Summary
- With Verizon not signing a new contract the upside for Smith has decreased and the risks have increased, but it's not necessarily the end of the world.
- The other (better, as based on the new SP7.0 platform) contracts with TMUS and T are safe for years.
- When TMUS and T start marketing, the company can still get to $1 EPS in a couple of years.
- It is a very surprising development as the switching costs for carriers are very high, they are normally loath to do this. Yet this is exactly what Verizon intends to do.
- It remains to be seen how successful Verizon will be in switching apps.
After a long wait things finally looked very positive for shareholders of Smith Micro Software ( SMSI ) a software supplier to the carrier industry.
The company had made huge investments which were mostly done with none of the returns yet emerging, it seemed like a particularly good time to be an investor of Smith Micro, but that was about to change.
There is still a huge upside, but the prospects have dimmed quite a bit and the risks have increased. What happened? Well, the end of the last decade is a good place to start.
At the end of the last decade, their family safety software SafePath (which it sells to carriers on a white label basis) had produced a rapid run at Sprint (in blue):
Running up from $2.1M in revenues in Q1/19 to $7.8M in Q1/20, until this spectacular ramp was cut short by the combined forces of the acquisition of Sprint by T-Mobile ( TMUS ) and the pandemic (Sprint was marketing mostly in through their shops).
After acquiring its two competitors in the carrier market, Circle Labs and the carrier business from Avast, the company had all three Tier-1 carriers as a customer, but all of them were running on legacy apps (from Avast or Circle labs) and legacy contracts that weren't as favorable for Smith.
Apart from the $80M or so spend on these acquisitions, two huge tasks remained:
- Integrating the best parts of the different software packages into a new platform, SafePath 7.0
- Migrating all of the subscribers from legacy apps onto the new platform.
So costs increased significantly:
While at the same time revenues were slowly declining as subscribers of SP at Sprint were running off as they were put on the T-Mobile network (and the same was happening with another product from Smith at Sprint, ViewSpot):
And considerable dilution:
On top of that, it took way more time than expected but one has to realize two things:
- All the costs (acquisitions, integration, and migration cost) are up-front, while none of the benefits (revenue ramp from SafePath running at the carriers) are.
- There was supposed to be a pot of gold at the end of the rainbow.
On the latter:
- Together, T-Mobile, Verizon ( VZ ) and AT&T ( T ) constitute 7x the market opportunity that Sprint represented.
- Keep in mind that the SafePath rally at Sprint was still in the very early innings before it was brutally cut short by the acquisition. This could easily have exceeded a $40M-$50M run rate, probably more.
So eventually there was a $350M+ market opportunity that would produce something in the order of several dollars per share in earnings (as the company produces close to 90% in gross margin when all the integration and migration costs are done and OpEx can be considerably reduced as well when that is done).
While the wait was long, things did gradually improve on the ground:
- The integration was done, SafePath 7.0
- Both T-Mobile (March 2022) as well as AT&T (January 2023) signed new contracts on more favorable (revenue sharing) terms comparable to the original Sprint contract.
- Verizon was expected to follow suit, especially as they had considerable success with marketing their old Avast app, raking in some 70K new subscribers a month.
However, this was thrown into disarray when it emerged on February 27 that Verizon is not going to sign a new contract for SafePath 7.0 and is cancelling the contract for the Avast app.
Supposedly they are developing their own app, given how successful they've been marketing the old Avast app, they see a lucrative market and they don't want to share the spoils with Smith.
This news seems to have leaked last week, as the company was notified on February 24 and the shares were already coming down late last week:
What next?
A few observations from us.
Verizon was the only carrier still on a legacy contract with a legacy app (Avast, which was acquired by Smith). These legacy contracts have worse terms than the new contracts based on the new software (SafePath7.0) signed with AT&T (Jan/23) and T-Mobile (March/22).
This is a very surprising development. The switching costs for carriers for these kinds of apps are very high as they are plugged into numerous systems and then subscribers have to migrate to a new app, an arduous task (we know this because we have been waiting forever for this to be completed at T-Mobile and AT&T). Carriers are normally loath to switch also not to upset current subscribers having to switch app.
