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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTER ENDED SEPTEMBER 30, 2005
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 |
COMMISSION FILE NUMBER 0-26536
SMITH MICRO SOFTWARE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE (STATE OR OTHER JURISDICTION OF ORGANIZATION) | 33-0029027 (I.R.S. EMPLOYER INCORPORATION OR IDENTIFICATION NUMBER) | |
51 COLUMBIA, SUITE 200, ALISO VIEJO, CA (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) | 92656 (ZIP CODE) |
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 362-5800
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YESþ NOo
Indicate by check mark if whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).
YESo NOþ
Indicate by check mark if whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
YESo NOþ
As of November 6, 2005 there were 22,081,761 shares of Common Stock outstanding.
SMITH MICRO SOFTWARE, INC.
FORM 10-Q
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PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SMITH MICRO SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Per Share Data)
September 30, | December 31, | |||||||
2005 | 2004 (A) | |||||||
(unaudited) | ||||||||
ASSETS | ||||||||
CURRENT ASSETS: | ||||||||
Cash and cash equivalents | $ | 20,389 | $ | 8,634 | ||||
Accounts receivable, net of allowances for doubtful accounts and other adjustments of $270 (2005) and $137 (2004) | 4,811 | 2,024 | ||||||
Income tax receivable | 35 | 35 | ||||||
Inventories, net | 306 | 47 | ||||||
Prepaid expenses and other current assets | 397 | 203 | ||||||
Total current assets | 25,938 | 10,943 | ||||||
Equipment and Improvements, net | 174 | 113 | ||||||
Goodwill | 9,566 | �� | 1,715 | |||||
Intangible Assets, net | 4,478 | — | ||||||
Other Assets | 13 | 57 | ||||||
$ | 40,169 | $ | 12,828 | |||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
CURRENT LIABILITIES: | ||||||||
Accounts payable | $ | 2,134 | $ | 939 | ||||
Accrued liabilities | 1,463 | 790 | ||||||
Total current liabilities | 3,597 | 1,729 | ||||||
COMMITMENTS AND CONTINGENCIES | ||||||||
STOCKHOLDERS’ EQUITY: | ||||||||
Preferred stock, par value $0.001 per share; 5,000,000 shares authorized; none issued or outstanding | — | — | ||||||
Common stock, par value $0.001 per share; 50,000,000 shares authorized; 22,082,000 and 18,011,000 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively | 22 | 18 | ||||||
Additional paid-in capital | 50,706 | 27,750 | ||||||
Accumulated deficit | (14,156 | ) | (16,669 | ) | ||||
Net stockholders’ equity | 36,572 | 11,099 | ||||||
$ | 40,169 | $ | 12,828 | |||||
(A) DERIVED FROM THE AUDITED CONSOLIDATED FINANCIAL STATEMENTS AT DECEMBER 31, 2004
SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In Thousands, Except Per Share Data)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
NET REVENUES | ||||||||||||||||
Products | $ | 6,743 | $ | 3,304 | $ | 11,781 | $ | 8,414 | ||||||||
Services | 153 | 252 | 475 | 747 | ||||||||||||
Total Net Revenues | 6,896 | 3,556 | 12,256 | 9,161 | ||||||||||||
COST OF REVENUES | ||||||||||||||||
Products | 1,089 | 555 | 1,835 | 1,802 | ||||||||||||
Services | 76 | 118 | 220 | 293 | ||||||||||||
Total Cost of Revenues | 1,165 | 673 | 2,055 | 2,095 | ||||||||||||
GROSS PROFIT | 5,731 | 2,883 | 10,201 | 7,066 | ||||||||||||
OPERATING EXPENSES: | ||||||||||||||||
Selling and marketing | 1,294 | 375 | 2,103 | 1,165 | ||||||||||||
Research and development | 1,244 | 633 | 2,638 | 1,922 | ||||||||||||
General and administrative | 1,430 | 790 | 3,367 | 2,156 | ||||||||||||
Total operating expenses | 3,968 | 1,798 | 8,108 | 5,243 | ||||||||||||
OPERATING INCOME | 1,763 | 1,085 | 2,093 | 1,823 | ||||||||||||
INTEREST INCOME | 161 | 14 | 475 | 28 | ||||||||||||
INCOME BEFORE INCOME TAXES | 1,924 | 1,099 | 2,568 | 1,851 | ||||||||||||
INCOME TAX EXPENSE | 47 | 22 | 55 | 37 | ||||||||||||
NET INCOME | $ | 1,877 | $ | 1,077 | $ | 2,513 | $ | 1,814 | ||||||||
NET INCOME PER SHARE, basic | $ | 0.09 | $ | 0.06 | $ | 0.12 | $ | 0.11 | ||||||||
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, basic | 22,016 | 17,254 | 21,097 | 17,117 | ||||||||||||
NET INCOME PER SHARE, diluted | $ | 0.08 | $ | 0.06 | $ | 0.11 | $ | 0.10 | ||||||||
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, diluted | 23,222 | 18,617 | 22,454 | 18,265 | ||||||||||||
SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(In Thousands)
Additional | ||||||||||||||||||||
Common stock | paid-in | Accumulated | ||||||||||||||||||
Shares | Amount | capital | deficit | Total | ||||||||||||||||
BALANCE, December 31, 2004 | 18,011 | $ | 18 | $ | 27,750 | $ | (16,669 | ) | $ | 11,099 | ||||||||||
Issuance of common stock in private placement | 3,500 | 4 | 20,782 | — | 20,786 | |||||||||||||||
Issuance of common stock in Allume acquisition | 398 | — | 1,858 | — | 1,858 | |||||||||||||||
Exercise of common stock options | 173 | — | 265 | — | 265 | |||||||||||||||
Non cash compensation recognized on stock options | — | — | 51 | — | 51 | |||||||||||||||
Net income | — | — | — | 2,513 | 2,513 | |||||||||||||||
BALANCE, September 30, 2005 | 22,082 | $ | 22 | $ | 50,706 | $ | (14,156 | ) | $ | 36,572 | ||||||||||
SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
Nine Months | ||||||||
Ended September 30, | ||||||||
2005 | 2004 | |||||||
CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||
Net income | $ | 2,513 | $ | 1,814 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 479 | 130 | ||||||
Provision for doubtful accounts and other adjustments to accounts receivable | 92 | 112 | ||||||
Non cash compensation recognized on stock options | 51 | — | ||||||
Change in operating accounts, net of effect from acquisition: | ||||||||
Accounts receivable | (2,021 | ) | (1,196 | ) | ||||
Inventories | (22 | ) | (2 | ) | ||||
Prepaid expenses and other assets | 94 | 85 | ||||||
Accounts payable and accrued liabilities | 832 | 550 | ||||||
Net cash provided by operating activities | 2,018 | 1,493 | ||||||
CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||
Acquisition of Allume Systems, Inc. | (11,270 | ) | — | |||||
Capital expenditures | (44 | ) | (46 | ) | ||||
Net cash used in investing activities | (11,314 | ) | (46 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||
Cash received from issuance of common stock, net of offering costs | 20,786 | — | ||||||
Cash received from exercise of stock options | 265 | 568 | ||||||
Net cash provided by financing activities | 21,051 | 568 | ||||||
NET INCREASE IN CASH AND CASH EQUIVALENTS | 11,755 | 2,015 | ||||||
CASH AND CASH EQUIVALENTS, beginning of period | 8,634 | 3,722 | ||||||
CASH AND CASH EQUIVALENTS, end of period | $ | 20,389 | $ | 5,737 | ||||
SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
For the Nine Months Ended | ||||||||
September 30, | ||||||||
2005 | 2004 | |||||||
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION | ||||||||
Cash Paid for income taxes | $ | 2 | $ | 30 | ||||
Details of business acquired in purchase transaction: | ||||||||
Fair value of assets acquired, including goodwill of $7,851 | $ | 14,164 | ||||||
Common stock issued in acquisition | (1,858 | ) | ||||||
Cash paid for acquisition | (11,270 | ) | ||||||
Liabilities assumed | $ | 1,036 | ||||||
SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
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SMITH MICRO SOFTWARE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business- Smith Micro Software, Inc. and subsidiaries (the “Company”) is a diversified developer and marketer of communications and utilities software products and services. The Company’s strategic focus is to market and sell value-added wireless products targeted to the original equipment manufacturers (“OEM”) market, particularly wireless service providers and mobile phone manufacturers as well as direct to corporations and consumers. The Company offers software products for Windows, Mac OSX, Unix and Linux operating systems. The Company also offers wireless communication software products and services to the enterprise market that include enhanced wireless security features.
