Smith Micro Software, Inc.: Form 10-Q for the period ended Sep 30, 2023

In this document, the terms “Smith Micro,” “Company,” “we,” “us,” and “our” refer to Smith Micro Software, Inc. and, where appropriate, its subsidiaries.

This Quarterly Report on Form 10-Q (this “Report”) contains forward-looking statements regarding Smith Micro which include, but are not limited to, statements concerning customer concentration, projected revenues, market acceptance of products, the success and timing of new product introductions, the competitive factors affecting our business, our ability to raise additional capital, gross profit and income, our expenses, the protection of our intellectual property, and our ability to remain a going concern. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will,” and variations of these words or similar expressions are intended to identify forward-looking statements. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. These statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, our actual results could differ materially from those expressed or implied in any forward-looking statements as a result of various factors. Such factors include, but are not limited to, the following:

• our customer concentration, given that the majority of our sales currently depend on a few large client relationships;
• our ability to establish and maintain strategic relationships with our customers and mobile device manufacturers, their ability to attract customers, and their willingness to promote our products;
• our ability and/or customers’ ability to distribute our mobile software applications to their end users through third party mobile software application stores, which we do not control;
• our dependency upon effective operation with operating systems, devices, networks and standards that we do not control and on our continued relationships with mobile operating system providers, device manufacturers and mobile software application stores on commercially reasonable terms or at all;
• our ability to hire and retain key personnel;
• the possibility of security and privacy breaches in our systems and in the third-party software and/or systems that we use, damaging client relations and inhibiting our ability to grow;
• failure to realize the expected benefits of prior acquisitions;
• interruptions or delays in the services we provide from our data center hosting facilities that could harm our business;
• the existence of undetected software defects in our products and our failure to resolve detected defects in a timely manner;
• our current client concentration within the vertical wireless carrier market, and the potential impact to our business resulting from changes within this vertical market, or failure to penetrate new markets;
• rapid technological evolution and resulting changes in demand for our products from our key customers and their end users;
• intense competition in our industry and the core vertical markets in which we operate, and our ability to successfully compete;
• the risks inherent with international operations;
• the impact of evolving information security and data privacy laws on our business and industry;
• the impact of governmental regulations on our business and industry;
• our ability to protect our intellectual property and our ability to operate our business without infringing on the rights of others;
• the risk of being delisted from NASDAQ if we fail to meet any of its applicable listing requirements;
• our ability to raise additional capital and the risk of such capital not being available to us at commercially reasonable terms or at all;
• risks related to the existence and terms of our outstanding convertible notes, including that they may restrict our ability to obtain additional financing, and adversely affect our business, financial condition and cash flows from operations in the future, and could require us to curtail or cease our operations;
• the risk that the conversion of our outstanding convertible notes and exercise of the warrants issued in connection therewith, which will dilute the ownership interest of our existing stockholders, may also depress the price of our common stock;
• the risk that our obligations to the holders of our convertible notes are secured by a security interest in substantially all of our assets, and if we default on those obligations, the note holders could foreclose on our assets;
• our ability to be profitable;
• our ability to remain a going concern;
• changes in our operating results due to shifts in our sales mix and variability in our operating expenses;
• our ability to assimilate acquisitions without diverting management attention and impacting current operations;
• the availability of third-party intellectual property and licenses needed for our operations on commercially reasonable terms, or at all;
• the difficulty of predicting our quarterly revenues and operating results and the chance of such revenues and results falling below analyst or investor expectations, which could cause the price of our common stock to fall; and
• those additional factors which are listed under Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2022 filed with the SEC on March 23, 2023 (the "2022 Form 10-K") under the caption “RISK FACTORS.”

The forward-looking statements contained in this Report are made on the basis of the views and assumptions of management regarding future events and business performance as of the date this Report is filed with the Securities and Exchange Commission (the “SEC”). In addition, we operate in a highly competitive and rapidly changing environment; therefore, new risk factors can arise, and it is not possible for management to predict all such risk factors, nor to assess the impact of all such risk factors on our business or the extent to which any individual risk factor, or combination of risk factors, may cause results to differ materially from those contained in any forward-looking statement. We do not undertake any obligation to update these statements to reflect events or circumstances occurring after the date this Report is filed.

