When I posted about the stock compensation abuse at Smith Micro last week I promised some follow-up notes. This be them. They are a mish-mash of old notes, so excuse me if I repeat myself or at times seem contradictory.

Smith Micro Software (SMSI) Enjoyed A Huge 2008

• 2008 Q4 Conference Call [Q1 conference call and release linked in my last post]
• 2008 Q4 Earnings Release 
• 2008 Annual Report 

Smith Micro is a small cap leader in mobility software products for the wireless market. They provide connectivity, security multimedia and device management. 2008 has bought a number of significant milestones for Smith Micro:

• they diversified away from a heavy reliance on Verizon, from 64.4% of sales in 2007 to 30.9% in 2008.
• Recorded their fourth year of consecutive record earnings growth. [As the table below shows SMSI were talking non-GAAP, GAAP earnings fell in 2008 to the lowest point since 2003]
• An explosion in the number of new deals signed. In Q4 08 they signed over a half dozen new customers [that's Bill Smith speak] which was more deals closed than in the last two years.

Their connectivity and security suite is driving huge growth with their sales up 98% in 2008. Smith Micro are sitting in one of the sweetest spots of the teens (the next decade), mobile convergence. Wireless data subscribers are estimated to increase almost 20 fold to 757M by 2013 and SMSI has the suite of products the carriers and OEMs need to enable this massive migration and growth that is being fuelled by Gen Y. That is SMSI’s current story and I think it is a good one.

SMSI had an excellent fourth quarter and the share price has moved up since them; however, there remains a significant opportunity as they continue to expand margins and sales throughout 2009. They are sitting at the start of a massive technological change wave and are well placed to be sucked up in the tornado. SMSI has high growth and no debt. That’s a wonderful combination to ride out the rest of this recession and should help propel them when the good times return. The last time I penned any serious thoughts about SMSI I said: 

SMSI sit squarely in my “show me the money” box. All the trends have been good except GAAP eps, so let’s look at those.

That was back in mid 2008, I’ve now updated their GAAP earning. Unfortunately Smith Micro has failed to show me the money, but fingers crossed 2009 will change that.              

As I mentioned in my last post, SMSI have now reported Q1 2009 earnings. GAAP earnings were $0.01. To be fair to SMSI, GAAP earnings is not the best measuring stick. While I generally dislike non-GAAP earnings, SMSI have a lot of non-cash tax and other charges. One easy shortcut is to use Non-GAAP earnings and subtract stock compensation, as I showed in my last post. Another way is look at the net cash provided by operations, since 2006 that has been $9.9 million, $18.3M and $16.4M in 2008. A third and more detailed method is to ignore earnings altogether and concentrate on cash.

Looking forward analysts expect SMSI to earn $0.69 this year and $0.78 in 2010 (non-GAAP) and despite the predicted no growth this year and a mere 13% in 2010, analysts are expecting 19% growth for the next five years. I am normally highly sceptical of analysts five year predictions and as a rule heavily discount them. While I’ll discount those predictions for SMSI, I can’t help but think analysts may actually be underestimating the opportunity SMSI has in revenue terms. Unfortunately even if SMSI hit that amazing growth in revenue, it is unlikely shareholders will enjoy comparable growth in earnings and cash flow.  Operating income took a large hit in 2008, falling from 16.1% of sales in 2006, to 5.8% in 2007 and down to a paltry 2.8% in 2008. The primary reason for this has been the massive increase in R&D which has increased from 14.5% to 31.3% over the same period.

An investment in SMSI is based in part on the faith that the increased R&D expenditure has been a wise investment in the future. I think the large number of customer signings in Q4 is proof that the investments were smart. At 2008 year end SMSI had $36.6 million in cash and cash equivalents and short-term investments and $47.7 million of working capital.

SMSI have an acquisitive history.

In 2006 they acquired PhoTags for $2.2 million. In 2007 they acquired Insignia for $17.4 million and Ecutel for $8.0M, eFrontier for $5.1M and had to payout an additional $3.5M to conclude the PhoTags acquisitions. Rather than digest all those SMSI continued the binging in 2008; acquiring the net assets of PCTEL’s Mobile Solutions Group of $60.9M. Dissecting all those purchases is difficult and muddies the waters considerably. The tell-tale sign of the acquisitions is the $84.5M of goodwill sitting on the balance sheet. That’s 47% of their assets.

Risks

While SMSI list the usual risks like customer concentration I see the primary risk in the evolving nature of software design away from the corporate structure to individuals and loosely knit communities. Open source and direct software sales as inspired by Apple Aps is the bull in the china shop no-one is talking about. Smith Micro’s market is highly competitive and subject to rapid change. I have been following SMSI for a few years and have seen them nimbly adapt to the changes. When I first invested I expected the main growth driver to be a compression product called Stuffit, which has almost faded in to obscurity. Then came and went music kits and now security and connectivity products have emerged as the growth driver. SMSI have been able to deliver the right product at the right time thus far. However, their acquisitions may not have been the best use of shareholder funds and muddy the waters considerably. The other large risk is competition from the likes of Microsoft. Would anyone be surprised if Softie built Smith Micro’s functionality into their next mobile OS release?

