the corner with SafePath and ViewSpot, CommSuite seems to be gaining traction as well.

In terms of dollars and cents, even one new CommSuite customer could materially impact SMSI’s revenue and earnings. In fact, I would estimate one new customer with this product could quite easily lead to 15-20x the revenue of one new ViewSpot customer. While SMSI, at this point, cannot possibly publicly predict how this current prospective customer scenario will play out, the mere fact that there is now interest in CommSuite is exciting and encouraging.

Risks

Up to this point, I have clearly highlighted the upside opportunities for SMSI, but risks still exist. The biggest risk is the fact that SMSI is expected to lose all VZ family safety revenue by EOY23. Earlier this year, VZ notified SMSI it was developing its own internal app. I estimate that VZ is currently on track to release this app in Q3 or early Q4 of this year. I would then expect VZ to transition its current user base to the new app. The possibility exists that VZ will struggle with this transition and that some revenue will continue to trickle in to SMSI from VZ into 1Q24, perhaps even beyond. But I do not think investors should plan on that. Instead, we should recognize the largest possible mitigating factor to this loss of revenue is increasing revenue from the T launch. If T becomes Sprint 2.0 for SMSI, then the loss of VZ’s approximately $4M of revenue per quarter will have minimal negative impact on the company. Of course, SMSI and its investors would prefer to have this VZ revenue in addition to T’s increasing revenues, but at the least T should help to minimize any damage.

The second biggest risk to highlight is that SMSI has been repaying its convertible debt in company shares. This means that current shareholders are being diluted. While the company can choose to fulfill its debt by paying cash, they have chosen not to do so at this time. The reason is that they have been burning cash as they prepared for the T launch, and also while they have been updating TMUS’s products and had been preparing for a VZ update. While the situation is now changing — the company expects to be profitable and cash flow positive in Q3 — I expect the company to continue fulfilling its debt obligation by issuing shares until such time as T revenue completely replaces VZ’s expected revenue loss. Once T has replaced that revenue run rate, the company should then have flexibility to pay in cash. Also, I would point out that if the T launch and marketing campaign is as successful as I predict, the company could, as early as next year, be in position to begin buying back shares. As I will point out below, SMSI’s gross margins on the T product should be in the 80%+ range and operating expenses should remain steady. In other words, a huge portion of the new T revenue should drop to the bottom line and increase the company’s cash position.

Valuation

Right now, my baseline valuation of SMSI assumes the following.

• Revenue will grow, per the company’s mid-range guidance on the last call, by 6% in 3Q23 and then remain steady to slightly lower, depending on the VZ and T situations, in 4Q23 and 1Q24.
• Gross margins will expand to 75.5% to 76% next quarter, and even further as new T revenue replaces old VZ revenue (SafePath [T] revenue has a much higher margin than the Avast-acquired [VZ] revenue). Ultimately, gross margins should approach the 85% range.
• Operating expenses will decrease around 3% next quarter and remain at that level through 1Q24.

These assumptions lead me to believe that between 3Q23 and 1Q24, SMSI will net to a roughly breakeven income and cash flow level. With that alone in mind, one might conclude that the current $1.65/share level is a fair valuation. But I believe this thinking is mistaken because it would only be looking at short-term results and not at SMSI’s future prospects, which is how we should value the company.

If the above assumptions are accurate—and I believe they could be quite conservative as it relates to new potential T revenue—then SMSI will exit 1Q24 as a company growing recurring, SaaS-type revenue at a nice clip, with 80%+ gross margins, and with OpEx holding steady. That means the company would presumably be having a setup for a “blowout quarter” in 2Q24. Of course, if the T launch is highly successful, that blowout quarter could even be in 1Q24. Those who have followed SMSI for some time certainly have not forgotten the blowout quarter they had in the summer of 2019, which led to a 67% one-day increase in the company’s share price.

(The above chart is from July 1, 2019 through August 1, 2019 and shows what happened the last time SMSI had a "blowout quarter.")

Based upon all of this, I am currently valuing SMSI at $2.50/share (roughly 50% upside from Friday's close), with the expectation that my valuation will begin to materially increase once I see T launch and market the new SafePath-powered Secure Family app. The $2.50/share at a 20x P/E valuation would equate to $0.125/share EPS. As I just noted, I currently project SMSI to be at or near breakeven over the next few quarters, followed by a period of material revenue, EPS, and cash growth. The notion that SMSI can get to a $0.125/share EPS run-rate in the near-term is quite reasonable, in my opinion.

Conclusion

As SMSI nears the launch of T’s new Secure Family app, the stars seem to be aligning for the company. TMUS is now starting to move away from a mere compliance-based approach to its SMSI products to one that will be adding new, valuable features. ViewSpot is also seeing success, with a new customer announced and multiple more expected over the coming quarters. Moreover, a renewed interest in the CommSuite product could lead to a new customer win and material revenue and EPS increases. As SMSI’s gross margins expand and OpEx remains steady to slightly lower, SMSI is setting up to show off its remarkable operating leverage. While this leverage may be temporarily blunted by the loss of VZ’s family safety revenue, investors are likely to look past this temporary blip if they see success with T’s launch. For that reason, I have once again become bullish on SMSI and want to own shares heading into the highly anticipated T launch.

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