Description

“That should have been blacklined” is something you’ll rarely hear a company say. Yet Synchronoss’ Verizon Cloud contract (~40% of sales) was not blacklined and the market is unaware of the bearish details buried within.

SNCR Short thesis 

• SNCR’s Verizon Cloud contract shows material declines in future economics to SNCR. The contract significantly boosted cash flow in 2018, but Verizon payments should decline over 40% (upwards of $70mm) in 2019. Verizon is SNCR’s largest customer and likely a bigger portion of profits. 
• A significant amount of revenue and EBITDA, potentially 50-85%, comes from a related party that is delinquent on its payables and has going concern risk.
• SNCR masquerades as a technology company but is low-margin provider of white-label services. Management is promotional and continues to mislead investors.
• SNCR burns cash and has declining adjusted EBITDA. A 14.5% $210mm convertible preferred sits in front of the common. SNCR has limited access to new capital and liquidity is running tight; the last two dividend payments have been PIK. I think SNCR will ultimately be owned by the convertible preferred holder, Siris Capital. My target is $0.

Background

SNCR was a popular short a few years ago and the idea worked extremely well. Roddy Boyd at SIRF did a great job of exposing the shenanigans and icebreaker25 did a great job highlighting the short for VIC. Synchronoss’s business, providing cloud and activation services to the large telcos, was deteriorating and management resorted to accounting fraud, a questionable related party transaction, and a hail mary acquisition (Intralinks) to mask the problems.

It didn’t work. The stock fell over 90% and was delisted. The company had to restate several years of financials and the entire c-suite turned over. In order to stay solvent, Synchronoss sold Intralinks to an opportunistic PE shareholder, Siris Capital, who also threw the company a lifeline in the terms of a 14.5% PIK convertible preferred. Most short sellers have taken their profits and moved on, but should they have?

Synchronoss Today 

Since Glenn Lurie joined as CEO in December 2017, SNCR has also replaced their CFO, CCO, CMO, and CPO. Yet despite the mistakes of previous management, little seems to have actually changed. SNCR still uses aggressive and misleading accounting, still has material weaknesses in internal controls, and new management appears equally as promotional as the previous team.

Synchronoss has transitioned from its telco activation roots to offering a broader set of products and services. The company plays buzzword bingo when describing itself; SaaS, PaaS, IoT, platform, cloud, smart buildings, digital transformations, you name it. SNCR appears to be an investment play on everything hot except weed and fake meat. From my research, Synchronoss is a low-margin BPO at the mercy of its customers. SNCR has limited technology and is competing against dominant branded platform companies. 

SNCR breaks itself into four pieces: Cloud, Digital, Messaging and IoT. Cloud represents 50% of revenues and is primarily a white-label cloud storage and backup solution. Verizon is the primary customer. The digital segment is 30% of revenues and represents a mixture of products and services designed to help customers with their digital transformation. Messaging is 20% of revenues and is another white label solution to offer enhanced messaging platforms for carriers. IoT is insignificant. 

Verizon Cloud

In 2018, SNCR renewed their Verizon Cloud contract as Verizon transitioned from a freemium to a premium model. The new Verizon Cloud is an optional service where customers can get 500gb for $5/month or 1tb for $10/month. The service also comes free with Verizon’s highest tier plan, aboveunlimited, but this is a very small fraction of plans sold. The Verizon Cloud competes with services from Apple, Google, Dropbox, etc. and is priced at a premium or inline with those services. SNCR argues cloud services help lower carrier churn and provide additional revenue streams, but the carriers have historically struggled to make their white label cloud solutions work. AT&T recently sunset their AT&T Locker. 

SNCR’s cloud business was down 30% in 2018 as a result of Verizon’s transition to a premium pricing model. SNCR’s cloud business bottomed in 1Q18 and has stabilized / grown since. My work suggests SNCR’s cloud growth has been primarily the function of Verizon’s free trial and “opt out” consumer game. When a Verizon phone is activated, the default option is for a one month free trial of Verizon Cloud. Most users forget to cancel, or are unaware they even signed up, and are enrolled at $5/month.