Overview

Smith Micro provides software solutions that simplify and enhance the mobile experience to some of the leading wireless service providers around the globe. From enabling the Digital Family Lifestyle™ to providing powerful voice messaging capabilities, we strive to enrich today’s connected lifestyles while creating new opportunities to engage consumers via smartphones and consumer IoT devices. Our portfolio includes a wide range of products for creating, sharing, and monetizing rich content, such as visual voice messaging, retail content display optimization and performance analytics on any product set.

We continue to innovate and evolve our business to respond to industry trends and maximize opportunities in emerging markets, such as digital lifestyle services and online safety, “Big Data” analytics, automotive telematics, and the consumer IoT marketplace. The key to our longevity, however, is not simply technological innovation, but our focus on understanding our customers’ needs and delivering value.

In the third quarter of 2023, our revenues declined by 6% to $11.0 million compared to the third quarter of 2022, primarily driven by a $0.5 million decrease in our Family Safety product line, coupled with a $0.3 million decrease in CommSuite revenues. These revenue declines primarily resulted from decreases associated with T-Mobile's efforts to migrate legacy Sprint subscribers to the T-Mobile network, which has impacted our revenues associated with legacy Sprint subscribers for both Family Safety and CommSuite. There was no legacy Sprint subscriber revenue for CommSuite in the third quarter of 2023. However, as a result of the decline in our cost of revenues, we have driven an increase in our gross profit during the third quarter of 2023 to $8.5 million, an increase of $0.4 million as compared to the prior year. Additionally, our operating expenses have decreased during the third quarter of 2023 compared to the third quarter of 2022 by approximately $5.8 million, primarily due to quarter-over-quarter reductions in Research and Development expenses of $3.7 million as

SafePath migration efforts have now been substantially completed. The net loss for the third quarter of 2023 was $5.1 million, resulting in a net loss of $0.08 per basic and diluted share.

While we currently provide white label Family Safety applications to all three Tier 1 wireless carriers in the United States, in accordance with the notice provided by one of our Tier 1 customers in February 2023, our Family Safety contract with that customer terminated effective June 30, 2023, and we will continue providing services to that customer for a post-termination period through November 2023. The revenues associated with that customer contract were approximately 36% of total revenues for the nine-month period ended September 30, 2023. Primarily as a result of that contract nearing the end of the post-termination period, we are anticipating our revenues to decline in the fourth quarter of 2023. In the first quarter of 2024, we expect no further material revenues related to that contract. Despite that termination, we continue to believe that we remain strategically positioned to offer our market-leading family safety platform to the majority of U.S. mobile subscribers. Since our acquisitions of Circle Media Labs, Inc.'s ("Circle") operator business in 2020 and the Family Safety Mobile Business from Avast in April 2021, we have been focused on migrating those customers from the acquired software platforms to our flagship SafePath platform, with the first such migration being completed during the first quarter of 2022 at one of our U.S. Tier 1 carrier customers. Another U.S. Tier 1 carrier customer successfully migrated to the SafePath platform during the third quarter of 2023. We believe that with these transitions to the SafePath platform now complete, we have an opportunity to increase the respective subscriber bases, and in turn, grow the revenues associated with these Tier 1 carriers.

Additionally, as a result of the termination notice referenced above, we announced actions late in the first quarter of 2023 that resulted in the elimination of approximately 26% of the Company's global workforce. The severance related costs associated with these actions were recognized in the first quarter of 2023. These actions, coupled with other cost reduction measures taken, have resulted in approximately $6.6 million of quarterly cost savings in the third quarter of 2023 as compared to the third quarter of 2022.

Refer to section titled "Liquidity and Capital Resources" for discussion of significant material changes in cash, and Note 4 of our Notes to the Consolidated Financial Statements for discussion regarding the changes related to the notes payable, derivative liabilities, and warrant liabilities.

