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Smith Micro Software, Inc. (NASDAQ:SMSI)

Q3 2008 Earnings Call Transcript

October 29, 2008, 4:30 pm ET

Executives

Charles Messman – MKR Group

Bill Smith – Chairman, President, and CEO

Andy Schmidt – CFO and VP

Analysts

Maynard Um – UBS

Lauren Ye – JP Morgan

Scott Sutherland – Wedbush Morgan Securities

Chad Bennett – Northland Securities, Inc.

Eric Kainer – ThinkPanmure

Kevin Dede – Morgan Joseph

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Smith Micro Software fiscal third quarter 2008 conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator instructions) I would now like to turn the conference over to Charles Messman with the MKR Group. Please go ahead.

Charles Messman

Good afternoon, and thank you for joining us today to discuss Smith Micro Software’s financial results for fiscal 2008 third quarter, which ended September 30th, 2008. By now, you should have received a copy of the press release discussing our third quarter results. If you do not have a copy and would like one, it is available at www.smithmicro.com, or by calling 949-362-5800, we will fax or email you one immediately.

With me on today’s call are Bill Smith, Chairman, President and Chief Executive Officer; and Andy Schmidt, Vice President and Chief Financial Officer.

Before we begin the call, I want to caution that on this call, the company may make forward-looking statements that involve risks and uncertainties, including, without limitation, forward-looking statements relating to the company's net revenues guidance for fiscal 2008, our financial prospects and other projections of our performance, the company's ability to increase its business and anticipate timing, and financial performance of new products and potential acquisitions.

Among the important factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements are changes in demand for our products from our customers and their end-users, new and changing technologies, customer acceptance of those technologies, new and continuing adverse economic conditions, and the company's ability to compete effectively with other software companies. These and other factors are discussed in the company filings with the Securities and Exchange Commission, including its filings on Forms 10-K and 10-Q. And could cause actual results to differ materially from those expressed or implied in any forward-looking statement.

The forward-looking statements contained in this conference call are made on the basis of the views and assumptions of management regarding future events and business performance as of the date of this call, and the company does not undertake any obligation to update these statements to reflect events or circumstances occurring after the date of this release.

At this time, I’d now like to turn the call over to Bill Smith, Chairman, President, and CEO. Bill?

Bill Smith

Thank you, Charles. Good afternoon everyone, and welcome. And thank you for joining us. Today, we announced our third quarter 2008 financial results. And I’m very pleased to say we had another record quarter for the company. During the quarter, we grew our revenues over 30% year-over-year to $26.6 million, and grew over the second quarter by 14%. This is our seventh consecutive quarter, in which we have achieved a new record in revenues, a significant milestone for our company.

I’m extremely pleased with the performance of the company and the overall demand we are experiencing for our total product portfolio. Our core business of connectivity and security continues to lead the way with growth of 107% year-over-year. Importantly, we added some key new customers, which I will talk about later in the call.

From a non-GAAP or pro forma earning standpoint, our net income increased in the quarter to $6 million or $0.19 per diluted share. This compares to $3.6 million or $0.12 that we reported in the second quarter of this year. Later in the call, Andy will discuss our financials in detail, but I am pleased that we continue to leverage our business model with strong earnings.

As I discussed in earlier calls with you this year, we predicted that the first half of 2008 would be a period of steady growth with the back half of 2008 performing stronger. We believe the results delivered today for Q3 are in line with the revenue guidance we provided earlier in the year. Looking ahead to our fourth quarter, we believe that our Q4 numbers are very solid, and we currently expect to close the year in the middle range of the annual revenue guidance for 2008. This would represent over 35% growth year-over-year with revenues up from $73.4 million in 2007.

I am very pleased with our recent announcement of a major new customer in Dell Computer. For the past 10 months, we have been deeply involved in the design and development of Dell’s Universal Connection Manager and Central Point Software. This new product for Dell recently began shipping in Dell’s E-Family of notebooks, which are embedded with mobile broadband modules. I will spend some time on this later in the call as I see this as a significant new market for the company and as we continue to expand our customers and the overall markets that we play in.

I also would like to note that our largest customer, Verizon Wireless, represented 25% of total revenues during the quarter, which is down from 39% last quarter. We consider this to be a significant accomplishment as we further expand our customer reach while eliminating customer concentration as a Smith Micro business issue.

I also should note that during the quarter, we had international revenues of 10% as our expansion plans throughout the world continues to make good progress.

But now I’d like to turn the call over to Andy Schmidt, our CFO, to go over the financial results in greater detail. Andy?

Andy Schmidt

Thank you, Bill. First, let me go over our customary introductory items. As we have in past quarters, we have provided non-GAAP results and a reconciliation of non-GAAP and GAAP results. The non-GAAP results discussed on this call net out amortization of intangibles associated with acquisitions, stock compensation related expenses, and non-cash tax expense to provide comparable operating results. Accordingly, all results that I refer to in my prepared remarks for both 2008 and 2007 are non-GAAP amounts.

Our earnings release, which will be furnished to the SEC in Form 8-K contains a presentation of the most directly comparable GAAP financial measures and a reconciliation of the differences between each non-GAAP financial measure provided in the press release and the most directly comparable GAAP financial measure. Earnings release can also be found in the Investor Relations section of our Web site at smithmicro.com.