This tactic has led to conversion rates of 80%, which surprised both SNCR management and analysts to the upside. There are numerous stories on consumer complaint sites by customers that feel they have been duped by Verizon (ex 1, ex2, ex3). However, earlier this year Verizon began trialing a much more consumer friendly “opt in” model after the free trial. This might explain the sequential decline in the cloud business in 1Q19 and 2Q19 and poses a significant threat to the cloud business going forward.

Synchronoss does not disclose Verizon's contribution to revenues and the 10K only states that the top 5 customers represented 69% of revenues in 2018. I was surprised to find the contract unredacted in exhibit 10.13 when SNCR filed their 2Q18 10Q. Yes, the previous contract was redacted. The company was surprised to learn this as well, so I suspect investors are unaware of the document. 

Breaking down the unredacted contract shows:

• Verizon is a significant customer for SNCR; estimated 30-40% of sales and 60-80% of the cloud segment.
• Significant one-time fees boosted cash flow in 2018 and are non-recurring. 
• Price/subscriber declines 37% from 2018 to 2020.

My findings are summarized below. I compare GAAP vs cash accounting using an estimated 5mm customers. GAAP requires SNCR to use three-year average pricing and to amortize upfront fees over three years. This is because Verizon can opt out of the contract at the end of year three (2020), but must notify SNCR a year in advance. I use 5mm customers which approximates Verizon as a 33% customer to SNCR. The recent Canaccord initiation report says Verizon is a 40% customer.  

In 2018, SNCR collected significantly more cash via higher customer pricing and upfront fees than is accounted for in GAAP results. I estimate the company faces a $70+mm cash flow headwind in 2019 vs 2018. EBITDA to cash flow conversion will continue to fall in 2019 and 2020 as a result of the contract accounting. In addition, if Verizon extends the contract beyond 2020, the average GAAP revenue/subscriber will fall from $1.50 to $1.13, driving an estimated $32mm GAAP revenue headwind. This should have close to a 100% flow-through to EBITDA.

I would not be surprised to see Verizon sunset their cloud solution in 2020. Despite a 4.5 star rating in the Apple App Store (56.6k ratings), most Verizon Cloud reviews are for the legacy product and recent reviews for the premium product appear to be much lower quality. 65% of 2019 reviews (130 out of the 200 total) are one and two star rated. Customers are frustrated with this unreliable product and their deceptive enrollment.

Cash Burn and Weak EBITDA Conversion

Management guides investors to adjusted EBITDA but the conversion of adjusted EBITDA to free cash is weak after adjusting for one-time payments. I have broken out the quarters in the table below. As noted on the quarterly conference calls, SNCR received $25mm from Siris in 4Q18 and a $19.5mm tax rebate in 2Q19. 

In summary, 2018 adjusted EBITDA of $14.0mm compares to my adjusted FCF of ($91.5mm). For 1H19, the company’s adjusted EBITDA of $15.3mm compares to my adjusted FCF of ($10.3mm).

Remember, the quarterly preferred payment of $7.6mm ($30.5mm per year) is not interest, it's a dividend in financing cash flow, which would not be included in the analysis above.

In order to see the adjusted EBITDA to FCF conversion deterioration as a result of the Verizon contract accounting, it is helpful to look at 2H18 vs. 1H19. Deferred revenue has flipped from a $46mm source of cash to a $13mm use of cash. This is in-line with my expectations of a ~$70+mm yoy cash flow headwind from Verizon.

SNCR is a forensic accountant’s dream and nightmare. With unique contracts and licenses, it is virtually impossible to make sense of the various puts and takes of GAAP accounting. The cash flow statement can be confusing given the large swings in working capital and various hidden one-time payments. 

Sequential Technology - Related Party Shenanigans

In December 2016, SNCR divested their AT&T activation business to a newly formed entity called Sequential Technology International (STI) for $141mm. This was the questionable related party transaction exposed by SIRF/VIC. SNCR was looking to remove their AT&T concentration risk while also monetizing a low-growth business segment.

But did they really monetize it? SNCR maintained 30% ownership of STI and financed the deal with a $70mm seller note. By 4Q18, SNCR had written the note to zero along with the equity investment. Now we know why SNCR was so desperate to dump this business in 2016. 