On July 1, 2005, the Company acquired Allume Systems (“Allume”), which was a wholly owned subsidiary of International Microcomputer Software, Inc. (see Note 4). Allume develops and publishes award-winning software solutions that empower users in the area of information access, removal, recovery, security, productivity and online distribution. Allume’s flagship product is StuffIt® Deluxe. StuffIt Wireless, a new and advanced technology that is patent pending by Allume Systems, will compress an already compressed JPEG file by up to 30% more without loosing any of the picture quality. This technology is particularly important to mobile phone manufactures who now can store up to 30% more images and carriers who are interested in the reduction of utilized bandwidth. Other award winning products include icSpyware Suite® and Internet Cleanup® which targets spyware and phishing intrusions, and Spring Cleaning® which cleans and optimizes computer operating systems.
Basis of Presentation- The accompanying unaudited interim consolidated financial statements reflect adjustments (consisting of normal recurring adjustments) necessary to present fairly the consolidated financial position of the Company at September 30, 2005, the consolidated results of its operations for the three and nine months ended September 30, 2005 and 2004 and its consolidated cash flows for the nine month periods ended September 30, 2005 and 2004. Certain information and footnote disclosures normally included in the consolidated financial statements have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”), although the Company believes that the disclosures in the unaudited consolidated financial statements are adequate to ensure the information presented is not misleading. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, contained in the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2004. The results of operations of interim periods are not necessarily indicative of future operating results.
Cash and Cash Equivalents- Cash and cash equivalents generally consist of cash, government securities and money market funds. These securities are all held in one financial institution and are uninsured except for minimum FDIC coverage. All have original maturity dates of three months or less.
Accounts Receivable- The Company sells its products worldwide. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains reserves for estimated credit losses, and those losses have been within management’s estimates. Allowances for product returns are included in other adjustments to accounts receivable on the accompanying consolidated balance sheets. Product returns are estimated based on historical experience and have also been within management’s estimates.
Inventories- Inventories consist principally of cables, CDs, boxes and manuals and are stated at the lower of cost (determined by the first-in, first-out method) or market. The Company regularly reviews its inventory quantities on hand and records a provision for excess and obsolete inventory based primarily on management’s forecast of product demand and production requirements.
Equipment and Improvements- Equipment and improvements are stated at cost. Depreciation is computed using the straight-line method based on the estimated useful lives of the assets, generally ranging from three to seven years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.
Long Lived Assets —The Company accounts for the impairment and disposition of long-lived assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144,Accounting for Impairment or Disposal of Long-Lived Assets. This
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statement addresses financial accounting and reporting for the impairment of long-lived assets and for the disposal of long-lived assets. In accordance with SFAS No. 144, long-lived assets to be held are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. The Company periodically reviews the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred. The Company has determined that there was no impairment at September 30, 2005.
Goodwill- The Company adopted SFAS No. 142,Goodwill and Other Intangible Assets,effective January 1, 2002. As a result of the adoption, the Company is no longer required to amortize goodwill. Prior to the adoption of SFAS 142, goodwill was amortized over 7 years. In accordance with SFAS No. 142, the Company reviews the recoverability of the carrying value of goodwill at least annually or whenever events or circumstances indicate a potential impairment. The Company’s annual impairment testing date is December 31. Recoverability of goodwill is determined by comparing the fair value of the Company’s reporting units to the carrying value of the underlying net assets in the reporting units. If the fair value of a reporting unit is determined to be less than the carrying value of its net assets, goodwill is deemed impaired and an impairment loss is recognized to the extent that the carrying value of goodwill exceeds the difference between the fair value of the reporting unit and the fair value of its other assets and liabilities. The Company determined that it did not have any impairment of goodwill at December 31, 2004.
The carrying amount of the Company’s goodwill was approximately $9,566,000 and $1,715,000 as of September 30, 2005 and December 31, 2004, respectively. The Company’s reporting units are equivalent to its operating segments. At September 30, 2005 the amount of goodwill allocated to the products segment is $9,231,000 and the amount of goodwill allocated to the services segment is $335,000. At December 31, 2004 the amount of goodwill allocated to the products segment is $1,380,000 and the amount of goodwill allocated to the services segment is $335,000.
Other Intangible Assets- The following table sets forth the acquired intangible assets by major asset class:
Useful | September 30, 2005 | December 31, 2004 | ||||||||||||||||||||||||||
Life | Accumulated | Net Book | Accumulated | Net Book | ||||||||||||||||||||||||
(in thousands) | (Years) | Gross | Amortization | Value | Gross | Amortization | Value | |||||||||||||||||||||
Amortizing: | ||||||||||||||||||||||||||||
Purchased and Licensed Technology | 3 | $ | 2,260 | (2,260 | ) | — | $ | 2,260 | (2,260 | ) | — | |||||||||||||||||
Capitalized Software | 5 | 2,649 | (267 | ) | 2,382 | — | — | — | ||||||||||||||||||||
Distribution Rights | 5 | 482 | (38 | ) | 444 | — | — | — | ||||||||||||||||||||
Customer Lists | 5 | 923 | (46 | ) | 877 | — | — | — | ||||||||||||||||||||
Tradmarks | 10 | 809 | (34 | ) | 775 | — | — | — | ||||||||||||||||||||
Totals | $ | 7,123 | $ | (2,645 | ) | $ | 4,478 | $ | 2,260 | $ | (2,260 | ) | $ | — | ||||||||||||||
Aggregate amortization expense on intangible assets was approximately $385,000 and $11,000 for the three months ended September 30, 2005 and 2004, respectively and approximately $385,000 and $40,000 for the nine months ended September 30, 2005 and 2004, respectively. Expected future amortization expense is as follows: $385,000 for the three months ended December 31, 2005, $1,378,000 for the year 2006, $1,074,000 for the year 2007, $743,000 for the year 2008, $449,000 for the year 2009 and $449,000 thereafter. Amortization expense is calculated on a discounted cash flow basis over five years for Capitalized Software, Distribution Rights and ten years for Trademarks. Amortization is calculated on a straight line basis over five years for Customer Lists.
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Revenue Recognition- Software revenue is recognized in accordance with the Statement of Position (SOP) 97-2,Software Revenue Recognition,as amended, when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable, and collectibility is probable. The Company recognizes revenues from sales of its software to Retail and OEM customers or end users as completed products are shipped and title passes, or from royalties generated as authorized customers duplicate the Company’s software, if the other requirements of SOP 97-2 are met. If the requirements of SOP 97-2 are not met at the date of shipment, revenue is not recognized until these elements are known or resolved. Returns from Retail and OEM customers are limited to defective goods or goods shipped in error. Historically, OEM customer returns have not been significant. The Company reviews available retail channel information and makes a determination of a return provision for sales made to distributors and retailers based on current channel inventory levels and historical return patterns. Certain sales to distributors or retailers are made on a consignment basis. Revenue for consignment sales are not recognized until sell through to the final customer is established.
Product sales directly to end-users are recognized upon delivery. End users have a thirty day right of return, but such returns are reasonably estimable and have historically been immaterial. The Company also provides technical support to its customers. Such costs have historically been insignificant.
Service revenues include sales of consulting services, web site hosting and fulfillment. Service revenues are recognized as services are provided or on a percentage of completion basis for projects with a duration longer than three months.
Sales Incentives- Pursuant to the consensus of EITF 01-09,Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Product),effective January 1, 2002, the cost of sales incentives the Company offers without charge to customers that can be used in, or that are exercisable by a customer as a result of, a single exchange transaction is accounted for as a reduction of revenue.
Software Development Costs- Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. The Company considers technological feasibility to be established when all planning, designing, coding and testing has been completed according to design specifications. After technological feasibility is established, any additional costs are capitalized. Through September 30, 2005, software has been substantially completed concurrently with the establishment of technological feasibility; and, accordingly, no costs have been capitalized to date.
