Sunday, January 13, 2008

SMSI: Profit from a fallen wall street story

Smith Micro (SMSI) is a former-high flying tech stock that has been beaten down over the last few months on concerns of slowing growth in one of their product divisions, customer concentration issues, and declining GAPP earnings. Trading now at about $6.70, and with a $200M market cap, SMSI should provide a very favorable risk reward in the near and long-term, as the company continues to benefit from its market leading position in a nascent, high growth, and incredibly profitable (70%+ GM) market. Currently trading at a proforma FY07 PE of about 8, I believe an investment in SMSI could offer upside of 100-300% in a reasonable scenario over the next 2-3 years, with relatively limited downside risk.

Company Overview:

Smith Micro markets a variety of software and solutions targeting mobile carriers and OEMs. It prides itself on being the market leader in offering a wide array of solutions to mobile carriers, primarily geared around enabling convergence in mobile devices. Their music software enables users to transfer music between mobile phones and their computer; their connectivity solution is frequently packaged with the mobile broadband cards that have become so popular with companies, allowing road warriors to access the internet from anywhere they can get cell phone reception. The company also has a consumer division, which recently signed up VMware fusion, a leading software solution for running windows and Mac simultaneously on Intel-based Macs, and which sells the popular Mac software titles like Stuff-it, Poser, and the leading manga software. They claim to have the largest presence of any publisher in Apple stores, with 13 titles on average available.

There are too many business lines to discuss without boring you to death: a wealth of information is available on the company website here. Suffice to say, the company operates in a variety of attractive, emerging growth niche's that are in high demand among carriers, device OEMs, and consumers. The cell phone is increasingly winning out as the consumer choice for mobile convergence, and as consumers continue to migrate to all in one devices like the iPhone, demand for SMSI's products will continue to grow. Let's take a brief look at the company on a by segment basis to see how the revenue and profits break out, based on my 2007 estimates:

% of Revenue % of Gross Profit Q3 Gross Margin % YoY Growth rate
Multimedia: 40% 30% 56% 10%
Connectivity: 38% 49% 94% (!) 108% (!)
Consumer: 18% 18% 73% 25%
Other: 4% 3% ~50% ~150%

The connectivity business is the real gem here. Growth has been stellar, and with new carrier customers continuing to be onbarded, and the overall market for the product expanding at a nice clip, this should be a 50%+ growing category for the foreseeable future. Thanks to the high gross margins, this busines will be an even larger percentage of gross profit next year.

In Q3, Verizon accounted for about 68% of SMSI's business. This concentration rightfully had a lot of people spooked. Since Q3, the company has announced a couple acquisitions which should immediately drop that number to about 50%. More importantly, the company has tremendous opportunity to offer the same services it currently offers to Verizon to other carriers and OEMs. It's latest acqusition of PCTell, while expensive, now gives it inroads into just about every major carrier in the world. This is a story that's hard to quantify. It's impossible to accurately predict revenue growth, but the opportunity is there. A market leading company that can rapidly grow its customer base, increase its services per customer, and also see strong growth in their existing products can benefit from a rare combination of factors that leads to the kind of enormous QoQ revenue increases we've seen from SMSI thus far.

Why is it cheap?
Recently, Verizon partned with Real Networks to straighten its mobile music offering. Some peope worry that this will pressure their lucrative multimedia business if Real networks offers Verizon a competing version of the sort of mobile software SMSI currently provides. The risk, while possible, is overblown. Real has great PC based music playing software, but it currently can't offer the same mobile to PC service that SMSI specializes in. Even if Real does build out this capability (which I imagine they eventually will), SMSI has much better relationships with the carriers and OEMs, and should be able to make up other business through additional carrier wins as market competition increases.