Results of Operations

The table below sets forth certain statements of operations and comprehensive loss data expressed as a percentage of revenues for the three months ended September 30, 2023 and 2022. Our historical results are not necessarily indicative of the operating results that may be expected in the future.

22

Three Months Ended September 30, 2023 Compared to the Three Months Ended September 30, 2022

Revenues. Revenues were $11.0 million and $11.7 million for the three months ended September 30, 2023 and 2022, respectively, representing a decrease of $0.7 million, or 6%. This decrease was primarily related to decreases associated with our Family Safety and CommSuite product lines of $0.5 million and $0.3 million, respectively. The revenue decline primarily resulted from decreases associated with T-Mobile's efforts to migrate legacy Sprint subscribers to the T-Mobile network, which has impacted our revenues associated with legacy Sprint subscribers for both Family Safety and CommSuite product lines.

Cost of revenues. Cost of revenues were $2.5 million and $3.6 million for the three months ended September 30, 2023 and 2022, respectively. This decrease of approximately $1.1 million was primarily due to cost reduction efforts and the period-over-period decline in revenue.

Gross profit. Gross profit was $8.5 million, or 77% of revenues, for the three months ended September 30, 2023, compared to $8.1 million, or 69.0% of revenues, for the three months ended September 30, 2022. The increase of $0.4 million in gross profit was driven by the period-over-period decline in cost of revenues.

Selling and marketing. Selling and marketing expenses were $2.4 million and $3.0 million for the three months ended September 30, 2023 and 2022, respectively. This decrease of approximately $0.5 million was primarily due to decreases in personnel related costs and advertising costs.

Research and development. Research and development expenses were $3.7 million and $7.4 million for the three months ended September 30, 2023 and 2022 respectively. This decrease of $3.7 million was primarily due to the decline in personnel-related costs of approximately $2.6 million associated with the workforce reduction efforts referenced above and reductions in contractor costs of $1.0 million due to the substantial completion of SafePath migration efforts during 2023.

General and administrative. General and administrative expenses were $2.9 million and $4.2 million for the three months ended September 30, 2023 and 2022, respectively. This decrease of approximately $1.3 million was primarily related to a reduction of $0.6 million due to transaction fees incurred related to the Note and Stock Offering in August 2022 and declines in personnel related costs of approximately $0.4 million associated with the workforce reduction efforts referenced above, and approximately $0.3 million of other administrative expense reductions.

Depreciation and amortization. Depreciation expense was $0.1 million and $0.3 million for the three months ended September 30, 2023 and 2022, respectively. Amortization expense was $1.5 million for both of the three months ended September 30, 2023 and 2022. The total decrease of approximately $0.3 million was primarily due to the quarter-over-quarter decrease in depreciation expense recognized as certain fixed assets have now been fully depreciated.

Change in fair value of warrant and derivative liabilities. Change in fair value of warrant and derivative liabilities was $0.1 million and $3.5 million for the three months ended September 30, 2023 and 2022, respectively. The total decrease of $3.4 million resulted from valuation related impacts to the warrant and derivative liabilities in the respective periods.

Loss on derecognition of debt. The loss recognized on derecognition of debt in the third quarter of 2023 was $1.6 million. This resulted from installment payments made on the convertible notes in the form of shares, and the required derecognition of the net debt position related to that principal balance, including the derivative and discounts.

Interest expense, net. Interest expense was $1.4 million and $0.9 million for the three months ended September 30, 2023 and 2022, respectively. The increase in interest expense of $0.5 million was primarily related to the amortization of the discount and debt issuance costs and stated interest expense related to the financing transaction from August of 2022, which is discussed in further detail in Notes 3 and 4 herein (the "Note and Stock Offering").

Other income (expense), net. Other income (expense) was nominal for both the three months ended September 30, 2023 and 2022.

Provision for income tax expense. Because of our cumulative loss position, the provision for income tax expense consists of state income taxes, foreign tax withholdings, and foreign income taxes for the three months ended September 30, 2023 and 2022. There were no material changes in the period-to-period comparison.

