Smith Micro Software (NASDAQ:SMSI), as a pure play on the rapidly growing wireless data space, makes for an interesting story.
Specifically, as a supplier to Verizon Wireless of Music Essentials Kits (MEKs), Smith Micro is levered tightly to that company's VCast Music service - though maybe too tightly right now. SMSI stock has corrected about 25% from its early July highs, despite Smith Micro putting up another record quarter of revenue and earnings results on July 26th.
There's little question the company is executing - cash continues to grow, there's no debt; new product offerings and relationships are on the horizon. Should investors pounce on the stock drop? Lets take a closer look.
Smith Micro Software, Inc. is a diversified developer and marketer of wireless communication software products. The company's wireless connectivity products are targeted toward original equipment manufacturers (OEMs), particularly wireless service providers and mobile phone manufacturers. Smith Micro's QuickLink Mobile connectivity solution provides laptop users with the ability to easily roam between wireless wide area networks (WWAN/cellular) and Wi-fi hot spots, while also allowing users to seek out and select available hot spots in their area.
The company's V CAST Music Essentials Kit complements Verizon Wireless' V CAST Music service, allowing users to download music from Verizon Wireless, or to transfer music files from a PC to a VCAST music phone. The company's Enterprise Solutions Group delivers wireless mobility solutions into medium and large enterprise businesses. The Consumer Products Group sells products into the PC Utility, Fax, and eBusiness markets. Future initiatives offering significant promise include Quicklink Music and StuffIt Wireless compression technology.
Earnings are at record levels. The first half of the year has been a hit, with the second quarter improving upon first quarter's record results. In fact, the company's really been on a roll for the last four quarters, with pro-forma EPS (excluding stock compensation and amortization intangible expenses from acquisitions) edging higher sequentially (.10, .11, .12, .13) in spite of a rise in share count from 22.7 mil to 25.6 mil; steady operating income sequential growth (2.14 mil, 2.45 mil, 2.72 mil, 3.00 mil); and a growing cash hoard of $31.3 million, up from $20.4 mil just three quarters ago. There's no long term debt.
Rapidly ramping sales of Music Essentials Kits are driving the top line. In just the second full quarter of the product offering, sales of MEKs amounted to $7.2 million (out of a total $12.6 mil in the quarter), up sharply from $3.5 million in Q1. However, gross margins on the product also slipped to 45% from 55% in Q1, and the stock got knocked. What's more, there's whopping customer concentration here, with Verizon Wireless accounting for 74% of total revenues in the quarter. This is also nothing new - as Verizon Wireless accounted for 71% of Q1 revs, 57% of revs in 2005, and 68% in 2004.
However, clearly, something has to be done about this to help mitigate the risk in the stock price. Right now management says the relationship with Verizon is sound, of a long-term contractual nature with several years remaining, and that they face no competition on sales of MEKs. As Verizon Wireless continues to expand its wireless mobile data footprint (only about half the network was offering data services at the beginning of the year), and grow subscribers through greater ad spend and lower subscription prices, so should Smith Micro's VCAST MEK and Quicklink Mobile sales grow.
However, with the company living and dying by Verizon Wireless, a disappointing gross margin on the MEKs has proven enough to pour cold water on the stock for the time being. So, what could boost the stock and get things going again?
Quicklink Music should launch before October, with gross margins exceeding 90%. Management has made it clear that they expect at least one carrier to pick up this new ("I-tunes-like") handset music manager software product in the third quarter, and that they are looking for multiple carriers in the music space by year-end.
Therefore, even if MEK gross margins linger around 45% from here, should Verizon Wireless adopt Quicklink Music to go with the MEK, it will provide an immediate lift to the top line and margins. Remember, music sales accounted for 57% of total revenues in only the second full quarter of the product offering, and that was with only one carrier. Obviously, additional carriers beyond Verizon would begin to reduce the extreme customer concentration risk.
In spite of the earnings trend at Smith Micro, there is still plenty of "show-me" to this story. QuickLink Mobile sales slowed sequentially in Q2 to $2.2 mil (from $2.6 mil in Q1), as management indicated on the call that owing to more embedded installations directly onto PCs (which require user activation in order for Smith Micro to recognize revenue) that backlog will no longer be a viable indicator for forecasting revenue. They also added that as Quicklink Music (a software product with short lead times), becomes an increasing component of business, the meaning of a backlog indicator would be further reduced.
This is all well and good, but with investors having less to work with now, the company better make good on the expectation they have generated for launching Quicklink Music this quarter, or else SMSI stock could suffer. Sales of MEKs are obviously showing no signs of weakness, but they have dragged company blended gross margins down from 82.4% in 2005 to 64.4% in the first half of '06. With SMSI stock trading as of this writing at $12.58, 25.6 mil shares out, and $31.3 mil in cash, Smith Micro's market cap of $322 mil and Enterprise Value of $291 mil are high relative to its current sales (~$55 mil) and free cash flow (~$16 mil) run rates.
With high multiples, product and customer concentration, and declining margins, Smith Micro needs to add new revenue streams like Quicklink Music that can boost margins and drive numbers. It would also help for the company to demonstrate a recovery in the Quicklink Mobile side of the business. Meanwhile, the consumer products side of the business remains relatively steady, and enterprise software - while beginning to show a little traction, remains in its infancy. The bottom line is that the rest of this year hinges on a successful launch of Quicklink Music and any resulting new carrier relationships. Looking ahead to 2007, management is optimistic that StuffIt compression technology could become another significant revenue stream.
Keep SMSI stock on your radar, and watch carefully for announcements related to Quicklink Music and any new carrier relationships. We think the stock will need a little time. With earnings out of the way and two months left to the quarter, the next catalyst for SMSI stock should be news related to the anticipated Q3 rollout of Quicklink Music and/or new carrier relationships. At $12.58, we're watching and waiting for a better entry, or the right type of news.
SMSI 1-yr chart: