I'm a Smith Micro Investor with Reasons to Be Wary

| About: Smith Micro (SMSI)

The Drinks are on the Shareholders and they’re flowing freely

Smith Micro Software Inc. (SMSI) reported Q1 2009 Earnings on Wednesday. Like most companies they concentrated their spin on the positives. The spin continued in their conference call with Bill Smith once again showing his mercurial salesmanship.

The amount of stock compensation tech and biotech companies handout has always annoyed me. Though I confess I sit here in my nice home doing what I wish due to a large degree to the largesse of tech and biotech to their employees, I never felt good about my partner or I “stealing” from shareholders earnings, while all the time getting paid extremely well. But, hey, it couldn’t of happened to a nicer couple. It’s not my fault that despite taking no risk with capital we were rewarded ahead of those who were risking their capital. Heck I felt bad, so bad I did go against the advice of every financial planner who has ever lived and actually put some capital at risk in the companies we worked for.

The number one way people justify stock options is staff retention. What a crock of stempweggle that is. People want to work for good companies, options are a secondary benefit not a deal maker. Yes, some greedy individuals may be motivated by options packages, but from my experience they are not the sort of people who are a long term benefit to a company. They are self interested. Being motivated by an interest in your work, a desire to be your best and a good pay packet is more than enough for most people. People want to work at Google (NASDAQ:GOOG) because it’s a great company, not because of stock options.

Stock options do help to retain people. Unfortunately it is often the dross who are retained. Good employees can get a new job whenever they want and are not afraid to move. They will move for better opportunities and other excellent reasons. The dross stay around spending half their working day looking at the share price.

Offering stock at a discounted price to employees is a much fairer system for everyone and it is considerably more motivating. If employees are putting some of their capital on the line they will be more motivated and act like owners. Options have no ownership concept attached. Discounted stock has the added benefit of removing all the earnings confusion.

Sorry, I got carried away. Theft always upsets me, though admittedly not enough to seek out shareholders and hand back my share of the booty.

What I really wanted to highlight is the quality or lack thereof, of Smith Micro’s earnings. The following graph shows SMSI’s earning over the last nine quarters. The large middle block with the numbers is stock compensation. Does that look right to you? Does that look fair to shareholders who have put their capital at risk? Is it fair that the lions share of earnings goes to employees who are already handsomely rewarded for their time? I think not.

click to enlarge

smsi-quality-of-earningsClick to enlarge

Stock compensation is a real cost. Management teams are basically lying when they exclude it from Non-GAAP earnings. The next graph shows SMSI’s earnings adjusted for stock compensation. So while SMSI would love investors to think they have trailing twelve month earnings of $0.72 the reality is the truer earnings are $0.33. Yup, that’s $0.39 to employees with no capital risk and $0.33 to stock holders with capital risk. Not only are the drinks on shareholders, we’re shouting Krug.

smsi-adjusted-non-gaap earningsClick to enlarge

Other reasons to be wary of SMSI include:

  • The aforementioned Bill Smith, William W. Smith, Jr., is the unholy trinity of President, Chief Executive Officer and Chairman of the Board of Directors. That is always a red flag to me. Power corrupts and ultimate power is ultimately corrupting.
  • Smith seldom gives exact details. He always talks in vague terms like more than half a dozen, just less than half a dozen and so on. Just tell us Bill, is it five or four, is it seven? Why hide the details? Are you afraid of tripping yourself up? There may be nothing behind this concern, but liars generally skip around details. It’s a red flag for me.
  • I’ll let an acquaintance of mine express a third concern. Tom knows SMSI better than me and has followed the company for years.

Another concern I have came to me as I listened to Bill Smith rail against share buybacks as a “fix” for investors at the annual meeting — the most animated he became during the whole meeting. (It is obvious that Bill Smith would never even consider the concept of a share buyback.) I understand that a growth company doesn’t pay dividends and I can understand that a company may view using money for growth as a better use of cash than share buybacks. But it did make me reflect on a broader topic. In the competitive tech area, Bill might be right in the view that the company must constantly plow profits back into the business to keep a competitive edge. In that case though, the “profit” is really illusionary. It is really just future growth cap-ex. If that is really the case, it is not a great business to own.

  • Analysts are predicting 19% annual growth for the next five years. Take a look at those recent earnings. Do you see a pattern to support such lofty predictions? I sure don’t. A month or so back analysts were predicting 22% annual growth. At that rate of reassessment analysts expectations may become realistic in another quarter.

Like me, Tom, does consider SMSI undervalued and we are both shareholders. Feel free to consider me insane for investing when I have both the above and more issues with this companies. I continue to like the underlying SMSI story, though strongly encourage all shareholders to vote no to all options grants for SMSI and most companies.

I will try to post some more SMSI notes within the week. If you want to work out the real cost of options, I highlighted a method in this post on Akamai.

Disclosure: The author is long SMSI stock.