Smith Micro Software: An undervalued software company worth triple

This is my brief write up on Smith Micro Software (SMSI)

SMSI is a mobile application developer who sells to carriers, which in turn sells to their subscribers. Similar to how Sprint bundles Hulu with their phone plans to end customers. I believe SMSI is worth significantly more than it’s current valuation and the market have not priced in the following key developments:

Main thesis:

1. SMSI shifting revenue from low margin graphics business to high margin mobile app business. Company grew gross margins from mid-70s in 2017 to 91% in 1Q19
2. Revenue and profit expected to increase QoQ over the next 2 years. Revenue expected to grow from 23M in 2017 to 38M (estimated) in FY19
3. Expected new partnerships with other carriers in 2019, as guided by management across several major product lines. Stock tripled when SMSI signed Sprint in late 2017.

SMSI recently turned the corner and became profitable in FY18. I expect they will continue to grow meaningfully while generating positive cash flow QoQ.

It’s hard to run into an opportunity as compelling as SMSI. Below I’ll provide a very brief background on SMSI and cover their margins, growth and upcoming opportunities for the company and shareholders. I believe the business will grow to be x3 – x5 it’s current market cap of $100M over the next two years.SMSI: A brief overview

SMSI Financial Profile:

The company is currently valuated at 100M, has zero debt, and $7.5M in cash at time of this writing.

*GAAP EPS. Non-GAAP EPS is generally 2c higher which excludes amortization and stock based compensation.

Smith Micro Software is a mobile application developer with three main applications product lines:

• -SafePath: Essentially a location, family and parental control app. Although they are growing the product line to expend into smart homes (SafePath Home), and IoT devices (SafePath IoT).
• CommSuite: A visual voice message app with integrations to Alexa and other smart home devices. This product line up is also extending, although I’ll skip the intro due the fact that the expansions are still being launched with minimal revenue at this point.
• ViewSpot: An application installed on a device in retail stores (think BestBuy, AT&T stores) to provide guided tours for retail customers. These ‘guided tours’ control what shoppers see and how they interact with a device. AT&T and Verizon are SMSI’s biggest customers for this product.

The company also has a legacy graphics business. This is a profitable business but has negligible revenue contributions so I’ll skip the intro. It contributes roughly $1M/year in revenue.

For more information, I recommend going to smithmicro.com to read more each of SMSI’s 3 main software products.

For the purpose of this write-up I’ll focus on the business itself.Overview of Smith Micro’s Sales Process:

SMSI’s has a deep sales relationship with all the Tier 1 and many Tier 2/3 carriers & MSOs in the US. Unlike most application developers who releases their apps directly to consumers, SMSI white labels their products to carriers and MSOs. Carriers & MSOs then rebrand SMSI’s products as their own, and sells these apps their own retail customers. Here’s a brief overview on how SMSI release their products to consumers:

1. SMSI sign a revenue share agreement with a carrier, which has historically been around a 50/50 revenue split
2. Carrier pre-installs SMSI’s apps on their phones to be sold to retail customers
3. When retail customers purchase a phone from a carrier, the carrier have the opportunity to upsell SMSI app subscriptions to these retail customers, similar to how BestBuy upsell customers on insurance when you buy a dishwasher
4. If retail customers purchases the subscription, they are billed an extra few dollars per month, resulting in 100% margins for carriers, and 91% gross margins for SMSI
5. If retail customers declines the subscription, they have the opportunity to use SMSI’s free-tier apps and subscribe to the premium version at a later time

This is a beautiful business model because:

– Carriers receive 100% margins of these sales, while offering their retail customers additional value provided by SMSI’s apps. Customers are less likely to leave a carrier when they have multiple service offerings with a single carrier (stickiness)- SMSI receives high margin revenue with zero to no marketing expense

For SMSI to grow, they need to:

1. Sign more carriers / MSOs, or
2. Grow their existing partnerships

As we’ll discuss below, SMSI is currently growing on both fronts.Catalysts – why now

SMSI’s recently turned the corner and became Non-GAAP profitable in FY18 (adjusting for outstanding warrants), with positive cash flow expected in the next 2-3 years. SMSI’s key growth areas is detailed below as well as their recent growth rates and forecasted 2019, 2020 growth rates. Most of this is fairly simple to model out given the recurring nature of their revenue.