All right, let’s discuss our detailed third quarter results. For our third quarter, we posted revenues of $26.6 million in earnings of $0.19 per diluted share. Total revenues of $26.6 million increased from revenues of $20.4 million in the third quarter of 2007, an increase of 31%. International revenue was approximately $2.8 million this quarter across all business groups.

Connectivity and security posted another record quarter with revenues of 16.6 million for the quarter as compared to $8 million last year, an increase of 107%. Consumer posted a strong quarter of $6.4 million as compared to $3.7 million last year, an increase of 72%. Third quarter revenue for multimedia was $2.1 million, down from $8 million in Q3 of 2007 due to a shift in product mix, specifically a shift from music kits to software downloads, and CDs. Device solution revenue was approximately $1.15 million for the quarter as compared to approximately $381,000 last year. And finally, we reported approximately $326,000 of other revenue, which compares to approximately $300,000 for third quarter of 2007. The total deferred revenue at September 30th, 2008 was approximately $2.4 million.

Okay, switching to gross profit. Non-GAAP gross margin dollars of $22.4 million increased $7.9 million or approximately 55% from the same period last year. Of key significance, while our revenue increased 31% year-over-year, our gross margin dollars increased 55% for the same period. As follows, non-GAAP gross margin as a percentage of revenue was approximately 84.2% for Q3 2008 compared to 71.1% for Q3 of 2007.

Non-GAAP gross margins by business unit were as follows, connectivity and security 97%, consumer 72%, and multimedia 66%. For device solutions and other revenue, gross margin dollars totaled approximately $800,000. As we’ve noted before, our margins are driven strictly by product mix.

Okay, switching to operating expense. Non-GAAP operating expenses for the third quarter of 2008 increased to $15 million, or an increase of approximately $400,000 from Q2 of 2008. The increase is as expected, and is attributed to additional engineering resources deployed to meet new customer product deliveries scheduled for future quarters. Non-GAAP operating margin for the current period was an exceptional 27.6%. This exceeds our previous guidance, and is above what we considered to be our benchmark 25% operating margin for growth quarters. Current period operating margin compares to approximately 29.7% for Q3 of 2007. Non-GAAP net income for the third quarter was $6 million or $0.19 per diluted share as compared to $6.9 million or $0.21 last year.

From a balance sheet perspective, our cash position closed at $31.2 million at September 30th, 2008, a decrease of approximately $56.3 million from the beginning of the year. The decrease from the beginning of the year is attributed to PCTEL MSG Group acquisition in January 4th, 2008.

Accounts receivable at September 30th, 2008 increased $20.4 million from $13.2 million at the beginning of the year driven by increased sales; the timing of new sales, which are typically at the end of the quarter; and, newly acquired customer accounts associated with the PCTEL MSG Group acquisition.

Networking capital at the end of the quarter was $43.8 million.

Cash generated from operations for the three quarters of the year was approximately $7 million, and was affected by an increase in accounts receivable, which is simply timing and growth related. Taking out the accounts receivable timing effect, we generated approximately $15 million in cash in the first three quarters of 2008. Primary uses of cash included the acquisition of PCTEL MSG Group, unrelated legal and banking fees for approximately $60.3 million, and capital expenditures totaling approximately $2 million.

As a quick summary of operations, irrespective of the challenging economic times under which we operate, we have an outstanding business model. Year-to-date 2008, while we’ve grown revenues 35%, we’ve grown gross margins 53%. And at the station that while we’re growing revenues, we’re also increasing the quality of our revenues. In terms of operating margin, we’ve integrated our largest acquisition to date, the PCTEL MSG Group, which was by far our largest competitor, and have since returned to an impressive mid 20% plus operating margin. We completed the integration transition in only two quarters. Finally, we are a business which generates cash. Netting out our growth related accounts receivable increase, we’ve generated $15 million in cash from operations so far this year. Or consider it another way, approximately 28% of our revenue becomes available as cash to be reinvested in our business.

Looking forward to the balance of 2008, we’re on track with our previously stated guidance of revenues between $95 million and $105 million for the year. We feel that we are right in the middle of the range. For fourth quarter, we expect to post non-GAAP gross margins between 80% to 82%. In terms of non-GAAP operating margin, we are targeting our benchmark 25% as we expect to continue to invest in human resources.

In terms of new contracts, the Dell contract should be expected to be a consistent quarterly contributor, and as a typical Smith Micro contract, which fits our modeling philosophy. The contract is a variable revenue model with upside potential, yet with a minimum revenue floor to compensate for our engineering commitment. In other words, as with all of our business, we build our contracts to grow with the market and don’t take money upfront. We’re building for the future.

Finally, we expect our 2008 cash phase tax expense to be 20% or less of non-GAAP net income. In terms of housekeeping, we expect to file our current reporting period 10-Q on time. And at this point, I’ll turn the call back to Bill.

Bill Smith

Thanks, Andy. Much of the company’s growth continues to be derived from our core competency of the connection management business. We have now fully integrated the acquisition of the PCTEL MSG Group. Sales for the connectivity and security group in Q3 grew – were up over 107% year-over-year representing an organic growth rate of 28% from the previous second quarter. Connectivity continues to be our largest contributor to revenues. And I am pleased with what we are seeing from a macro view in the marketplace today.