It remains to be seen how successful Verizon will be in developing its own app. We're not at all convinced they can do this and migrate all their Avast subscribers onto their own app before June 2023, when the Avast contract terminates. They will likely need the 180-day extension.
The end result isn't likely to match SafePath in features, but Verizon might not care too much about that given their recent success with the older Avast app.
Investors might keep in mind that SafePath is a platform, other stuff can run on it (there is SafePath Home, SafePath IoT and SafePath Drive) that offer additional potential revenue streams for carriers (and Smith Micro), we'll have to see how Verizon's app compares.
So the revenue that Smith generates from the Avast app at Verizon (32% of Smith's revenues YTD 2022, in the order of $4.5M per quarter) is likely to be safe until the end of 2023, while the costs will go down almost immediately as Smith will terminate all but the most essential work at Verizon.
Verizon might very well become a very profitable customer for the year, although needless to say, we would have much preferred it sign a new contract and moving to SafePath 7.0.
Smith's contracts with T-Mobile and AT&T are multi-year contracts and safe for that period , although we have to admit that the customer concentration risk has been highlighted by these events.
Still, it would be difficult to imagine either T-Mobile or AT&T pulling off what Verizon just did. They would have to either:
- Wait for the contract to expire and develop their own app (or use a yet unidentified third-party app)
- Proceed with SafePath 7.0 but still develop its own app and migrate subscribers onto that when the contract expires.
It's possible, but remember what we wrote above about switching costs, carriers are usually loath to switch. With both AT&T and T-Mobile customers already having to switch once, will they be put to the wringer again? Possible, but how likely is it?
It's possible that they will try something else when the contracts near expiration, try to get better terms from Smith (in fact, we can't discard the possibility that Verizon's termination might be a ploy to achieve exactly that)
We still expect T-Mobile and AT&T to start marketing , they did sign multiyear contracts for a reason and they have seen (from Sprint a couple of years ago and from Verizon's marketing of the Avast app lately) that it can ramp rapidly.
The pot of gold at the end of the rainbow has diminished. Instead of 7x Sprint (T, TMUS, VZ), the company now has just over 4.5x Sprint (T-Mobile and AT&T) as a market to go after (keep in mind the carriers do most of the marketing)
That is, Smith could still do $40M a quarter or so in a couple of years and earn over $1 in EPS . The upside is less, but still significant.
However, this development has also brought home the customer concentration risk and many investors will likely be on the sidelines until the dust settles, so we are not likely to be in for a quick recovery, at least not with further positive clarifications or developments (like T-Mobile and/or AT&T starting to market, Smith signing up new carriers, for instance in Europe, and the like).
Then, as fellow SA author Hendrik Alex pointed out , there is the $15M in convertible notes that expire at the end of the year.
On the other hand, the company could also sign new carriers as customers, for instance in Europe.
Conclusion
At a most inopportune moment, when the company was at the point where almost all costs (acquisitions, integration of software, migration of legacy app subscribers) were in the rearview mirror and investors could look forward to the company starting to cash in on all these investments, an unexpected turn of events happened in the form of Verizon going it alone.
That is a significant setback, it reduces the (still very significant) upside and increases the risk, there is no doubt about that.
But it remains to be seen what the real intentions of Verizon are and if they can build a successful family safety app in a reasonable amount of time and switch all their legacy Avast subscribers over in time.
This year, revenue from Verizon seems secure and the associated cost will greatly diminish softening the financial impact this year.
We're not concerned their other Tier 1 customers will follow suit, certainly not in the short term, and we would argue that high switching costs also make this unlikely (albeit, as we now see, not impossible) in the longer run.
Based on the experience at Sprint in 2019 and Verizon late last year, SafePath can produce similar ramps at T-Mobile and AT&T which constitute 4.6x the market that Sprint had, a $160M-$200M opportunity at close to 90% gross margin with $50M in OpEx, that's still well over $1 in EPS.
For further details see:
Setback At Smith Micro Software