Income Taxes- The Company accounts for income taxes under SFAS No. 109,Accounting for Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company’s assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. The Company currently has a full valuation allowance on its deferred tax assets. Based on the Company’s assessment of all available evidence, the Company concluded that it is not more likely than not that its deferred tax assets will be realized. This conclusion is based primarily on our history of net operating losses as compared to only a recent trend of profitable operations, the potential for future stock option deductions to significantly reduce taxable income, annual net operating loss limitations under Section 382 of the Code and the need to generate significant amounts of taxable income in future periods on a consistent and prolonged basis in order to utilize the deferred tax assets. The Company will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If the Company continues to meet our financial projections and improve our results of operations, or if circumstances otherwise change, it is reasonably possible that we may release all or a portion of our valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the valuation is released.
Stock-Based Compensation- The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employeesand related interpretations.
SFAS No. 123R, Accounting for Share-Based Payment,requires the disclosure of pro forma net income (loss) and income (loss) per share had the Company adopted the fair value method. Under SFAS No. 123R, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value
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of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.
The Company’s calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 24 to 48 months following the grant date; stock volatility, 111% and 127% for grants issued in 2005 and 2004, respectively; risk-free interest rates of 3.97% and 3.48% in the nine months September 30, 2005 and 2004, respectively; and no dividends during the expected term. The Company’s calculations are based on a single-option valuation approach, and forfeitures or cancellations are recognized as they occur. If the computed fair values of the existing awards had been amortized to expense over the vesting period of the awards, pro forma net income would have been as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
(in thousands, except per share data) | (in thousands, except per share data) | |||||||||||||||
Net income, as reported | $ | 1,877 | $ | 1,077 | $ | 2,513 | $ | 1,814 | ||||||||
Add: Total stock-based employee compensation expense included in reported net income, net of related tax effects | — | — | — | — | ||||||||||||
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects | (376 | ) | (213 | ) | (658 | ) | (362 | ) | ||||||||
Pro forma net income | $ | 1,501 | $ | 864 | $ | 1,855 | $ | 1,452 | ||||||||
Income per common share | ||||||||||||||||
Basic, as reported | $ | 0.09 | $ | 0.06 | $ | 0.12 | $ | 0.11 | ||||||||
Basic, pro forma | $ | 0.07 | $ | 0.05 | $ | 0.09 | $ | 0.08 | ||||||||
Fully Diluted, as reported | $ | 0.08 | $ | 0.06 | $ | 0.11 | $ | 0.10 | ||||||||
Fully Diluted, pro forma | $ | 0.06 | $ | 0.05 | $ | 0.08 | $ | 0.08 |
A summary of the Company’s stock option activity is as follows:
Weighted Ave. | ||||||||
# of Shares | Exercise Price | |||||||
Outstanding as of December 31, 2004 | 1,799,000 | $ | 1.58 | |||||
Granted | 2,286,000 | 4.89 | ||||||
Exercised | (173,000 | ) | 1.53 | |||||
Cancelled | (75,000 | ) | 5.27 | |||||
Outstanding as of September 30, 2005 | 3,837,000 | 3.48 | ||||||
Net Income per Share- Pursuant to SFAS No. 128,Earnings per Share,the Company is required to provide dual presentation of “basic” and “diluted” earnings per share (EPS). Basic EPS amounts are based upon the weighted average number of common
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shares outstanding. Diluted EPS amounts are based upon the weighted average number of common and potential common shares outstanding. Potential common shares for diluted EPS include stock options, using the treasury stock method, of 1,206,000 and 1,363,000 for the three months ended September 30, 2005 and 2004, respectively. Potential common shares for diluted EPS include stock options, using the treasury stock method, of 1,357,000 and 1,148,000 for the nine months ended September 30, 2005 and 2004, respectively.
Fulfillment Services- The Company currently holds consigned inventory for a customer, which is used to fulfill internet orders. As the Company does not hold title to the inventory, it is not recorded in the accompanying unaudited condensed consolidated balance sheet. In addition, the Company receives cash for internet fulfillment orders which is paid out to the fulfillment customer on a monthly basis. Such cash and the related payable are recorded on a net basis as the amounts are held for the benefit of this fulfillment customer. Revenue is recognized for fulfillment services as services are performed.
Segment Information- The Company currently operates in two business segments: products and services. In addition, revenues are broken down into two units, Wireless and OEM Sales, and Internet and Direct Sales. The Company’s Internet and Direct Sales unit includes Internet based software products as well as consulting, fulfillment and hosting revenue .
The Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore, segment information reported includes only revenues and cost of revenues.
The following table shows the net revenues and cost of revenues generated by each segment:
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||||||||||||||||||
(in thousands) | (in thousands) | |||||||||||||||||||||||||||||||
Products | Services | Products | Services | Products | Services | Products | Services | |||||||||||||||||||||||||
Wireless & OEM Revenues | $ | 4,316 | $ | — | $ | 3,095 | $ | — | $ | 8,939 | $ | — | $ | 7,670 | $ | — | ||||||||||||||||
Retail & Distribution | 2,241 | — | — | — | 2,241 | — | — | — | ||||||||||||||||||||||||
Internet & Direct Revenues | 186 | 153 | 209 | 252 | 601 | 475 | 744 | 747 | ||||||||||||||||||||||||
Total Revenues | 6,743 | 153 | 3,304 | 252 | 11,781 | 475 | 8,414 | 747 | ||||||||||||||||||||||||
Cost of Revenues | 1,089 | 76 | 555 | 118 | 1,835 | 220 | 1,802 | 293 | ||||||||||||||||||||||||
Gross Profit | $ | 5,654 | $ | 77 | $ | 2,749 | $ | 134 | $ | 9,946 | $ | 255 | $ | 6,612 | $ | 454 | ||||||||||||||||
Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the three months ended September 30, 2005 and 2004, respectively, included one OEM customer at 51.5% in 2005 and two OEM customers at 58.9% and 12.5% in 2004. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the nine months ended September 30, 2005 and 2004, respectively, included one OEM customer at 60.3% in 2005 and one OEM customer at 64.2% in 2004.
Use of Estimates- The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could materially differ from those estimates.
Comprehensive Income- Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. For each of the periods ended September 30, 2005 and 2004, there was no difference between net income, as reported, and comprehensive income.
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2. RELATED PARTY TRANSACTIONS
In October 2004, the Company entered into a Master Software Services Agreement with Arrange Technology LLC, providing for the development of certain software applications and integration services. A member of the Company’s Board of Directors is a principal beneficial owner of Arrange Technology LLC. During fiscal 2004, $19,000 was expensed under the terms of the agreement, of which $7,100 is included in accounts payable in the consolidated balance sheet at December 31, 2004. The amount included in accounts payable at December 31, 2004 was paid during the nine months ended September 30, 2005, along with an additional $118,000 that was expensed during the current year.
3. EQUITY TRANSACTIONS
On February 18, 2005, the Company entered into a Securities Purchase Agreement with certain institutional investors related to the private placement of 3,500,000 shares of our common stock, par value $0.001 per share. The transaction closed on February 18, 2005 and the Company realized gross proceeds of $22.4 million from the financing before deducting commissions and other expenses. Offering costs related to the transaction totaled $1,613,000, comprised of $1,344,000 in commissions and $269,000 cash payments for legal and investment services, resulting in net proceeds of $20,786,000. The Company agreed to register for resale the shares of Common Stock issued in the private placement. Such registration statement became effective on June 17, 2005. The agreement provides for penalties of one percent (1%) of the purchase price per month should effectiveness of the registration not be maintained.
In conjunction with the severance agreement with Robert Scheussler, the former CFO, the Company recognized approximately $230,000 in severance related costs during the three months ended June 30, 2005. As per the agreement, Mr. Scheussler will continue to provide services to the Company as a consultant and, under the terms of the Company’s Stock Option Plan, will continue to vest in his existing, unvested option grants (which were not modified) totaling 108,333 options. The unvested portion of these option grants were valued by the Company at approximately $424,000 on July 1, 2005, utilizing the Black Scholes option pricing model. The Company expensed approximately $51,000 in the three months ended September 30, 2005 and expects to expense another $51,000 in the fourth quarter with respect to Mr. Scheussler’s employee stock option agreements.