Most importantly, we’re starting to see a significant broadening of our customer base as we bring in several new types of customers that we haven’t traditionally done business with. Not only as seen with in the addition of the preeminent notebook manufacturer in the world, Dell Computer, to our established base of carrier customers, but we are also beginning to see, what I would call, a new breed of carrier customers who offer new high-speed 4G technologies as the demand for wireless connectivity expands throughout the world.

Significantly for our industry, another positive indicator that the demand for connectivity and security products is strong is the introduction of new wireless connectivity chipsets from leading silicon vendors such as Ericsson, Intel, and Qualcomm, with its Gobi brand. Embedded wireless chipsets on the motherboards of PCs is very early in the adoption, what we believe we have positioned the company to be the dominant player providing enabling connection management software. Early reviews of the Dell solution created by Smith Micro gave it the distinction of being the Best of Breed, a label that has frequently been used to describe our wireless products.

Today we announced that we acquired certain assets related to the mobile broadband business unit of Tatara Systems’ Inc. These assets include certain intellectual property, patents, and technology related to the broadband connectivity space. The acquired products include connection management software and a mobility gateway software to support security, session management reporting, and AAA (authentication, authorization, and accounting) for carrier deployments. Tatara also had a solid group of customers that fall right into Smith Micro’s core competency, and we look forward to bringing them in the fold.

We are very pleased to be able to call Bell Mobility in Canada a customer and O2 in the UK via relationship with the Cloud, a customer as well, as a result of this transaction. We have already begun to discuss the power of the Smith Micro portfolio of technologies with both firms. With the acquisition, we also acquired a talented group of engineers in Vancouver, Canada that will complement us well. The wireless industry is clearly continuing to consolidate, where the market leaders like Smith Micro continue to grow rapidly and lead the evolution of the market forward.

In these current times of economic uncertainty, we believe that there will be opportunities for us to deploy capital in a favorable manner, such as this Tatara transaction, to enhance our leadership position through the purchase of companies and technologies.

Looking ahead, we expect our connectivity and security business segment to continue to be a strong growth driver for the company during the remainder of our fiscal year and moving in to 2009 as the overall wireless market continues its rapid adoption rate throughout the world.

Now, turning to our consumer business segment, we are also pleased to see that our consumer segment continues to show strength as revenues increased 72% year-over-year. Although volatility is present in today’s market, our consumer group offers a broad base of titles that had been – that have seen consistent sales growth, and part of this is due to today’s mix of products as 77% of our consumer software sales are related to the Macintosh. And as reported, Apple broke quarterly sales records for its Mac line of desktops and notebooks. Some key contributors to our strong quarter for the consumer group with the sales of StuffIt, VMware Fusion, and our graphics line of products led by our Poser title. We will continue to watch this business segment closely, but we do believe we are positioned very well for the long haul.

Moving on to multimedia, as we reported last quarter, we continue to see changes in how our customers deliver their music and multimedia products. In addition to modifying their distribution models by focusing more on downloads or new subscription based models, there appears to be a reduction in the promotion of handset sales by pairing handsets with multimedia management software. These trends have resulted in further sales erosion for this business segment. That said, we see our multi – we see new multimedia customers on the horizon. This should pump new energy back into our multimedia business case. We are also continuing to see opportunities for collaboration of efforts between our multimedia and device solutions group as we provide the market with new exciting products that always Smith Micro is positioned to create.

Looking at our device solutions group, we’re continuing our focus to build our device solutions business through our strategic relationships with HTC and Huawei. Huawei continues to deploy two to three new device management solutions per quarter for carriers abroad, the most recent being in Cambodia and Kuwait. I am pleased that we are starting to see the opportunities beginning to emerge within this business segment. And I expect to see continued progress this year in moving into 2009.

In conclusion, we are very pleased with the progress we’ve made during the first three quarters of 2008. We achieved several key milestones to date while continuing to report record financial results, a trend that I’m pleased to say has happened over the last seven quarters. As we look at the broader marketplace, we think it represents an opportunity to invest in new product concepts that will maximize our growth potential as the market rebounds, as well as open up the opportunity for acquisitions that may not had been there in the past.

As I mentioned to you earlier, we believe Q4 will be inline with the revenue guidance of $95 million to $105 million we provided earlier this year as we expect to land in the midpoint of that range for the fiscal year. We continue to position the company with a very strong foundation for long term sustainable growth. I am very excited about the growth in revenues, profits, and cash that we have booked already in each quarter of 2008. In the year where many are focused on what is wrong in our economy, we have prospered. Customer concentration issues are a thing of the past as our largest customer represents only 25% of sales in the current quarter down from 64% going into 2008.

I would also like to compliment my team at Smith Micro for the expeditious integration of the PCTEL MSG acquisition. This consolidation of the wireless software space has positioned us in a strong leadership role. We now have working relationships with over 40 wireless carriers and service providers around the world. We have added a significant new customer in Dell Computer, expanding our reach into the PC manufacturing world, and we expect to broaden that base. And as we continue to build a very compelling business case, our products and technologies could not be more relevant in a world where mobile devices and mobile laptops require broadband wireless connections.

With that said, I would like to open the call to questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question and answer session. (Operator instructions) And our first question comes from the line of Maynard Um with UBS. Please go ahead.

Maynard Um – UBS

Hi, thanks. Can I just start with getting the stock comp and amortization by the different sales and marketing, R&D, and G&A?