Nine Months Ended September 30, 2023 Compared to the Nine Months Ended September 30, 2022

Revenues. Revenues were $32.3 million and $37.1 million for the nine months ended September 30, 2023 and 2022, respectively, representing a decrease of $4.8 million, or 13%. This decrease was primarily related to declines associated with our Family Safety and CommSuite product lines of $3.2 million and $1.6 million, respectively. The decrease in revenues was primarily associated with T-Mobile's efforts to migrate legacy Sprint subscribers to the T-Mobile network, which has impacted our revenues associated with legacy Sprint subscribers for both Family Safety and CommSuite.

Cost of revenues. Cost of revenues were $8.4 million and $10.9 million for the nine months ended September 30, 2023 and 2022, respectively. This decrease of approximately $2.5 million was primarily due to the period-over-period decline in revenue coupled with the cost reduction efforts undertaken in 2023.

Gross profit. Gross profit was $23.9 million, or 74% of revenues, for the nine months ended September 30, 2023, compared to $26.2 million, or 70.7% of revenues, for the nine months ended September 30, 2022. The decrease of approximately $2.4 million in gross profit was driven by the period-over-period decline in revenue volume.

Selling and marketing. Selling and marketing expenses were $8.6 million and $9.7 million for the nine months ended September 30, 2023 and 2022, respectively. This decrease of $1.1 million was primarily due to decreases in personnel-related costs of $0.7 million coupled with a period-over-period reduction in severance and reorganization related costs of $0.7 million, partially offset by an increase in stock based compensation of $0.3 million.

Research and development. Research and development expenses were $13.3 million and $22.8 million for the nine months ended September 30, 2023 and 2022 respectively. This decrease of approximately $9.5 million was primarily due to the decline in personnel-related costs of approximately $6.9 million associated with the workforce reduction efforts referenced above and reductions in contractor costs of $2.7 million due to the substantial completion of SafePath migration efforts during 2023.

General and administrative. General and administrative expenses were $9.4 million and $11.9 million for the nine months ended September 30, 2023 and 2022, respectively. This decrease of approximately $2.4 million was primarily related to declines in in personnel related costs of approximately $1.0 million associated with the workforce reduction efforts referenced above, a reduction of $0.6 million due to transaction fees incurred related to the Note and Stock Offering in August 2022, a decrease in travel costs of approximately $0.2 million and a reduction in stock-based compensation expense of approximately $0.2 million.

Depreciation and amortization. Depreciation expense was $0.5 million and $0.9 million for the nine months ended September 30, 2023 and 2022, respectively. Amortization expense was $4.4 million and $4.8 million for the nine months ended September 30, 2023 and 2022, respectively. The total decrease of approximately $0.8 million was primarily due to certain fixed assets and intangible assets that have now been fully depreciated and amortized.

Change in fair value of warrant and derivative liabilities. Change in fair value of warrant and derivative liabilities was $3.5 million for both the nine months ended September 30, 2023 and 2022. The fair value adjustments resulted from valuation related impacts to the warrant and derivative liabilities.

Loss on derecognition of debt. The loss recognized on derecognition of debt for the nine months ended September 30, 2023 was $3.0 million This resulted from installment payments made on the convertible notes issued under the Note and Stock offering in August 2022 (the "Notes") in the form of shares, and the required derecogition of the net debt position related to that principal balance, including the derivative, and discounts. There was nothing commensurate in the nine months ended September 30, 2022.

Interest expense, net. Interest expense was $5.7 million and $0.9 million for the nine months ended September 30, 2023 and 2022, respectively. The increase in interest expense of $4.8 million was primarily related to the amortization of the discount and debt issuance costs and stated interest expense related to the August 2022 Note and Stokc Offering, with the Notes issued thereunder being outstanding for the full year in 2023 versus less than two months during the nine months ended September 30, 2022.

Other income (expense), net. Other expense was $0.1 million and nominal for the nine months ended September 30, 2023 and 2022, respectively. The increase was primarily related to changes in foreign currency rates for the respective periods.

Provision for income tax expense. Because of our cumulative loss position, the provision for income tax expense consists of state income taxes, foreign tax withholdings, and foreign income taxes for the nine months ended September 30, 2023 and 2022. There were no material changes in the period-to-period comparison.