SNCR still has significant exposure to a struggling STI. SNCR collects ~$26mm a year from a 3-year transition service agreement, which is sometimes referred to as a Cloud and Telephony Support Services agreement. SNCR is paid for providing “access to certain Synchronoss software and private branch exchange systems” to STI. This contract expires at the end of 2019 and ~8% of SNCR’s revenues are at risk.

This revenue stream is likely extremely high margin. Software is 80% gross margin and a PBX is just an enterprise phone system. PBX capex was incurred years ago and runs through depreciation, so the EBITDA margin on leasing a PBX is high. Oh, and SNCR said the contract was 100% EBITDA margin when they got financing, see pages 14 and 15. STI could account for 50-85% of SNCR’s 2019 adjusted EBITDA.

While SNCR recognizes the high margin payments from STI, cash collection is weak. As of 2Q19, SNCR’s receivables from STI has grown to $35.4mm (vs. total AR of $99.9mm) and DSOs have ballooned to 498 days. These are ominous trends: 

How long until SNCR is forced to write off STI’s receivables? STI is struggling. STI’s financial distress also suggests payments to SNCR are likely to end when the transition agreement terminates in December 2019. 

Digital Segment (~30% of sales)

SNCR’s digital business declined 11% in 2018 and would have been down 30% on an apples to apples basis excluding a $20mm benefit from ASC606 adoption. So far in 1H19 the digital segment is flat/down. This is despite the acquisition of Honeybee and management's enthusiasm around DXP, “digital experience platform.”

Honeybee was acquired from Dixons Carphone in May 2018 for an upfront $10mm payment and has become a significant talking point for SNCR’s turnaround story. This is surprising considering Dixons “dumped” this loss-making unit to Synchronoss. Honeybee was a disaster for Dixons and the company recognized a $68mm loss on the sale. Nevertheless, Glenn Lurie declared this acquisition as “monumental” at the recent analyst day.

I’d encourage you to review the recent analyst day presentation for more additional details on the digital business. Despite the nauseating amount of buzzwords, this is basically a collection of legacy software products where the business trajectory is down.

Management now hypes new relationships with Microsoft and Rackspace in smart buildings, but the financial impact is not quantified. This is a very crowded space. 

Messaging Segment (~20% of sales)

SNCR also hypes their messaging platforms, but this is predominantly technology from the 2016 acquisition of Openwave. Openwave’s business was focused with a few telcos in Japan and that is where the business remains. “Messaging” faces an uphill battle as telcos are trying to battle against platform companies such as Line, WeChat, and Facebook Messenger.

In May 2018, Japanese carriers NTT DoCoMo, KDDI and Softbank launched +Messenger, based on Synchronoss’s technology. Despite hype that this would allow the carriers to connect directly with their customers, engagement appears to be minimal. NTT DoCoMo hardly mentions +Messenger, only noting another enhancement is planned for launch in August 2019 or beyond. No customer engagement numbers are given.

Messaging was one of the few growth bright spots in 2018 and grew about 15% excluding 606 changes. So far in 2019 the business is up just 4%. At just ~20% of sales, this is a small segment for SNCR and a small contributor to financial performance.

What does Synchronoss even do?

Analysts struggle to understand exactly how SNCR makes money. A Credit Suisse analyst asked in March18: “I don’t even know what your business is anymore…I don’t know where the revenue is coming from. Could you just tell me in real simple terms what the business is?” Glenn Lurie gave another long winded answer that provided little substance for analyzing the business. Glenn even joked at the end of the recent analyst day that he hopes analysts stop asking him what exactly Synchronoss does.

Analysts and investors aren’t alone. The most recent glassdoor review from a veteran employee is comically titled "Not sure what the company actually does".

Over Promise, Under Deliver

In mid-2018, SNCR guided to year-end exit margins of 15% and cost savings of $20mm, to be followed by an additional $25mm of cost savings in 2019. After reporting ~$25mm of normalized adjusted EBITDA in 2H18, SNCR telegraphed that they would deliver ~$50mm of adjusted EBITDA plus $25mm from cost savings plus organic growth.