Andy Schmidt

Sure. All right, Maynard. Stock comp totaled $3.4 million for the period, of which case approximately $100,000 is associated with cost of sales. We have got $840,000 associated with selling and marketing. Approximately $915,000 associated with research and development, and approximately $1.5 million with G&A. Are you interested in amortization as well?

Maynard Um – UBS

Yes.

Andy Schmidt

Amortization has totaled approximately $2 million for the period across all groups, in which case $875,000 is related to cost of sales, $585,000 related to selling and marketing, and $500,000 associated with R&D.

Maynard Um – UBS

Okay. Great. And then, a question on the guidance, when you gave the guidance, it was presumably in the backdrop of, obviously, something better. I guess, can you just go into a little bit more detail about your guidance going into next quarter? I’m a little bit, I guess, positively surprised that you’re reiterating at the mid part of the range. But can you talk a little bit more about that visibility, if there’s been any kind of shifts within that guidance you’re seeing? Is it the more the connectivity and less the consumer, or any of the parts of the businesses?

Bill Smith

Yes. Okay, Maynard. I think the way we viewed it is we’re being fairly conservative in our view on the consumer side because we feel if there’s exposure that would be the place we’ve seen it or where we would see it. But candidly, if you look at these numbers that we just gave you, you can see that consumer’s up quarter-over-quarter. We expect that – very well be up quarter-over-quarter and fourth quarter as well. But we think we really factored in a very conservative look. So we’d like to say that we’re going to be at the top of the range, but we think the midpoint range in the current economic times is pretty solid performance, and I think a 35% year-over-year growth should bode well for our shareholders.

Maynard Um – UBS

And I guess in terms of linearity, I guess some of the comments you made about the balance sheet made it sound like it was back and loaded, so you didn’t really see a kind of weakness going in towards the end of the quarter in September. Is that a fair statement?

Andy Schmidt

Yes. We didn’t see that. We’ve already seen, through the last couple of periods, key customers, let’s say, playing the usual cards that you would expect in this type of economy, which includes managing inventories tighter, pulling inventory levels in, et cetera. We’ve seen that across all the business groups, but that’s already been played out in third quarter as much as we’ve seen. So as of right now, I think it’s been a fairly consistent movement by the key customers as far as being more conservative in their models. So at this point, with our visibility we have so far, we’ve already seen some very conservative movements by our customers. And we don’t expect anything unusual just based on the visibility we have so far.

Maynard Um – UBS

Okay. And then, just lastly from me, I know there isn’t a whole lot of visibility into 2009. But if you look at the last market downturn in terms what was happening to your revenues, I mean they were down more than 20% year-over-year. I’m not saying history is any kind of judge of what’s going to happen in the future, but – and you’re a completely different company. But I guess, how should we kind of frame that up in terms of relative to the market versus the kind of secular growth of what you’re talking about from embedded wireless and other key markets that presumably we’ll see even some growth in the top market? Thanks.

Bill Smith

Okay. Well let me kind of tackle a couple of things. First off, yes, we contemplated actually giving you a top line revenue guidance for 2009 on this call. In the spirit of just being prudent and letting more of the current economic environment play out, we’ve chosen to kind of delay it. We have a couple of opportunities where we could bring it to the street. And we’ll probably choose one of these two. The first would be at the UBS conference in the middle of November, and the second one would be at the Needham conference in the beginning of the year. I think we might lean more towards the second option, and give you annual guidance during our talks at the Needham conference. So I would encourage all analysts to listen to that presentation.

We look at where we’ve come and what’s going on in the marketplace. I mean think there’s a couple of points that probably should be made. I know that many folks in the street tend to kind of try to watch what happens at the PC card manufacturers ,and then extrapolate that’s going to be what the look and feel of things is going to be like at Smith Micro. I think things have changed. I think that old axiom doesn’t really work that well any longer. And I would encourage you guys to maybe take a broader view going forward. I actually think what happens at Smith Micro might be more in a parallel of what happened to Qualcomm. So I think that’s the view that you’d maybe want to focus on going forward.

As far as the downturn in the economy and what effect might happen in the beginning of the next year, we are very bullish about our business case. We are very cognizant of the difficult economic environment that we operate in. Clearly in my business career, I’ve never seen one as challenging as this. But I have to say, the honest truth is we’re bullish.

Andy Schmidt

Just adding on to what Bill commented on, keep in mind, obviously, that we’re much broader as far as customer reach as we end 2008 than we were ending 2007. And a different indicator we looked at is when we look at the deal volume passing through our organization, it is increased. It is not decreased whatsoever. So there are a lot of significant sized companies looking to get into this space, and whether – we’re basically the leader in the space. So what we can do in 2009 is basically look for growth just in terms of new customer accounts.

Maynard Um – UBS

Okay. Thank you.

Operator

Thank you. And our next question is from the line of Lauren Ye with JP Morgan. Please go ahead.

Lauren Ye – JP Morgan

Hey, guys. How are you?

Bill Smith

Good.

Lauren Ye – JP Morgan

Yes, first question, just – I guess presumably, Dell did contribute to this quarter to connectivity. I just wanted to know, I guess, what was the first day that they did ship this quarter. And then of the $16.6 million, how much of that is Dell and how much of it is growth through volume of your existing customers, either quantitative or qualitative comments would be fine.