A quick look at SMSI

from a Hewitt Heiserman’s It’s Earnings That Count perspective.

Defensive profit: subtract capital spending and acquisitions from cash flow. There are a few other finer points, but after checking I am comfortable ignoring them for SMSI.

• Cash $16,449
• Acquisitions (26,892)
• Capex (294)
• Sum ($25,150)

The large negative results suggests SMSI has a negative defensive income and therefore may struggle to fund their own expansion. “But” you say “that is just from the last quarter” [mid 2008] with three acquisitions. OK, so let’s look at the 2006, 2007 and 2008 annual statements. 

So in 2006 SMSI possibly eked out a defensive income, but 2007 and 2008 paint a dreary picture. Keep in mind how SMSI like to claim their four years of consecutive rising earnings, but seldom mention their failing GAAP earnings or their falling cash from operations. Heck if I keep telling this story I might convince myself to sell. SMSI fail on the defensive profit measure and as such may not be able to fund their growth. 

Enterprising profit: divide EBIT by sum of stockholder equity and debt. In 2008 for SMSI that was roughly 2701/165,404 = 0.016 or 1.6%. Heiserman said “If the return is over 18%, the company probably has enterprising profits”. At 1.6% it looks likely that SMSI also fails to have enterprising profits. You may wish to do the longer version to confirm that. If they are failing to generate an enterprising profit they are failing to create value.

In summary this quick look using the Hewitt Heiserman’s shorthand version suggests that SMSI is not creating value nor can continue to fund their own acquisitive growth. However, that does not categorically mean that SMSI and its shareholders can’t prosper going forward.

Further Notes

Following is an old note by Stan Huber. It was in reference to SMSI, but highlights an excellent approach to investing in any “story stock”. This was written in late 2006 or early 2007 so the products have changed since then.

“The best way I’ve found to get comfortable with companies like this is to get a detailed understanding of their products, the dynamics of their target market, and what the competition is apt to be. You then wait for verifiable milestones to be achieved. I want to see at least two carriers adopt QL Music by the end of the year. I want to see no cracks in the Verizon partnership. I want to see a handset maker adopt StuffIt in the first half of 2007. I want to see a carrier implement a StuffIt handler on the network side. And so on. All along, I’m listening to what management is saying and how closely it correlates with reality. Achievement of the milestones and confidence in the predictions of management build my confidence in the company over time.” Stan Huber aka TMFPlatoish

Stan’s Story Stock Steps

1. Get detailed understanding of products and dynamics of target market.
2. Understand the current and possible future competition.
3. Create a list of verifiable milestones.
4. Listen to what management say and compare it to what happens 

If you add Hewitt’s defensive and enterprising perspective to that then you stand a good chance of sifting the wheat from the chaff. You’ll also know whether the story is panning out or a wash out.

General Guidelines on Investing in Story Stocks

• Avoid infatuation. Almost any story can be made to sound good. Don’t fall in love with a story.
• Diversify. The likelihood of you picking a winner is low, very low. Maybe 1 in 20. So diversification is essential. You need to invest in many story stocks if you hope to ride one winner.
• Step into a story. There is no need to invest heavily all at once. Don’t be afraid to miss the train. Once you’ve decided to get on board then sit down get comfortable and more familiar with your surroundings. Once you’re moving and have seen a couple stations go by to confirm you’re on the right track, then add to your investment if you still see an excellent risk/return picture. 
• Cut and run. You need to cut your losers. If the milestones are not met, if the company fails to create value then you need to sell out and preserve your capital. You can always buy back in if the story improves. Preservation of capital is vital in all forms of investing. Take you losses, they’ll build your IQ (investing quotient).

Summary

SMSI are well positioned on the edge of the wireless tornado. Whether they get sucked up Inside the Tornado depends on their execution and on the powerful competitors like Microsoft who are no doubt eying this market.
Smith Micro have carved out a strong niche position and forged many strategic partnership with carriers, PC and device manufacturers. Despite a changing product line up and the disappointment of StuffIt, they have manged to evolve through acquisitions and internal R&D and grow revenues for the four consecutive years. 2009 looks likely to be a fifth year of growth. An investment in SMSI appears to have a lot more upside potential over the next year than downside risk. I continue to want SMSI to show me the money. To achieve this it is essential they bring operating costs back under control after they ballooned to 76.8% in 2008 up from 66.1% in 2007 and 46.7% in 2006. Watch these costs closely! 

Smith Micro have taken shareholders funds and any earnings and ploughed them back in to an acquisitive growth strategy. There is a chance this may pay off and they finally appear to be signing the deals required to make it happen. Smith Micro has a strong balance sheet.  Connectivity and security is the growth driver for the business up almost 100% year on year, though this slowed to 69% in Q1. SMSI remains a speculative investment in the entrepreneurial skills of Bill Smith. 

I am long SMSI as part of a diversified portfolio.

For more details on SMSI:

• Smith Micro’s Website
• Previous Year’s Annual Reports
• SEC Filings
• Non-GAAP earnings history
• Virtual IR Kit

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