On July 28, 2005, the Shareholders approved the 2005 Stock Option / Stock Issuance Plan. The Plan, which became effective the same date, replaced the 1995 Stock Option / Stock Issuance Plan which expired on May 24, 2005. All outstanding options under the 1995 Plan will remain outstanding, but no further grants will be made under that Plan. The maximum number of shares of the Company’s Common Stock available for issuance over the term of the 2005 Plan may not exceed 5,000,000 shares, plus that number of additional shares equal to 2.5% of the number of shares of Common Stock outstanding on the last trading day of the calendar year commencing with calendar year 2006 (but not in excess of 750,000 shares).
On July 28, 2005, the Shareholders approved a proposal to amend the Amended and restated Certificate of Incorporation to increase the number of authorized Common Shares from 30,000,000 to 50,000,000, as reflected in the accompanying interim condensed consolidated balance sheet. Increasing the number of authorized shares of Common Stock is expected to provide the Company with additional capital resources to finance the long-term growth of the Company and with sufficient shares of Common Stock for stock splits. The additional shares of Common Stock could be issued for acquisitions and in public or private offerings, the proceeds of which could be used to finance the Company’s growth through increased working capital, expansion of existing businesses and other corporate purposes. The Company does not currently have any plans to issue shares of Common Stock or Preferred Stock in any public or private offering, for any acquisition other than the Allume acquisition discussed below, or otherwise, nor are there any present negotiations which could lead to such an issuance.
4. ACQUISITION OF ALLUME INC.
On July 1, 2005, the Company acquired 100% of the issued and outstanding capital stock of Allume, Inc. from International Microcomputer Software, Inc. (IMSI) for $11 million in cash and 397,547 restricted shares of its common stock. Allume, Inc. is a leading developer of compression software solutions for JPEG, MPEG and MP3 platforms. A portion of the purchase price, including
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$1,250,000 cash and shares of common stock having a market value of $750,000 were deposited in an indemnity escrow to secure certain representations and warranties included in the Stock Purchase Agreement. The aggregate purchase price of approximately $13.0 million, which includes $11 million cash paid, the 397,547 shares issued which have been valued using the average closing market price of the Company’s common stock over the two-day period before and after the sale was announced and $316,000 of direct acquisition costs. The direct acquisition costs incurred to date include $116,000 for legal and professional services, as well as a transaction fee of $200,000.
The results of operations of the business acquired have been included in the Company’s consolidated financial statements from the date of acquisition. Depreciation and amortization related to the acquisition were calculated based on the estimated fair market values and estimated lives for property and equipment and an independent valuation for certain identifiable intangibles acquired.
The total purchase price is summarized as follows (in thousands):
Cash consideration | $ | 11,000 | ||
Common stock | 1,858 | |||
Acquisition related costs | 316 | |||
Total purchase price | $ | 13,174 | ||
The purchase price is contingent upon a final calculation of Allume’s net assets. If the final net asset calculation is less than the minimum amount specified in the purchase agreement, the purchase price will be adjusted downward accordingly. Any such adjustment will be recorded as an adjustment to the cost of Allume Systems, Inc. and reflected in the final purchase price allocation.
The Company’s preliminary allocation of the purchase price is summarized as follows (in thousands):
Assets: | ||||
Cash | $ | 46 | ||
Accounts Receivable, net | 858 | |||
Inventories, net | 237 | |||
Property & Equipment | 67 | |||
Other Assets | 288 | |||
Intangible Assets | 4,863 | |||
Goodwill | 7,851 | |||
Total Assets | 14,210 | |||
Liabilities: | ||||
Accounts Payable | 643 | |||
Accrued Liabilities | 393 | |||
Total Liabilities | 1,036 | |||
Total purchase price | $ | 13,174 | ||
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Unaudited pro forma consolidated results of operations for the three months ended September 30, 2004 and the nine months ended September 30, 2005 and September 30, 2004 as if the acquisition had occurred as of the beginning of each period presented are as follows (in thousands, except per share data):
Three Months Ended | Nine Months Ended | Nine Months Ended | ||||||||||||||||||||||
September 30, 2004 | September 30, 2005 | September 30, 2004 | ||||||||||||||||||||||
Historical | Proforma | Historical | Proforma | Historical | Proforma | |||||||||||||||||||
Net Revenues | $ | 3,556 | $ | 6,115 | $ | 12,256 | $ | 16,645 | $ | 9,161 | $ | 16,205 | ||||||||||||
Net Income | $ | 1,077 | $ | 1,137 | $ | 2,513 | $ | 1,915 | $ | 1,814 | $ | 1,230 | ||||||||||||
Net Income per share, basic | $ | 0.06 | $ | 0.06 | $ | 0.12 | $ | 0.09 | $ | 0.11 | $ | 0.07 | ||||||||||||
Net Income per share, diluted | $ | 0.06 | $ | 0.06 | $ | 0.11 | $ | 0.08 | $ | 0.10 | $ | 0.07 | ||||||||||||
Weighted average shares outstanding, basic | 17,254 | 17,651 | 21,097 | 21,495 | 17,117 | 17,515 | ||||||||||||||||||
Weighted average shares outstanding, diluted | 18,617 | 19,014 | 22,454 | 22,852 | 18,265 | 18,663 | ||||||||||||||||||
Pro forma adjustments have been applied to reflect the addition of amortization related to the intangible assets and the fixed assets acquired and reduction in interest income as if the acquisition had occurred at the beginning of such period presented. The pro forma adjustment for amortization related to intangible assets acquired was $385,000 for the 3 month pro forma period ended September 30, 2004, $1,155,000 for the nine month pro forma period ended September 30, 2004 and $770,000 for the nine month pro forma period ended September 30, 2005.
5. NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (revised 2004),Share-Based Payment, which replaces SFAS No. 123,Accounting for Stock-Based Compensationand supersedes APB No. 25,Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, beginning with the first annual period after June 15, 2005, with early adoption encouraged. In addition, SFAS No. 123R will cause unrecognized expense (based on the amounts in our pro forma footnote disclosure) related to options vesting after the date of initial adoption to be recognized as a charge to results of operations over the remaining vesting period. The Company is required to adopt SFAS No. 123R beginning January 1, 2006. Under SFAS No. 123R, the Company will determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition alternatives include prospective and retroactive adoption methods. Under the retroactive methods, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and share awards at the beginning of the first quarter of adoption of SFAS No. 123R, while the retroactive methods would record compensation expense for all unvested stock options and share awards beginning with the first period restated. The Company is evaluating the requirements of SFAS No. 123R and expects that the adoption of SFAS No. 123R could have a material impact on its consolidated results of operations and earnings per share. The Company has not determined the method of adoption or the effect of adopting SFAS No. 123R.
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ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
This report contains forward-looking statements regarding Smith Micro which include, but are not limited to, statements concerning projected revenues, expenses, gross profit and income, the competitive factors affecting our business, market acceptance of products, customer concentration, the success and timing of new product introductions, the protection of our intellectual property, and the need for additional capital. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:
• | our ability to predict consumer needs, introduce new products, gain broad market acceptance for such products and ramp up manufacturing in a timely manner; | ||
• | the intensity of the competition and our ability to successfully compete; | ||
• | the pace at which the market for new products develop; | ||
• | the response of competitors, many of whom are bigger and better financed than us; | ||
• | our ability to successfully execute our business plan and control costs and expenses; | ||
• | our ability to protect our intellectual property and our ability to not infringe on the rights of others; | ||
• | our ability to integrate Allume into our business model; | ||
• | our depressed market capitalization; and | ||
• | those additional factors which are listed under the section “Risk Factors” beginning on page 24. |
All forward looking statements included in this document are based on information available to us on the date hereof. We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason.
OVERVIEW
Our business model is based primarily upon the design, production and sale of software and connectivity kits for use with wireless communication networks worldwide. Our products are utilized with major wireless networks throughout the world that support data communications through the use of cell phones or other wireless communication devices such as PC cards. Wireless network providers generally incorporate our products into their accessory products sold directly to individual consumers to offer wireless PC data connectivity to their wireless networks.
On July 1, 2005, the Company acquired Allume Systems (“Allume”), which was a wholly owned subsidiary of International Microcomputer Software, Inc. Allume develops and publishes award-winning software solutions that empower users in the area of information access, removal, recovery, security, productivity and online distribution. Allume’s flagship product is StuffIt® compression. StuffIt Wireless, a technology that is patent pending by Allume Systems, will compress an already compressed JPEG file by up to 30% more without loosing any of the picture quality. This technology is particularly important to mobile phone manufactures who now can store up to 30% more images and carriers who are interested in the reduction of utilized bandwidth. Other award winning Allume products include icSpyware Suite® and Internet Cleanup® which targets Spyware and Phishing problems, and Spring Cleaning® which cleans and optimizes computer operating systems. We feel that the acquisition provides diversity in our
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product mix and reduces our key customer concentration. In addition, we feel that the Allume technology is readily transferable to the wireless industry which has been our strategic focus the past years.