Andy Schmidt

Okay. As you can probably expect, we can’t give you the exact Dell number based on contract. They are not yet a 10% contributor. Verizon is our key 10% contributor, but we saw some nice step ups across the board and connectivity from all of our different participants, including AT&T, Sprint, and so on. So it was a very solid performance across the board with Dell being a new entrant. Again, as I commented before though, they will be a consistent contributor each quarter. And again, it’s a typical Smith Micro contract that’s variable. We saw full quarter’s worth of participation from Dell this period so it wasn’t a partial quarter. So maybe that helps you.

Lauren Ye – JP Morgan

Okay. Yes, maybe if I could ask it one other way, which is just from the volumes of existing customers, did the growth there – was that about the same as last quarter, above or below? I just kind of want to understand of the existing just volumes from connectivity products. How is that doing?

Andy Schmidt

Volume of the existing products taken into account, everyone but Dell, it’s a – there was an increase.

Lauren Ye – JP Morgan

Okay, very nice. And then, just in the multimedia, we’ve seen this, I guess, product mix shift at Verizon for some quarters now. Have we reached a steady state where maybe the revenues can actually kind of, I guess, trend up from now on just due to volumes or are we still seeing a product shift there?

Bill Smith

I think we’ve seen – reached a steady state. We do have a number of new accounts that we believe we’ll close in the next quarter or so that will contribute and cause growth in this area. And as I said in my prepared comments, we’re seeing more and more opportunities for utilizing our multimedia technologies along with our device solutions technologies to create new opportunities. We feel that the downward slope has been reached, and should be behind us. And we’ll move forward from here.

Lauren Ye – JP Morgan

Okay. And then, the new – or the new accounts you were chatting about, are those music managers or are they multimedia managers?

Bill Smith

I got to keep a few secrets.

Lauren Ye – JP Morgan

Sounds good. Okay, great. Thanks, guys.

Operator

Thank you. Our next question is from the line of Scott Sutherland with Wedbush Morgan Securities. Please go ahead.

Scott Sutherland – Wedbush Morgan Securities

Hi. Great. Thank you. Good afternoon.

Bill Smith

Thanks, Scott.

Scott Sutherland – Wedbush Morgan Securities

A couple of questions for you guys, first of all, if you’re saying that Dell is one of the three new deals are ramping up, they are seven-figure deals. Can you kind of discuss how the other two are ramping at this point in time?

Bill Smith

That’s a great question, and your guess is right on. As I said in prior calls, there would be three customers that would come on line during 2008. They gave us the good indication that we would be able to grow revenues and profitability in the back half of the year, which obviously this quarter proves out. The first one, as I’ve said, was a headset provider of multimedia play. It did provide some revenues the first quarter, but hasn’t really given us the lift we thought. And I think I mentioned that on the last call. Dell was the number two name in that list of three. We had been working with Dell for about 10 months. This has been a long term effort, and a lot of people here at Smith Micro have worked very diligently on this project. And it is a big deal for the company moving forward. The third opportunity has yet to be announced. I don’t think you’re going to have to wait too much longer. and it is a carrier, and we’ll go from there.

Scott Sutherland – Wedbush Morgan Securities

And that last one as well is a signed, executed deal?

Bill Smith

Right.

Scott Sutherland – Wedbush Morgan Securities

Okay. Again, you mentioned this consumer software, and in that area, we thought there might be weakness as well but obviously, it’s doing very well. This has been a seasonally stronger quarter. Can you talk about with one left behind you now, how you see that business tracking, and that you’re seeing typical seasonality being overcautious with what you’re seeing right now?

Bill Smith

We’re very happy with what we see. I guess I’m being cautious just because I listen to all the pundits too often, and they make me think I should be cautious. But I think if you look at what’s happening, in our business case, we’re very pleased with everything that we see.

Andy Schmidt

And just kind of following up on the comment I made a little bit earlier, we’ve been working out with this questionable consumer confidence for a good six months. So we’ve already seen the large retailers on the consumer side already stringing inventories, et cetera. So everything’s been working under this particular guise right now of consumer confidence question, so that when we look at Q4, there shouldn’t be any unusual activities from a perspective of inventory management.

Scott Sutherland – Wedbush Morgan Securities

Okay. And my last question, you mentioned this earlier in your comments. When you look at ’09, you talked about being more tied to things like Qualcomm Gobi, Ericsson, Intel, Silicon India notebooks. Do you see that and the connectivity segment being tied, same percent like 20% to 30% tied more to Silicon rather than cards and other connectivity solutions? And how do you think that opens up or creates different opportunities for you guys to partner with players in the market?

Bill Smith

Yes. It’s a good question, but I don’t know if I have an answer for you yet. We are working diligently on our modeling for 2009 at present. And I need to go through that before I can really comment to you. Let’s look at it this way, we see that the trends remained very, very strong for USB devices and PC cards. I think the key message here is that these embedded devices, unlike the embedded devices that came to the marketplace a year and a half ago or so, are not overpriced. They are very cost effective. And we think that the adoption of these embedded chips from the likes of Ericsson and Intel and Qualcomm have a very strong likelihood that it’s going to take off. I think 2009 and beyond will bear that out. And we just have to kind of watch it. I do think that it’s a major driver in the marketplace.

