Summary
- Smith Micro Software, Inc. shares sell off after the company discloses a surprise contract termination by a leading U.S. wireless carrier, which I would assume to be Verizon.
- Annual revenue impact likely to be in the $15 million to $16 million range, with gross profit being reduced by an estimated $11 million.
- Company has also experienced issues with its remaining U.S. Tier 1 customers AT&T and T-Mobile, thus resulting in underwhelming financial performance.
- Recently issued senior secured convertible notes are likely to result in substantial dilution for common equity holders. In addition, liquidity might become an issue going into 2024.
- Smith Micro Software, Inc. equity holders appear to have been caught between a rock and a hard place as they will either be saddled with substantial dilution or even face an outright bankruptcy filing next year. Considering the obvious lose-lose situation, investors should consider selling existing positions and moving on.
Two years ago, Smith Micro Software, Inc. ( SMSI ), or "Smith Micro," announced the surprise acquisition of the Family Safety Mobile Software Business of competitor Avast PLC, thus adding leading U.S. wireless carriers AT&T Inc. ( T ) and Verizon Communications Inc. ( VZ ) to its customer base.
Prior to the acquisition, Smith Micro's family safety offerings in the U.S. had been largely limited to the smallest Tier 1 carrier Sprint, which ended up being acquired by T-Mobile ( DTEGY , DTEGF ) in 2020.
Unfortunately, things haven't played out as envisioned by management at that time, as T-Mobile has been hesitant to actively promote the latest iteration of its family safety offering while AT&T's migration to Smith Micro's new SafePath software platform has experienced unforeseen delays .
As a result, the company's financial performance has deteriorated materially in recent quarters, with revenues for the first nine months of 2022 declining by more than 25% year-over-year.
Even worse, Smith Micro has experienced substantial cash outflows this year, thus resulting in the requirement to access the capital markets again in August.
As of September 30, 2022, the company had $19 million in cash and $15 million in potentially toxic convertible notes outstanding, with installment payments scheduled to commence on April 1. The notes will be maturing on December 31.
To be perfectly honest, I wouldn't have considered Smith Micro a promising investment before Monday's announcement, but after the surprise contract termination by a U.S. Tier 1 carrier - which I would assume to be Verizon - things have started to look really ugly:
Smith Micro Software, Inc. today announced that on February 21, 2023, the Company received written notice of contract termination from a U.S.-based Tier 1 carrier customer for the Company’s family safety solution, effective June 30, 2023. At the customer’s election, the Company remains obligated to deliver service under the agreement for a transition period of up to 180 days beyond June 30, 2023. The Company is reviewing and expects to take appropriate action to reduce expenses associated with the affected customer agreement, and will reallocate certain resources to the Company’s multiple other Tier 1 U.S. carrier customers and to its customers outside of the U.S.
“We were surprised to have received this notice from our customer, and though we are disappointed, we believe we have positioned the Company well over the past few years to diversify our overall client base. This customer portfolio will continue to include our largest Tier 1 customer and another Tier 1 carrier that just recently entered into a new multi-year contract with us for our family safety solutions,” said William W. Smith Jr., President, and CEO of Smith Micro.
Mr. Smith continued, “Looking ahead, we will continue to honor our obligations under the terminating contract through the remainder of the fiscal year while receiving compensation in accordance with the terms of the existing contract. We will also immediately take steps to reallocate resources to accelerate growth and integration efforts with our other customers and partners. We will also accelerate the cost saving initiative that began last year, to better align our cost structure model as we look to return the Company to growth and profitability.”
The company's respective 8-K filing with the SEC held even more bad news (emphasis added by author):
On February 21, 2023, the Company received written notice of termination of a U.S. tier 1 customer agreement for the Company’s family safety solution, effective June 30, 2023. Thereafter the Company is obligated to deliver service under the agreement for a transition period of up to 180 days at the election on the customer. The agreement accounted for approximately 32% of the revenues of the Company for the nine-month period ended September 30, 2022 . The Company is reviewing and expects to take appropriate action to reduce expenses associated with the affected customer agreement, and in connection with its review expects to reallocate certain resources to the Company’s multiple other tier 1 U.S. carrier customers and to its customers outside of the U.S.
(...)
In connection with the notice of termination of the customer agreement (...), the management of Smith Micro Software, Inc. is conducting an impairment review under applicable accounting rules to determine whether, and to what extent, this change creates any impairment. (...)
Based on Smith Micro's disclosures, I would estimate the annual revenue loss to be in a range of $15 million to $16 million, which would equate to a gross profit impact of approximately $11 million.
With the company trying to accelerate recent cost savings initiatives while at the same time " reallocating resources to accelerate growth and integration efforts with our other customers and partners," I would expect operating expenses to remain elevated relative to the much smaller footprint of the company going forward.
But the elephant in the room remain the company's recently issued senior secured convertible notes , which contain a toxic conversion feature that is very likely to come to fruition now.
At the company's election, both quarterly interest and monthly installments can be made in newly issued common stock which will be valued at a meaningful discount to prevailing share prices thus incentivizing noteholders to short the company's common shares ahead of conversion dates:
“Installment Conversion Price” means, with respect to a particular date of determination, the lowest of (i) the Conversion Price then in effect, and (ii) the greater of (x) the Floor Price and (y) 90% of the quotient of (a) the sum of the closing prices of the Common Stock for each of the three (3) Trading Days with the lowest closing prices of the Common Stock during the twenty (20) consecutive Trading Day period ending and including the Trading Day immediately prior to the applicable Installment Date, divided by (b) three (3).
Please note that the conversion floor price has been set at just $0.62, so there's still plenty of flesh on the bone for convertible noteholders looking to maximize returns.
Assuming an aggregate 16.5 million in principal and accrued interest to be converted at an average conversion price of $1.35, Smith Micro would be required to issue 12.2 million new shares.
As a consequence, equity holders will likely have to prepare for substantial near-term dilution as the company is looking to limit cash outflows.
The second major headache will be liquidity going forward. With the contract scheduled to end on June 30 and transitional services likely being required for much of the second half of the year, the full impact of the termination won't be felt before 2024.
That said, Smith Micro urgently needs to reduce cash burn going forward as otherwise the company would be in danger of running out of funds by year end.
Bottom Line
Clearly, Avast's decision to unload its family safety software business was the right strategic move, with Smith Micro Software, Inc. now being left holding the bag.
While the company still has contracts with the remaining U.S. Tier 1 carriers, results have been fairly disappointing in recent quarters.
Given this issue, it's difficult to envision a near-term inflection point in Smith Micro Software, Inc.'s business, particularly when considering the company's looming debt and liquidity issues.
Smith Micro Software, Inc. equity holders appear to have been caught between a rock and a hard place, as they will either be saddled with substantial dilution or even face an outright bankruptcy filing next year.
Considering the obvious lose-lose situation, investors should consider selling existing positions in Smith Micro Software, Inc. and moving on.
For further details see:
Smith Micro: Stock Craters After Tier 1 Carrier Contract Termination - Sell