1. Growing existing partnerships

SMSI signed and begun ramping up Sprint for their SafePath application in 2018. This single relationship has grown from $200k in 1Q18 to $2,100k in 1Q19 revenue. Management has also guided towards continued growth in 2019.

Below we show SMSI’s 3 key applications and their current and expected growth for 2019, and 2020.

I’ve included 2018 and 1Q19 (actuals) revenue for reference.

A few assumptions:

1. I assume conservative growth of 100k/Q for CommSuite, based on CC guidance and 1 on 1 calls with management
2. I assume a growth rate of 30% for Q2 for Safepath, an 400k/Q thereafter. The 30% growth comes from guidance from conversations CFO Tim Huffmyer (who has historically been fairly conservative with his guidance). And the $400k/Q thereafter uses a historical average. This does not take into account the expected Sunset of Sprint’s legacy subscriber base to SafePath, which will bring an additional 3M/Q in revenue to SMSI. You can read more about this in SMSI’s 2Q18 or 3Q18 CC transcripts.
3. Viewspot is a new purchase in late 2018. I assume growth to be conservative at 100k/Q for 2019, although speaking with management, they’ve told me they expects growth to be ~20-30%.
4. I assume no revenue for SafePath IoT and SafePath Home. Speaking with CFO Tim Huffmyer, he stated that it’s ‘too soon to tell’ on how much revenue these two new expansions will drive in 2019.

My forecast last year and Q1 has been fairly accurate to actual earnings releases (I expected 8.4M in revenue, they came in at 8.43M in 1Q19). I have fairly high confidence that actuals will come in line with these forecasts. If SMSI signs a new carrier, my ’19 and ’20 models will be revised accordingly.

2. Signing more carriers

Last year prior to SMSI acquiring ViewSpot, CEO Bill Smith had guided towards signing a new Tier 1 carrier by 1H19 (all evidence points to T-Mobile). This would a meaningful win for the company since T-Mobile is 50% larger than Sprint, and SMSI’s stock tripled on the Sprint signing.

However when asked about this guidance on 1Q19’s CC, Bill revised his guidance in saying he expect the signing would go past his initial guidance of 1H19, but he now expects to sign a new customer for each of Safepath, CommSuite, and Viewspot.


While I’m not as bullish as Bill, all data points to T-Mobile has the next SMSI customer. I expect T-Mobile’s delay may be tied to their impending merger with Sprint, which is expected to close in the short term.So what’s SMSI worth?

Below I share my revenue guidance for the company. A few granular points to note:

1. The company has higher expenses in Q1 due to higher sales variable cash compensation (bonuses), and trade shows at the Consumer Electronics Show (CES), and Mobile World Congress (MWC).
2. The company is ramping up their engineering team for deployments at additional carrier wins this year. CFO Tim Huffmyer told he they currently have 20 open reqs. I have modeled towards increased R&D expense per Tim’s guidance.
3. For expenses, Tim has guided towards a $500k decrease in expenses for Q2, and fairly consistent run rate for 2019, with slight increases in 2H19 due to R&D
4. While management does not provide overall guidance, Tim did say he expects SafePath revenue to increase 30-40% QoQ.

SMSI Model

A few key takeaways:

1. The company is expected to generate 0.21 in cash EPS next year. Shares currently rate at only $3.30/share.
2. The company has no significant cash obligations and is expected to generate cash every quarter

Conclusion

As a microcap value investor, it’s easy to fall into value traps or invest in cigar butts. However when a true value opportunity arises, it’s hard not to get excited.

SMSI is a profitable software developer with high operating leverage, clean balance sheet, and growing 40%/year without even accounting for the expected large customer wins in the next 7 month.

I won’t dive to deeply on valuation as every investor has their own valuation methods and discount rates. Here’s my simple DCF model:

A simple DCF valuates the company at $13/share. This assumes a 15% discount rate and did not include any future customer wins.

For terminal year, I valued the company at a simple PE of 10. Software application companies traditionally trade at PE of 25+.

If this opportunity looks compelling, I recommend doing your own due diligence and arriving at your own conclusions and value for the company. Please reach out if you find any mistakes or oversight on my part.