Instead, in March 2019 the Company guided to 2019 adjusted EBITDA of just $30-$40mm (9-11% margins) and said they would reinvest the $25mm of cost savings. Despite analysts pressing the Company that those cost savings should have been additive, and not subtract from the 2H18 base run rate, management stubbornly stuck by their “reinvestment” story. The market was less forgiving and SNCR sold off from $8.50 to $5.50.

Two other examples:

• 2Q18 comment on Cloud: “Q2 cloud revenue is at a low point, and we will only go up from here” Cloud peaked in 3Q18 and has declined in each of the three quarters since. 
• 2Q18 comment on Digital: “However, with the integration of honeybee into our digital experience platform and based on the proof of concepts we currently have in place with several customers, we anticipate sequential revenue growth in digital in the second half of the year.” Digital peaked in 3Q18 and has declined in each of the three quarters since.

SNCR’s weak 2019 guidance counterpoints management’s enthusiasm. Despite recent agreements with British Telecom, Assurant, Rackspace, AT&T, Amazon and a “substantial” new cloud customer, SNCR has kept 2019 guidance the same. The reality is these deals are immaterial to the company’s financial performance.

So why is stock up?

SNCR has rallied ~60% over the past few months to above $8. The main drivers have been:

• 1Q19 headline beat on both sales and EBITDA. The offset was weak cash flow, a lowering of 2Q19 expectations, and unchanged back-half weighted guidance. To me, the most bullish information was the disclosure of a $19.5mm tax refund in 2Q19 from the sale of Intralinks.
• In early June, SNCR hosted an investor day and hyped the potential for their various business segments.
• In mid June, Roth initiated with $13 target. The initiation had just nine pages of text and the analyst slapped a 2x revenue multiple to justify a $13 target. Interestingly, Roth estimates $30mm of EBITDA for 2019, at the low end of $30-40mm guidance.
• SNCR rejoined the Russell 3000 at the end of June 2019.
• In early August, the company reported a 2Q19 adjusted EBITDA beat
• In late August, Canaccord Genuity initiated with a $13 target also based on a 2x revenue multiple. 

SNCR Capital Structure Remains Distressed

At $8/share and with 43mm shares outstanding, SNCR has a market cap of $348mm. Net cash as of 2Q19 was $31.4mm, but net cash is misleading because of the $210mm 14.5% convertible preferred stock outstanding. That’s over $30mm a year that needs to be paid in cash or in-kind, and represents ~100% of 2019 EBITDA. 

SNCR’s liquidity situation is tight and management appears increasingly concerned. The Company currently has less than $30mm in cash and no access to a credit facility. Management has recently discussed exploring working capital financing to provide additional liquidity (factoring receivables is a big red flag) and the company paid its last two preferred dividends to Siris in PIK stock (April, July). 

The 14.5% convertible preferred is a growing problem from SNCR as payments-in-kind compound at 14.5%. Moreover, the preferred has restrictive terms which handcuff SNCR’s ability to take on additional capital, thus exacerbating SNCR’s liquidity problems.

Bulls view the convertible preferred as a non-issue and expect a refinancing in August 2020. But where is SNCR going to get the money? Even if the SNCR makes all future interest payments in cash, SNCR will need over $210mm to retire the preferred. With 6x preferred leverage ($210mm preferred, $35mm adjusted EBITDA) and negative operating cash flow, it is unlikely the company will be able to raise enough capital to refinance the preferred. 

$0 Target

At $8/share, SNCR trades at 1.5x EV/Sales and 15x EBITDA. While this might seem reasonable for a SaaS/PaaS/platform/recurring software business, that’s not SNCR. SNCR is a low-margin, white-label service provider with customer concentration risk and limited life contracts. I wouldn’t be surprised if Verizon walked away at the end of 2020 or if STI filed for bankruptcy. Either would be extremely negative for SNCR. 

SNCR has low single digit sales growth, barely double digit EBITDA margins, and a healthy cash burn. The company has 6x preferred stock leverage and both debt (via the preferred) and cash flow are going in the wrong direction. As the market wakes up to the increased cash burn and looming liquidity issues, I believe SNCR will be buried by the convertible preferred, Siris Capital will take control of the company, and the common shares will be worthless.

Catalyst

Sell-side/Buy-side awareness of Verizon Contract

Earnings

Contract Terminations

Dilutive Capital Raises