And maybe kind of – really not to get too long winded about this, but I still see a very strong opportunity for us to continue to sell all the products we sell to carriers who want branding and they want to accentuate the things that they think make them different from other carriers offering similar service. So I think that that part of the market continues and will grow. With the launch of WiMax, you’re going to see a number of new names entering into the carrier space. It started at the end of this year. Then you’re going to see all the PC manufacturers who want to market product to specially the enterprises, looking to have connectivity solutions as part of their own overall offering. And then lastly, we haven’t talked about it much, but the growth of the direct and surprise connectivity space is really continuing to pick up. We see a lot of very large names on the enterprise side that we’re working with directly who want to deploy wireless connectivity broadly around the world. And they want to buy products directly from us, so all three of these focuses within the wireless space are very strong. And frankly, all of them should still be considered in the early stage of the growth.

Scott Sutherland – Wedbush Morgan Securities

Okay, great. Thank you.

Andy Schmidt

Operator, can we have the next question please, if there is one? Operator, are you there?

Operator

I’m here, sir. Sorry, it was muted. And ladies and gentlemen, the next question is from the line of Chad Bennett. One moment, please. Please go ahead, Mr. Bennett.

Chad Bennett – Northland Securities, Inc.

Hey, by the way, good quarter in this environment. Just a couple of questions, Andy, maybe a housekeeping thing or two, so I believe you indicated that there were not any other 10% customers outside of Verizon in the quarter.

Andy Schmidt

For this particular period we had – just for this period, not year-to-date, we did have AT&T just make over 10%, right at about 11%.

Chad Bennett – Northland Securities, Inc.

They did. Okay, okay. And then, on the Dell arrangement, from a revenue recognition standpoint, Andy, is it based on shipment? Or I remember you talked about activation in prior embedded deals, what are kind of the terms, as much as you can say?

Andy Schmidt

I think the best way to look at it is it’s a ratable approach, which means that, again, we don’t take any revenue upfront. And during the life of the contract, there’s going to be a consistent contribution.

Bill Smith

But it’s based on engineering deliverables as far as how we increase revenue, and actually performance. So best way I can describe it is it’s a variable with upside. But in this size of a contract, we always build in, what we call, a floor, considering the amount of engineering resource we put on support of this type of project.

Chad Bennett – Northland Securities, Inc.

So it’s not necessarily based on units?

Andy Schmidt

Not necessarily based on units, but variable of some upside.

Chad Bennett – Northland Securities, Inc.

Okay. And if we look at – I think a number of people asked the question a couple of different ways, but if we look at what your organic growth rate was in the connectivity side this quarter of I think you said 28%, and we annualized the PCTEL deal starting Q1 in next year. The organic growth rate that you put out this quarter, is that how we should view the connectivity business looking out two, three quarters or should we view it differently?

Andy Schmidt

Well, here’s something to consider, one of the key reasons we purchased the MSG group is we, as a company, are 100% focused on software, where PCTEL was primarily a hardware company. As such, when we went into – when we looked at the integration, it wasn’t just engineering integration. We basically work on the contracts to actually turn them into, what we call, a Smith Micro contract and Smith Micro customer relationship. So the fact that AT&T, who was previously a PCTEL customer, notched over 10% has a lot to do with how we’re managing the contract versus our predecessors.

So in terms of organic growth, we took on customers and product from PCTEL that were performing at a certain level. And we’ve already seen it step up considerably. So we consider that to be organic growth from a Smith Micro perspective, not acquired growth. So when we look across all accounts, we’re seeing very strong performance. Our existing accounts and connectivity are growing. And when we take a look at how we’ve done with the PCTEL acquired customers, we’re seeing some significant step up in growth on those customers as well based on how the product is being managed.

Chad Bennett – Northland Securities, Inc.

Okay. Maybe this is a question for Bill. Bill, in looking at what the laptop opportunity on the connectivity side, with respect to the specific software, I believe the Control Point software that you’re in with Dell, what are competitive laptop makers? Do they have any comparable software solution right now that allows them to give the same functionality as Dell does with their software or where are we at from that standpoint in terms of other vendors out there?

Bill Smith

Dell now creates their own software. They have a very large team that is dedicated to that process. There is one other competitor that has built the product, and we are seeing them in the marketplace. They seem to not build as good a product, and maybe the product doesn’t work quite as well. And we’re using that as a significant competitive advantage. We look forward to beating them in the open marketplace.

Chad Bennett – Northland Securities, Inc.

Okay. So outside of Lenovo, have the other laptop makers made decisions yet with respect to this functionality?

Bill Smith

You have some. HP is shipping a product that was built by a competitor. Others are in the works, I can’t really comment on the rest.

Chad Bennett – Northland Securities, Inc.

Okay. Fair enough. And then, Andy, just a quick one again, the gap tax rate this quarter was a pretty big number, is there anything, I guess, what’s going on there and can you explain that?

Andy Schmidt

Sure. I got to tell you, one of the – certainly one of the principles in accounting that absolutely make no sense in the real world are gap taxes. There are two key elements that are affecting us in gap taxes. One is the fact that FAS 123(NYSE:R), the stock compensation expense is not tax deductible under GAAP, but you’re taxed on – you’re taxed on a higher number, not taking into account FAS 123, but you apply it to the net income taking into account FAS 123. so you kind of get slammed on that. That number was about $1.8 million for us this period.