Liquidity and Capital Resources

The Company’s principal sources of liquidity are its existing cash and cash equivalents, and cash generated by operations. The Company's primary needs for liquidity relate to working capital requirements for operations and its debt service requirements. As of September 30, 2023, the Company's cash and cash equivalents were approximately $8.0 million. We believe that we will be able to meet our financial obligations as they become due over the next twelve months.

Operating activities

Net cash used in operating activities was $6.0 million for the nine months ended September 30, 2023. The primary uses of operating cash were a net loss of $17.7 million less non-cash expenses totaling $13.0 million, and a decrease in accounts payable and accrued liabilities of $2.2 million, partially offset by an increase in other liabilities of $0.6 million and a decrease in accounts receivable of $0.2 million and a decrease in operating prepaid expenses and other assets of $0.2 million.

Net cash used in operating activities was $14.5 million for the nine months ended September 30, 2022. The primary uses of operating cash were the net loss of $21.3 million, offset by net non-cash expenses totaling $7.2 million coupled with a decrease in accounts payable and accrued liabilities of $1.5 million, partially offset by a decrease in accounts receivable of $1.1 million and a increase in prepaid and other assets of $0.2 million.

Investing activities

Net cash provided by investing activities was $0.1 million for the nine months ended September 30, 2023. Net cash used in investing activities for nine months ended September 30, 2022 was nominal.

Financing activities

Net cash provided by financing activities of $0.2 million for the nine months ended September 30, 2023 was primarily attributable to the timing of borrowings and repayments from short-term insurance premium financing arrangements.

Net cash provided by financing activities of $17.4 million for the nine months ended September 30, 2022, was primarily attributable to proceeds from our convertible notes and warrants offering of $15.0 million and our stock and warrants offering of $3.0 million. Partially offsetting the proceeds from the convertible notes and warrants were $1.2 million in transaction fees. Also impacting net cash provided by financing activities were proceeds from insurance premium financing agreements and revolver draws of $1.5 million, offset by repayments on those arrangements of $1.0 million.

Recent Accounting Guidance

See Note 2 of our Notes to the Consolidated Financial Statements for information regarding our recent accounting guidance.

Critical Accounting Policies and Estimates

Our discussion and analysis of results of operations, financial condition, and liquidity are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may materially differ from these estimates under different assumptions or conditions. On an on-going basis, we review our estimates to ensure that they appropriately reflect changes in our business or new information as it becomes available. See Note 1 of our Notes to the Consolidated Financial Statements in our 2022 Form 10-K for information regarding our critical accounting policies and estimates. There have been no material changes to the Company's critical accounting policies and estimates since the 2022 Form 10-K.

Evaluation of disclosure controls and procedures

We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)) as of September 30, 2023. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have determined that as of September 30, 2023, our disclosure controls and procedures were effective to ensure that the information required to be disclosed in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and our management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Management’s responsibility for financial statements

Our management is responsible for the integrity and objectivity of all information presented in this Report. The consolidated financial statements were prepared in conformity with U.S. GAAP and include amounts based on management’s best estimates and judgments. Management believes the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements fairly represent the Company’s financial position and results of operations for the periods and as of the dates stated therein.

The Audit Committee of the Company’s Board of Directors, which is composed solely of independent directors, meets regularly with our independent registered public accounting firm, SingerLewak LLP, and representatives of management to review accounting, financial reporting, internal control, and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors have free access to the Audit Committee.

Changes in internal control over financial reporting

There have been no changes in our internal control over financial reporting during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In addition to the other information included in this Report, you should carefully consider the factors discussed in Part I, Item 1A. “Risk Factors” in our 2022 Form 10-K, and the factors identified at the beginning of Part I, Item 2 of this Report, under the heading, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which could materially affect our business, financial condition, cash flows, or results of operations. The risks described in the 2022 Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to the Company or that the Company currently considers immaterial also may materially adversely affect its business, financial condition, and/or operating results. There have been no material changes to the risk factors included in our 2022 Form 10-K.