Our business is primarily dependent upon the demand for wireless communications and the corresponding requirements for software and connectivity kits to support this demand. During the last three years, demand for these types of products has fluctuated dramatically, and there has been a significant increase in price competition within our industry.
We continue to invest in research and development of wireless software products, and we believe that we have one the industry’s leading wireless product lines in terms of performance and features. We believe that our “out-of-the-box” design technology further differentiates our products.
We also sell eBusiness and utility software and professional consulting services related to eBusiness applications.
Throughout 2004 and 2005 we have maintained a sharp focus on our operating cost structure while ensuring that we maintain our operating flexibility to support future growth in the industry. We measure success by monitoring our net sales and gross margins and operating cash flow while striving to achieve profitability. We believe that there continues to be excellent growth opportunities within the wireless communications software marketplace and we continue to focus on positioning Smith Micro to benefit from these opportunities.
RESULTS OF OPERATIONS
The three and nine month results of operations as of September 30, 2005 include the results of Allume Systems operations from the date of acquisition. As the acquisition occurred on July 1, 2005, the first day of the current quarter, no pro-forma adjustments are necessary to provide a full quarter view of combined company results.
The following table sets forth, for the periods indicated, certain statement of operations data expressed as a percentage of total revenue.
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Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net Revenues: | ||||||||||||||||
Products | 97.8 | % | 92.9 | % | 96.1 | % | 91.9 | % | ||||||||
Services | 2.2 | % | 7.1 | % | 3.9 | % | 8.1 | % | ||||||||
Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | ||||||||
Cost of revenues: | ||||||||||||||||
Products | 15.8 | % | 15.6 | % | 15.0 | % | 19.7 | % | ||||||||
Services | 1.1 | % | 3.3 | % | 1.8 | % | 3.2 | % | ||||||||
Total cost of revenues | 16.9 | % | 18.9 | % | 16.8 | % | 22.9 | % | ||||||||
Gross profit | 83.1 | % | 81.1 | % | 83.2 | % | 77.1 | % | ||||||||
Operating expenses: | ||||||||||||||||
Selling and marketing | 18.8 | % | 10.6 | % | 17.2 | % | 12.7 | % | ||||||||
Research and development | 18.0 | % | 17.8 | % | 21.5 | % | 21.0 | % | ||||||||
General and administrative | 20.7 | % | 22.2 | % | 27.5 | % | 23.5 | % | ||||||||
Total operating expenses | 57.5 | % | 50.6 | % | 66.2 | % | 57.2 | % | ||||||||
Operating income | 25.6 | % | 30.5 | % | 17.0 | % | 19.9 | % | ||||||||
Interest income | 2.3 | % | 0.4 | % | 3.9 | % | 0.3 | % | ||||||||
Income before income taxes | 27.9 | % | 30.9 | % | 20.9 | % | 20.2 | % | ||||||||
Income tax expense | 0.7 | % | 0.6 | % | 0.4 | % | 0.4 | % | ||||||||
Net income | 27.2 | % | 30.3 | % | 20.5 | % | 19.8 | % | ||||||||
Three and Nine Months Ended September 30, 2005 and 2004
Revenues
Total net revenues were $6.9 million and $3.6 million for the three months ended September 30, 2005 and 2004, respectively, representing an increase of $3.3 million, or 93.9% from 2004 to 2005. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the three months ended September 30, 2005 and 2004, respectively, included one OEM customer at 51.5% in 2005 and two OEM customers at 58.9% and 12.5% in 2004. If our sales to these customers are reduced, it could have a material negative effect on our results of operations. The current period results include approximately $2.2 million of net revenue attributable to the Allume acquisition.
Total net revenues were $12.3 million and $9.2 million for the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $3.1 million, or 33.8% from 2004 to 2005. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the nine months ended September 30, 2005 and 2004, respectively, included one OEM customer at 60.3% in 2005 and one OEM customer at 64.2% in 2004. The current nine month period includes three months of net revenue, or $2.2 million, attributed to the Allume acquisition.
We currently operate in two business segments: products and services. In addition, revenues are broken down into two business units, Wireless and OEM and Internet and Direct. Our Internet and Direct unit sales include software products as well as consulting, fulfillment and hosting.
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The following table shows the net revenues and cost of revenues generated by each segment (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||||||||||||||||||
Products | Services | Products | Services | Products | Services | Products | Services | |||||||||||||||||||||||||
Wireless & OEM | $ | 4,316 | $ | — | $ | 3,095 | $ | — | $ | 8,939 | $ | — | $ | 7,670 | $ | — | ||||||||||||||||
Retail & Distribution | 2,241 | — | — | — | 2,241 | — | — | — | ||||||||||||||||||||||||
Internet & Direct | 186 | 153 | 209 | 252 | 601 | 475 | 744 | 747 | ||||||||||||||||||||||||
Total Net Revenues | 6,743 | 153 | 3,304 | 252 | 11,781 | 475 | 8,414 | 747 | ||||||||||||||||||||||||
Cost of Revenues | 1,089 | 76 | 555 | 118 | 1,835 | 220 | 1,802 | 293 | ||||||||||||||||||||||||
Gross Profit | $ | 5,654 | $ | 77 | $ | 2,749 | $ | 134 | $ | 9,946 | $ | 255 | $ | 6,612 | $ | 454 | ||||||||||||||||
Products.Net product revenues were $6.7 million and $3.3 million in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $3.4 million, or 104.1%, from 2004 to 2005. Wireless and OEM sales increased $1.2 million, or 39.5%, as a result of the continued success of the EVDO rollout by our carrier customers. Retail and Distribution sales represent the sales of Allume products to distributors, retail customers and individuals. Allume was acquired on July 1, 2005 (see Note 4). Internet and Direct Sales decreased $23,000 or 11.0% as a result of lower direct and web store sales of legacy Smith Micro products. Product revenues accounted for 97.8% of total revenues in the three months ended September 30, 2005 compared with 92.9% of total revenues in the comparable period of 2004.
Net product revenues were $11.8 million and $8.4 million in the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $3.4 million, or 40.0%, from 2004 to 2005. Wireless and OEM sales increased $1.3 million, or 16.5%. Retail and Distribution sales are attributed to the Allume acquisition on July 1, 2005 (see Note 4). Internet and Direct Sales decreased $143,000 or 19.2% as a result of lower direct and web store sales of legacy Smith Micro product. Product revenues accounted for 96.1% of total revenues in the nine months ended September 30, 2005 compared with 91.9% of total revenues in the comparable period of 2004.
Services.Service revenues were $153,000 and $252,000 in the three months ended September 30, 2005 and 2004, respectively, representing a decrease of $99,000 or 39.3%, from 2004 to 2005. Service revenues accounted for 2.2% of total revenues in the three months ended September 30, 2005 compared with 7.1% of total revenues in the comparable period of 2004.
Service revenues were $475,000 and $747,000 in the nine months ended September 30, 2005 and 2004, respectively, representing a decrease of $272,000 or 36.4%, from 2004 to 2005. Services revenue accounted for 3.9% of total revenues in the nine months ended September 30, 2005 compared with 8.2% of total revenues in the comparable period of 2004. The decline in Services revenue in both the three month and nine month period is due to the de-emphasis of this offering in the current fiscal year.
Cost of Revenues and Gross Margin
Cost of Product Revenues. Cost of product revenues were $1.1 million and $555,000 in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $534,000, or 96.2%, from 2004 to 2005. Cost of product revenue as a percentage of product revenues was 16.2% and 16.8% for 2005 and 2004, respectively. Gross margin as a percentage of net revenue was 83.8% as compared to 83.2% for the year earlier period. Cost of Revenues for the current period includes $267,000 of amortization of intangibles associated with the acquisition of Allume which is not included in 2004 expenses. Factoring out said amortization of intangibles, gross margin for the three month period ending September 30, 2005 was 87.8%. The 4.6% pro-forma increase from the year earlier period is attributed to favorable product mix.
Cost of product revenues remained relatively constant at $1.8 million in the nine months ended September 30, 2005 and 2004, respectively, with only a nominal increase of $33,000, or 1.8%, from 2004 to 2005. Cost of product revenue as a percentage of product revenues was 15.6% and 21.4% for 2005 and 2004, respectively. Gross margin as a percentage of net revenue was 84.4% as compared to 78.6% for the year earlier period. Cost of Revenues for the current period includes $267,000 of amortization of intangibles associated with the acquisition of Allume which is not included in 2004 expenses. Again factoring out the amortization of
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intangibles, gross margin for the nine month period ending September 30, 2005 was 86.7%. The 8.1% pro-forma increase from the year earlier period is attributed to favorable product mix.
Cost of Service Revenues.Cost of service revenues were $76,000 and $118,000 in the three months ended September 30, 2005 and 2004, respectively, representing a decrease of $42,000 or 35.6%, from 2004 to 2005. Cost of service revenue as a percentage of service revenues was 49.7% and 46.8% for 2005 and 2004, respectively. Cost of service revenues includes the cost of our consulting personnel and the cost of hiring outside contractors to support our staff of consultants and vary by contract.
Cost of service revenues were $220,000 and $293,000 in the nine months ended September 30, 2005 and 2004, respectively, representing a decrease of $73,000 or 24.9%, from 2004 to 2005. Cost of service revenue as a percentage of service revenues was 46.3% and 39.2% for 2005 and 2004, respectively. Cost of service revenues includes the cost of our consulting personnel and the cost of hiring outside contractors to support our staff of consultants and vary by contract.
Operating Expenses
The following table presents a breakdown of our operating expenses by functional category and as a percentage of total net revenues (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | ||||||||||||||||||||||||||||||||
2005 | 2004 | 2005 | 2004 | ||||||||||||||||||||||||||||||
Operating expenses: | |||||||||||||||||||||||||||||||||
Selling and marketing | $ | 1,294 | 18.8 | % | $ | 375 | 10.6 | % | $ | 2,103 | 17.2 | % | $ | 1,165 | 12.7 | % | |||||||||||||||||
Research and development | 1,244 | 18.0 | % | 633 | 17.8 | % | 2,638 | 21.5 | % | 1,922 | 21.0 | % | |||||||||||||||||||||
General and administrative | 1,430 | 20.7 | % | 790 | 22.2 | % | 3,367 | 27.5 | % | 2,156 | 23.5 | % | |||||||||||||||||||||
Total operating expenses | $ | 3,968 | 57.5 | % | $ | 1,798 | 50.6 | % | $ | 8,108 | 66.2 | % | $ | 5,243 | 57.2 | % | |||||||||||||||||
Selling and Marketing.Selling and marketing expenses were $1.3 million and $375,000 in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $919,000, or 245.1%, from 2004 to 2005. Our selling and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions and trade show expenses. These expenses vary significantly from quarter to quarter based on the timing of trade shows and product introductions. While most of the increases in selling and marketing expenses were due to the Allume acquisition, we also had a slight increase in headcount and increases in costs related to product collateral concept and design. As a percentage of revenues, selling and marketing expenses increased to 18.8% for the three months ended September 30, 2005 from 10.6% in the three months ended September 30, 2004, as a result of the increase in costs.
Selling and marketing expenses were $2.1 million and $1.2 million in the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $938,000, or 80.5%, from 2004 to 2005. Again, while the largest component of the increase is the Allume acquisition, we did have some increases in other costs such as trade show expenses, headcount and product-design related costs which were partially offset by decreases in other miscellaneous costs. As a percentage of revenues, selling and marketing expenses increased to 17.2% for the nine months ended September 30, 2005 from 12.7% in the nine months ended September 30, 2004, as a result of the increase in costs.
Research and Development.Research and development expenses were $1.2 million and $633,000 in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $611,000, or 96.5%, from 2004 to 2005. Our research and development expenses consist primarily of personnel and equipment costs required to conduct our software development efforts. We remain focused on the development and expansion of our technology, particularly our wireless, diagnostic, utility and Internet software technologies. The increase in our research and development expenses was primarily due to the addition of the Allume operations, outsourced engineering services which began in the fourth quarter of 2004 and a refocus of our consulting services to internal product development. As a percentage of revenues, research and development expenses increased to 18.1% for the three months ended September 30, 2005 from 17.8% in the three months ended September 30, 2004, as a result of the increase in costs.
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Research and development expenses were $2.6 million and $1.9 million in the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $716,000, or 37.3%, from 2004 to 2005. The increase in our research and development expenses was primarily due to the Allume acquisition, as well as the addition of outsourced engineering services which began in the fourth quarter of 2004 and a refocus of our consulting services to internal product development. As a percentage of revenues, research and development expenses increased to 21.5% for the nine months ended September 30, 2005 from 21.0% for the nine months ended September 30, 2004, as a result of the increase in costs.
General and Administrative.General and administrative expenses were $1.4 million and $790,000 in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $640,000, or 81.0%, from 2004 to 2005. The increase in our general and administrative expenses is due to the Allume acquisition as well as increases in accounting, legal and consulting fees (including transition costs) of $350,000, annual meeting expenses of approximately $36,000, travel and miscellaneous expenses of approximately $45,000, offset by reductions in our compensation expense of approximately $42,000. As a percentage of revenues, general and administrative expenses decreased to 20.7% for the three months ended September 30, 2005 from 22.2% in the three months ended September 30, 2004, as a result of the increase in revenues.
General and administrative expenses were $3.4 million and $2.2 million in the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $1.2 million, or 56.21%, from 2004 to 2005. The increase in our general and administrative expenses is primarily due to non-recurring increases in compensation and benefits costs of approximately $300,000, which is partially a non-recurring severance expense associated with our change in Chief Financial Officers (June 20, 2005), accounting, legal and consulting fees of approximately $700,000, travel and miscellaneous expenses of approximately $60,000 and insurance expenses of approximately $50,000, offset by reductions in our rent expense and bad debt expense of approximately $156,000. As a percentage of revenues, general and administrative expenses increased to 27.5% for the nine months ended September 30, 2005 from 23.5% in the nine months ended September 30, 2004, as a result of the these increased costs.
Interest Income.Interest income was $161,000 and $14,000 in the three months ended September 30, 2005 and 2004, respectively, representing an increase of $147,000 or 1,050.0% from 2004 to 2005. Interest income was $475,000 and $28,000 in the nine months ended September 30, 2005 and 2004, respectively, representing an increase of $447,000 or 1,596.4% from 2004 to 2005. Interest income is directly related to our average cash balance during the period and varies among periods. We had net proceeds of $20.8 million from a private placement of our common stock which took place during the first quarter of 2005. We have not changed our investment strategy during the periods being reported on, with our excess cash consistently being invested in short term marketable debt securities classified as cash equivalents.
Provision for Income Taxes.The provision for income taxes was $47,000 and $22,000 in the three and six months ended September 30, 2005 and 2004, respectively. The provision for income taxes was $55,000 and $37,000 in the nine months ended September 30, 2005 and 2004, respectively. In all periods, the provision for income taxes relates to an accrual for alternative minimum taxes which are expected to be owed on income as well as certain state minimum tax payments. The Company has a full valuation allowance on its net deferred tax assets.
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Liquidity and Capital Resources
Since our inception, we have financed operations primarily through cash generated from operations and from proceeds of $18.1 million generated by our initial public offering in 1995. On February 18, 2005, the Company entered into a Common Stock Purchase Agreement for the private placement of 3,500,000 shares of the Company’s common stock, $0.001 par value, at a price of $6.40 per share, resulting in aggregate gross cash proceeds to the Company of $22,400,000 and approximate net cash proceeds to the Company of $20,786,000 after expenses. The transaction closed simultaneously with the execution of the Purchase Agreement on February 18, 2005. C.E. Unterberg, Towbin LLC, the placement agent for the transaction, received a cash fee equal to 6% of the aggregate gross proceeds of the Private Placement.
Net cash provided by operating activities was $2.0 million in the nine months ended September 30, 2005 compared to $1.5 million in the comparable period of 2004. The primary source of operating cash in both periods was the net income and the increase in accounts payable and accrued liabilities, offset by the collection of accounts receivable.
During the nine months ended September 30, 2005, we used $11.3 million in investing activities compared to $46,000 in the same period of 2004. This included $11.3 million for the purchase of Allume in 2005 as well as $44,000 for other capital expenditures. Our capital expenditures in both periods consisted of the purchase of computers and other office equipment.
We received $265,000 in cash from the exercise of employee stock options during the nine months ended September 30, 2005 compared to $568,000 during the comparable period of 2004.
At September 30, 2005, we had $20.4 million in cash and cash equivalents and $22.3 million of working capital. Our accounts receivable balance, net of allowance for doubtful accounts and other adjustments, was $4.8 million at September 30, 2005. We have no significant capital commitments, and currently anticipate that capital expenditures will not vary significantly from recent periods. We believe that our existing cash, cash equivalents and cash flow from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. We may require additional funds to support our working capital requirements or for other purposes and may seek to raise additional funds through public or private equity or debt financing or from other sources. If additional financing is needed, we cannot assure you that such financing will be available to us at commercially reasonable terms or at all.
Our corporate headquarters, which includes our principal administrative, sales and marketing, customer support and research and development facilities, is located in Aliso Viejo, California. We have leased this space through May 2009. We also lease approximately 7,700 square feet in Watsonville, California under a new lease that expires September 30, 2010. We are currently working on a new operating lease for our facility in Lee’s Summit, Missouri to replace the lease that expired in June 2005.
As of September 30, 2005, we had no debt and no long term liabilities. The following table summarizes our contractual obligations as of September 30, 2005 (in thousands):
Payments due by period | ||||||||||||||||||||
1 year | More than | |||||||||||||||||||
Contractual obligations: | Total | or less | 1 - 3 Years | 3-5 Years | 5 Years | |||||||||||||||
Operating lease obligation | $ | 2,062 | $ | 508 | $ | 1,025 | $ | 529 | $ | 0 | ||||||||||
Employment agreements | 830 | 360 | 470 | 0 | 0 | |||||||||||||||
Purchase obligations | 149 | 149 | 0 | 0 | 0 | |||||||||||||||
Total | $ | 3,041 | $ | 1,017 | $ | 1,495 | $ | 529 | $ | 0 | ||||||||||
During our normal course of business, we have made certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These include: intellectual property indemnities to our customers and licensees in connection with the use, sale and/or license of our products; indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease; indemnities to vendors and service providers pertaining to claims based on the negligence or willful misconduct; indemnities involving the accuracy of representations and warranties in certain contracts; and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware. We may also issue a guarantee in the form of a standby letter of credit as security for contingent liabilities under certain customer
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contracts. The duration of these indemnities, commitments and guarantees varies, and in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees may not provide for any limitation of the maximum potential for future payments we could be obligated to make. We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets.
CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of results of operations, financial condition and liquidity are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may materially differ from these estimates under different assumptions or conditions. On an on-going basis, we review our estimates to ensure that the estimates appropriately reflect changes in our business or new information as it becomes available.
We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our consolidated financial statements:
Revenue Recognition- Software revenue is recognized in accordance with the Statement of Position (“SOP”) 97-2,Software Revenue Recognition,as amended, when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable, and collectibility is probable. We recognize revenues from sales of our software to OEM customers or end users as: completed products are shipped and title passes; or from royalties generated as authorized customers duplicate our software, if the other requirements of SOP 97-2 are met. If the requirements of SOP 97-2 are not met at the date of shipment, revenue is not recognized until these elements are known or resolved. Returns from OEM customers are limited to defective goods or goods shipped in error. Historically, OEM customer returns have not exceeded the very nominal estimates and reserves. Management reviews available retail channel information and makes a determination of a return provision for sales made to distributors and retailers based on current channel inventory levels and historical return patterns. Certain sales to distributors or retailers are made on a consignment basis. Revenue for consignment sales are not recognized until sell through to the final customer is established.
Product sales directly to end-users are recognized upon delivery. End users have a thirty day right of return, but such returns are reasonably estimable and have historically been immaterial. We also provide technical support to our customers. Such costs have historically been insignificant.
Service revenues include sales of consulting services, website hosting and fulfillment. We recognize service revenues as services are provided or on a percentage completion basis for projects with durations longer than three months.
Accounts Receivable– We sell our products worldwide. We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history, the customer’s current credit worthiness and various other factors, as determined by our review of their current credit information. We continuously monitor collections and payments from our customers. We estimate credit losses and maintain a bad debt reserve based upon these estimates. While such credit losses have historically been within our estimated reserves, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. If not, this could have an adverse effect on our consolidated financial statements.
Goodwill– We have adopted SFAS No. 142,Goodwill and Other Intangible Assets,effective January 1, 2002. As a result of the adoption, we are no longer required to amortize goodwill. Prior to the adoption of SFAS 142, goodwill was amortized over 7 years. In accordance with SFAS No. 142, we review the recoverability of the carrying value of goodwill at least annually or whenever events or circumstances indicate a potential impairment. Our annual impairment testing date is December 31. Recoverability of goodwill is determined by comparing the estimated fair value of our reporting units to the carrying value of the underlying net assets in the reporting units. If the estimated fair value of a reporting unit is determined to be less than the carrying value of its net assets, goodwill is deemed impaired and an impairment loss is recognized to the extent that the carrying value of goodwill exceeds the difference between the estimated fair value of the reporting unit and the fair value of its other assets and liabilities. We determined that we did not have any impairment of goodwill at December 31, 2004. Estimates of reporting unit fair value are based upon market capitalization and therefore are volatile being sensitive to market fluctuations. To the extent that our market capitalization decreases significantly or the allocation of value to our reporting units changes, we could be required to write off some or all of our goodwill.
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Deferred Income Taxes- We account for income taxes under SFAS No. 109,Accounting for Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in our financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of our assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. We currently have a full valuation allowance on our deferred tax assets. Based on our assessment of all available evidence, we concluded that it is not more likely than not that our deferred tax assets will be realized. This conclusion is based primarily on our history of net operating losses as compared to only a recent trend of profitable operations, the potential for future stock option deductions to significantly reduce taxable income, annual net operating loss limitations under Section 382 of the Code and the need to generate significant amounts of taxable income in future periods on a consistent and prolonged basis in order to utilize the deferred tax assets. We will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If we continue to meet our financial projections and improve our results of operations, or if circumstances otherwise change, it is possible that we may release all or a portion of our valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the valuation is released.
Stock-Based Compensation –We currently account for the issuance of stock options to employees using the intrinsic value method according to Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). We grant stock options with an exercise price equal to the fair market value on the date of grant and, accordingly, no compensation expense is recorded for stock options. When the recently issued SFAS No. 123R “Share-Based Payment” pertaining to accounting treatment for employee stock options takes effect, we will be required to treat the fair value of the stock options granted to employees as compensation expense, which could have a materially adverse impact on our business, results of operations and financial condition.
RISK FACTORS
Our future operating results are highly uncertain. Before deciding to invest in our common stock or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the SEC, including our Annual Report onForm 10-K, Amendment No. 2 for the year ended December 31, 2004 and our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occur, that could seriously harm our business, financial condition or results of operations. In that event, the market price for our common stock could decline and you may lose all or part of your investment.
Our quarterly operating results may fluctuate and cause the price of our common stock to fall.
Our quarterly revenue and operating results have fluctuated significantly in the past and may continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. If our operating results do not meet the expectations of securities analysts or investors, our stock price may decline. Fluctuations in our operating results may be due to a number of factors, including the following:
• | the size and timing of orders from and shipments to our major customers; | ||
• | the size and timing of any return product requests for our products; | ||
• | our ability to maintain or increase gross margins; | ||
• | variations in our sales channels or the mix of our product sales; | ||
• | the gain or loss of a key customer; |
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• | our ability to specify, develop, complete, introduce, market and transition to volume production new products and technologies in a timely manner; | ||
• | the availability and pricing of competing products and technologies and the resulting effect on sales and pricing of our products; | ||
• | the effect of new and emerging technologies; | ||
• | deferrals of orders by our customers in anticipation of new products, applications, product enhancements or operating systems; and | ||
• | general economic and market conditions. |
A large portion of our operating expenses, including rent, depreciation and amortization is fixed and difficult to reduce or change. Accordingly, if our total revenue does not meet our expectations, we may not be able to adjust our expenses quickly enough to compensate for the shortfall in revenue. In that event, our business, financial condition and results of operations would be materially and adversely affected.