There are also concerns over the mix of SMSI's multimedia business. Currently, the majority of revenue comes from selling music kits, which include headphones, a USB chord, and a Smith-Micro CD. The margin is about 45%, but the revenue per unit is high. The product is sold as an add on, and has an attach rate of about 10-20% (according to management's November investor presentation). Recently, carriers have been bundling the software with certain phones. Under this model, SMSI receives less revenue, but has higher gross margins (~95%), and experiences a higher attach rate as the product comes standard on most phones (~90%). Even though the revenue is much less, the increased profit and volume means that gross profit should stay relatively flat. Unfortunately, management has not provided revenue per unit under both models, so analysts haven't been able to do the modeling and are taking a "wait and see" approach. We can't do the precise math, but we have enough information to get comfortable. Let's do some basic math to see the impact to gross profit from the change:

Gross Profit from Music Kits: revenue/unit (x) * attach rate (15%) * gross profit (45%)
Gross Profit from Software: revenue/unit (y) * attach rate (90%) * gross profit (95%)


Gross Profit from Music Kits: .0675x
Gross Profit from Software: .885y

Which means that as long as revenue per software unit is more than 8% (.0675/.885) of the revenue received from music kits, then changes between models should have no impact on earnings. I think this is a reasonable assumption, with the music kits retailing for $30. Additionally, the higher volume benefit means higher adoption of the software, which in the long run is a strong positive for SMSI, as it validates consumer acceptance and allows SMSI to book more revenue from product usage.

Other reasons for the stock price include analyst frustration with not receiving guidance, and generally having difficulty modeling the business and the frequent acquisitions and customer wins. If you get the story here and understand the potential economics, its clear that revenue and earnings 2-3 years from now should be much more than they are currently, even if you can't quite chart the path to there accurately. I don't mind the quarter to quarter uncertainty, and believe the long term story is compelling.

The company has also burned through much of its cash, making two pricey acquisitions relative to sales. The startegic logic is solid, but the pricey valuations lead some to be cautious in the near-term. The company is acquiring customer relationships that improve the value of all their products through cross-selling opportunities. By acquiring companies that offer best-of-breed solutions to the carriers, it has become a dominant player in multiple high growth solutions, and the only company with true scale to offer multiple solutions to the carriers and OEMs. It also has the opportunity to sell its existing products into the newly acquired customers, and visa-versa.

Another issue worth mentioning is the difference between the pro-forma and GAAP numbers. For those of you who are unfamiliar with the terms, proforma notably adjusts earnings for stock based compensation and other one time expenses, while GAAP earnings do not. Recently, Pro-forma and GAAP earnings have diverged, with GAAP earnings down on a YoY basis due to much higher (and frankly, nearing egregious) stock grant and option expenses, as well as tax rate differneces (GAPP is fully taxed, cash taxes used for Pro-forma calculation are lower due to some NOLs). Analysts are using pro-forma numbers, which peg earnings at about $.80 for the year: a P/E of about 8 on current prices. GAAP should come in at more like $.18, which puts the P/E at about 38. So the stock is cheap on a pro-forma basis, pricey on a GAPP basis, and about fairly valued on a P/S of about 3.

For better or worse, analysts usually value companies on Pro-forma numbers, which helps here: the stock was previously trading at about 20x pro-forma PE, or 30x on a fully taxed pro-forma basis. If the growth story catches on again and stock returns to that same valuation, the stock could very well double to triple over the next year. On a GAPP basis, this can still work out well, too. According to my relatively conservative estimates, GAAP earnings should come in at $.40 in FY08, or a forward P/E of about 18x, with 30%+ growth thereafter , which would still make this a relatively strong performer in a weak market. Note that the company, which had been paying cash taxes in the single digit range in 2007, will likely be fully taxed in 08', which means profit growth will likely pause before accelerating again in FY09.

SMSI is a complex situation with a lot of moving pieces, but the value is there. It trades at an attractive multiple of current earnings, and is perhaps one of the more exciting, high growth, and profitable companies available in the market today--and certainly at these prices. Continued earnings growth, the attractive "story nature" of the stock, and the possibility of drastically increased multiples (from 8x today to 20-30x historically) mean the stock could be worth several times its current value if a few things work right. If things go mediocre, with multimedia growth slowing down, you've still got the high growth connectivity business that is chugging along and should keep earnings from falling apart. In the unlikely event that both the multimedia and connectivity division collapses and/or SMSI loses Verizon at as a customer, the stock could drop substantially, but given the potential upside I think that's a risk we are more than compensated for.

Note: Author is long SMSI

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