The other part has to do with the fact that we’re using NOLs from prior periods. If you look at our balance sheet, you’ll see a very nice number out there as far as what we have as a tax asset. And basically, the way that number got on our balance sheet was back in fourth quarter of 2006. We basically took a reserve off of the taxed NOLs, and pushed it through the P&L to get in the balance sheet. Now appropriately, as we do report pro forma, we pro forma that big net gain in Q4 of 2006. So as we make use of that tax asset, if you will, we don’t see any benefit on our P&L from a GAAP perspective, even though from a real life perspective, we basically get a reduction in tax expense. So those are the two pieces that are in play specifically.

Now, the last part that I’ll kind of comment on is this has been an unusual year for us in that Q1 and Q2, we are running at an operating loss from a GAAP perspective. Again, primarily due to the FAS 123, our expense pro forma, we are profitable. But because we are at a GAAP loss at the operating level on Q1 and Q2 related to the PCTEL acquisition integration, we utilize what’s called the effective tax rate or estimated tax rate method for calculating GAAP taxes. That basically allows you to say, “Okay. If I’m at a tax loss, I can take a tax credit so that I don’t add tax expense to a tax loss.” But now in Q3 of 2008, we’ve shifted to a profit on a GAAP basis operating profit. We’re switching to what’s called the cutoff method. So what ends up happening is it calculates taxes into a more logical manner if you’re profitable, but we have to actually credit back those tax credits we took.

So once again, it’s fairly complicated. But what I can tell you is when we look at Q4 of 2008, if we operate within the guidance that we gave you as far as making – going from a revenue perspective between the $95 million and $105 million, and we operate at 25% up margin, the taxes will work out to where we will be GAAP profitable in Q4. So in other words, all of these will work its way through the wash.

Chad Bennett – Northland Securities, Inc.

Okay. And what shall we use for cash tax rate going forward, and hopefully, you have some idea of what that will be in ’09?

Andy Schmidt

You know what, we’re going to come in better than 20%. Go ahead and model 20% for Q4, but when all’s said and done, it’s going to come in something less. 2009 is going to be really interesting and let me give you an example. Again, we have people modeling 30%, and we’ll just say at this point, stay there. Obviously, these are going to be different tax realities that could come into play in 2009 that none of us can really figure out at this – and by way of example, California, basically suspended use of NOLs for even 2008 due to the budget crisis in California. So it’s hard to say what’s going to happen in 2009 with taxes. So at this point, I think we’re advising everyone keep it at 30% cash taxes and we’ll do our best to do better as we do each year.

Chad Bennett – Northland Securities, Inc.

Okay. That’s all I have, thanks.

Operator

Thank you, and our next question is from the line of Eric Kainer with ThinkPanmure. Please go ahead.

Eric Kainer – ThinkPanmure

Thank you very much for taking my call. Also, congratulations on a fantastic quarter, especially from a profitability perspective. First question is about Verizon Wireless, obviously, 25% of revenues here coming down from about 39%. That means sequentially, it was off between $3 million and $4 million. Could you talk about kind of what the impact were? From your comments, Bill, it almost sounded like you didn’t expect that absolute number to move up again and be “a problem”. Am I reading that correctly or am I just misinterpreting?

Bill Smith

Well, okay. There are two ways of looking at this and they’re all good. Candidly, the Verizon decline comes from the music side. So that’s all baked in, and it’s kind of over with, and that’s part of the issue. On the other hand, we expect to sell more product to Verizon, and we continue to grow the overall absolute revenue dollars on a quarter-over-quarter basis going forward. We just believe we’re going to grow other things even faster. So the net effect is, with new customer wins, and I’ve alluded to it a few times, we expect to dominate the WiMax space, we expect to dominate the PC manufacturer space going forward. Those are big chunks of business. And as much as Verizon – and we hope that it would be a wonderful problem to have if the Verizon percentage had to go up a percentage or two even with all these added customers. So this is all good stuff.

Eric Kainer – ThinkPanmure

Okay. Fair point. Let me ask on kind of the Verizon issue one more time, is Alltel currently a customer for the connectivity manager product?

Bill Smith

That’s a good question. Yes they are. And if indeed, the Alltel-Verizon merger does come about, that would change what I just said because they – we would have to add that in.

Eric Kainer – ThinkPanmure

Okay. And was Rural Cellular a customer of yours before their acquisition by Verizon?

Bill Smith

No, I don’t think so. I don’t know Rural Cellular.

Eric Kainer – ThinkPanmure

Okay. Fair enough. Next is you mentioned WiMax that you intend to dominate that space. Are you part of the zone project ,which obviously Sprint just launched in Baltimore?

Bill Smith

When they’re talking about multi-protocol devices, devices that will operate both on the WiMax and on the CVA networks, the answer is yes.

Eric Kainer – ThinkPanmure

Okay. So those are products that aren’t obviously out yet ,but as those become available, you’ll be part of that.

Bill Smith

Right.

Eric Kainer – ThinkPanmure

And then, the last question is, unfortunately the least interesting, what is the fully diluted pro forma share count that you used this quarter and what number shall we use for next quarter?

Andy Schmidt

Okay. We’re at $31.8 million for this quarter. And next quarter, the safe thing to do is just use $32 million even.

Eric Kainer – ThinkPanmure

Okay. Fair enough. Well, congratulations and good luck, gentlemen.

Bill Smith

Thanks, Eric.

Operator

Thank you. And our next question is from the line of Kevin Dede with Morgan Joseph. Please go ahead.

Kevin Dede – Morgan Joseph

Good afternoon, guys, and let me add my congrats, very nice job in the quarter.

Bill Smith

Thank you.

Kevin Dede – Morgan Joseph

So can you go on a little bit more detail on the Dell deal. I mean, obviously you got the E-Family. Is there a chance that this connectivity software is included in other families of laptops? And how would you see that happen if you did? Are you guys tied to the Gobi module? How does that work?

Bill Smith

Okay. I’m trying to think how I can answer this. Could we see beyond other Dell products? The answer is yes. Are we prepared to announce it today? The answer is no. On the Gobi side, Gobi is one of a number of solutions that Dell is looking at using and we will fully support Gobi as well as these others with our product offering.

Kevin Dede – Morgan Joseph

Okay. How–?

Bill Smith

I hope I did not mix words. Hopefully, that answered your question. I’m sort of limited to what I can say.

Kevin Dede – Morgan Joseph

Understood, yes. That helps, a little more detail. I just wanted to make sure that you weren’t sort of pigeon holed there, and that’s definitely not the case.

Bill Smith

Oh no, no, there’s no pigeon hole at all.

Kevin Dede – Morgan Joseph

Okay. How about some more detail on the acquisition that you announced today? Is the real motivation there, given that there’s already an overlap on connectivity software, is the motivation there just getting your hands on new customers? Or what can that gateway product offer you if you address other service providers?

Bill Smith

We are very intrigued by the gateway product. And in our conversations with both Dell Mobility and O2, they impressed that upon us. We look at that product as being a significant opportunity from a technology standpoint going forward. It’s something that we might incorporate in some of our other server offerings we currently have or expand our offerings to incorporate it as it stands now.

So when we look at this particular transaction, it really is all the things I listed. We looked at it. We said there’s a technology play. There were some patents involved. It had book value. And then we looked at the customers. And I only mentioned two because they were the two largest ones, but there are others. And we looked at what we’ve been able to achieve with the customers that joined the Smith Micro family from the MSG transaction. As Andy has already alluded to, that transaction has already proven to be very successful, and we are growing those customers, and we are growing our presence at those customers. And I would expect that we will do the same thing with the customers we acquired from Tatara.

And then lastly, and this is not insignificant, we’ve gotten an engineering team in Vancouver that is experienced, that’s ready to go to work. And as we’ve been talking about, look at the growth that Smith Micro has had from fourth quarter of last year to now, and you must guess that one of our biggest assets is our people. And one of the hardest things to find is all the new people we need to continue to grow. We have a number of customer wins we haven’t announced yet. But we’re building products for them now, and we need people to do that. So adding an experienced team who knows the business in Vancouver is a very valuable thing. And it shouldn’t be lost on anybody that paying folks in Canadian dollars, when you mark that against US dollars, is also an advantageous thing.

Kevin Dede – Morgan Joseph

Okay. Good point. Just for a little more detail, how many heads were you at the end of June and where will you – where are you now with this acquisition done?

Andy Schmidt

We’re about 380 full time equivalents.

Kevin Dede – Morgan Joseph

Is that now, Andy?

Andy Schmidt

Yes.

Kevin Dede – Morgan Joseph

Okay. How about the end of June, just to refresh my memory?

Andy Schmidt

Maybe about 10 less. It wasn’t a very significant difference.

Kevin Dede – Morgan Joseph

Oh, okay.

Bill Smith

And yes, and actually to the 380, you would add because this transaction is now closed in the fourth quarter and you got a few heads if you pick up from those transactions. So add eight or nine, so that’s it.

Kevin Dede – Morgan Joseph

Oh, okay. Good. Yes. Thanks, Bill. All right. On HTC, I know you can’t offer too much detail, but obviously a lot of hoopla on the G1. I was wondering if you guys had a connection with Google at all and via HTC. I mean, I know it’s kind of a stretch, but I thought it was a fair question.

Bill Smith

Yes. It’s a fair question, but I don’t know that I have a good answer for you. So I’ll have to get back to you on that one.

Kevin Dede – Morgan Joseph

Okay. Last one for me is just on the Instinct and how that did for you since its launch and the trends that you’re seeing now?

Bill Smith

It’s done fine. But I guess, it’s obvious that the multimedia revenues haven’t gone up so it kind of gets lost in the mix. Another point to be made is the second carrier to ship the Instinct is Bell Mobility. You might guess we were having some conversations about that.

Kevin Dede – Morgan Joseph

Oh, okay. Well, congrats again, gentlemen. Nice job and thanks for your help.

Bill Smith

Thanks.

Operator

Thank you. (Operator instructions) And there are no further questions in the queue at this time. I would like to turn the call back to management for any closing remarks.

Andy Schmidt

Okay. I want to thank you for joining us today. And if you have any further questions, please feel free to give us a call in the office. And just so that you are aware, we will be presenting in AEA next week in San Diego, so there will be a webcast for that as well. Thanks.

Operator

Ladies and gentlemen, this concludes the Smith Micro Software fiscal third quarter 2008 conference call. You may now disconnect. Thank you for your participation.

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