Due to all of the foregoing factors, and the other risks discussed in this report, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of future performance.
Although we have begun reporting backlog, our ability to predict our revenues and operating results is extremely limited.
We have historically operated with little backlog because we have generally shipped our software products and recognized revenue shortly after we received orders because our production cycle has traditionally been very short. As a result, our sales in any quarter were generally dependent on orders that were booked and shipped in that quarter. As our wireless business has evolved, production cycle time for items such as data kits has increased to the point that orders received towards the end of a quarter may not ship until the subsequent quarter. Additionally, customers may issue purchase orders that have extended delivery dates that may cause the shipment to fall in a subsequent quarter. These situations make it difficult for us to predict what our revenues and operating results will be in any quarter. Therefore, the level of backlog is not necessarily indicative of trends in our business. As of September 30, 2005, we had a backlog of approximately $2.1 million.
We depend upon a small number of customers for a significant portion of our revenues.
In the past we have derived a substantial portion of our revenues from sales to a small number of customers and expect to continue to do so in the future. The agreements we have with these entities do not require them to purchase any minimum quantity of our products and may be terminated by the entity or us at any time for any reason upon minimal prior written notice. Accordingly, we cannot be certain that these customers will continue to place large orders for our products in the future, or purchase our products at all. Our largest OEM customer accounted for 60.3% and 64.2% of our net revenues in the nine months ended September 30, 2005 and 2004, respectively. Our three largest OEM customers accounted for 68.5% and 77.0% in the nine months ended September 30, 2005 and 2004, respectively.
Our customers may acquire products from our competitors or develop their own products that compete directly with ours. Any substantial decrease or delay in our sales to one or more of these entities in any quarter would have an adverse effect on our results of operations. In addition, certain of our customers have in the past and may in the future acquire competitors or be acquired by competitors, causing further industry consolidation. In the past, such acquisitions have caused the purchasing departments of the combined companies to reevaluate their purchasing decisions. If one of our major customers engages in an acquisition in the future, it could change its current purchasing habits. In that event, we could lose the customer, or experience a decrease in orders from that customer or a delay in orders previously made by that customer. Further, although we maintain allowances for doubtful accounts, the insolvency of one or more of our major customers could result in a substantial decrease in our revenues.
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Competition within our product markets is intense and includes numerous established competitors, which could negatively affect our revenues.
We operate in markets that are extremely competitive and subject to rapid changes in technology. Specifically, Microsoft Corporation poses a significant competitive threat to us because Microsoft operating systems may include some capabilities now provided by certain of our OEM and retail software products. If users are satisfied relying on the capabilities of the Windows-based systems or other operating systems, or other vendors products, sales of our products are likely to decline. In addition, because there are low barriers to entry into the software market, we expect significant competition from both established and emerging software companies in the future. Furthermore, many of our existing and potential OEM customers may acquire or develop products that compete directly with our products.
Microsoft and many of our other current and prospective competitors have significantly greater financial, marketing, service, support, technical and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the promotion and sale of their products. There is also a substantial risk that announcements of competing products by large competitors such as Microsoft or other vendors could result in the cancellation of orders by customers in anticipation of the introduction of such new products. In addition, some of our competitors currently make complementary products that are sold separately. Such competitors could decide to enhance their competitive position by bundling their products to attract customers seeking integrated, cost-effective software applications. Some competitors have a retail emphasis and offer OEM products with a reduced set of features. The opportunity for retail upgrade sales may induce these and other competitors to make OEM products available at their own cost or even at a loss. We also expect competition to increase as a result of software industry consolidations, which may lead to the creation of additional large and well-financed competitors. Increased competition is likely to result in price reductions, fewer customer orders, reduced margins and loss of market share.
Acquisitions of companies or technologies may disrupt our business and divert management attention and cause our current operations to suffer.
We recently acquired all the outstanding capital stock of Allume, Inc. See note 4 of Notes to Unaudited Condensed Consolidated Financial Statements. We expect to continue to consider acquisitions of complementary companies, products or technologies. As part of any such acquisition, including that of Allume, Inc., we will be required to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may cause disruptions in our operations and divert management’s attention from our company’s day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. Acquisitions may also subject us to liabilities and risks that are not known or identifiable at the time of the acquisition.
We may also have to incur debt or issue equity securities in order to finance future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our existing stockholders. In addition, we expect our profitability could be adversely affected because of acquisition-related accounting costs and write offs. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have had limited or no prior experience. If we are unable to fully integrate acquired businesses, products or technologies within existing operations, we may not receive the intended benefits of acquisitions.
If the adoption of new technologies and services grows more slowly than anticipated in our product planning and development, our future sales and profits may be negatively affected.
If the adoption of new technologies and services does not grow or grows more slowly than anticipated in our product planning and development, demand for certain of our products and services will be reduced. For example, our new QuickLink Mobile and QuickLink Enterprise products provide notebook users with the ability to roam between wireless wide area networks (“WWAN”)
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and Wi-Fi hot spots. Therefore, future sales and any future profits from these and related products are substantially dependent upon the widespread acceptance and use of Wi-Fi as an effective medium of communication by consumers and businesses.
Our products may contain undetected software errors, which could negatively affect our revenues.
Our software products are complex and may contain undetected errors. In the past, we have discovered software errors in certain of our products and have experienced delayed or lost revenues during the period it took to correct these errors. Although we and our OEM customers test our products, it is possible that errors may be found in our new or existing products after we have commenced commercial shipment of those products. These undetected errors could result in adverse publicity, loss of revenues, delay in market acceptance of our products or claims against us by customers.
Technology and customer needs change rapidly in our market, which could render our products obsolete and negatively affect our revenue.
Our future success will depend on our ability to anticipate and adapt to changes in technology and industry standards. We will also need to continue to develop and introduce new and enhanced products to meet our customers’ changing demands, keep up with evolving industry standards, including changes in the Microsoft operating systems with which our products are designed to be compatible, and to promote those products successfully. The communications and utilities software markets in which we operate are characterized by rapid technological change, changing customer needs, frequent new product introductions, evolving industry standards and short product life cycles. Any of these factors could render our existing products obsolete and unmarketable. In addition, new products and product enhancements can require long development and testing periods as a result of the complexities inherent in today’s computing environments and the performance demanded by customers. If our software markets do not develop as we anticipate, or our products do not gain widespread acceptance in these markets or if we are unable to develop new versions of our software products that can operate on future operating systems, our business, financial condition and results of operations could be materially and adversely affected.
Delays or failure in deliveries from our component suppliers could cause our net revenue to decline and harm our results of operations.
We rely on third party suppliers to provide us with services and components for our product kits. These components include: compact discs; cables; printed manuals; and boxes. We do not have long-term supply arrangements with any vendor to obtain these necessary services and components for our products. If we are unable to purchase components from these suppliers or if the compact disc replication services that we use do not deliver our requirements on schedule, we may not be able to deliver products to our customers on a timely basis or enter into new orders because of a shortage in components. Any delays that we experience in delivering our products to customers could impair our customer relationships and adversely impact our reputation and our business. In addition, if our third party suppliers raise their prices for components or services, our gross margins would be reduced.
A shortage in the supply of wireless communication devices such as PC cards could adversely affect our revenues.
Our products are utilized with major wireless networks throughout the world that support data communications through the use of wireless communication devices such as PC cards. Since wireless network providers generally incorporate our products into the wireless communication devices that they sell directly to individual consumers, our future success depends upon the availability of such devices to consumers at reasonable prices. A shortage in the supply of wireless communication devices could put upward pressure on prices or limit the quantities available to individual consumers which could materially affect the revenues that we generate from our products.
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We may be unable to adequately protect our intellectual property and other proprietary rights, which could negatively impact our revenues.
Our success is dependent upon our software code base, our programming methodologies and other intellectual properties and proprietary rights. In order to protect our proprietary technology, we rely on a combination of trade secret, nondisclosure and copyright and trademark law. We currently own United States trademark registrations for certain of our trademarks and United States patents for certain of our technologies, however, these measures afford us only limited protection. Furthermore, we rely primarily on “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. Accordingly, it is possible that third parties may copy or otherwise obtain our rights without our authorization. It is also possible that third parties may independently develop technologies similar to ours. It may be difficult for us to detect unauthorized use of our intellectual property and proprietary rights.
We may be subject to claims of intellectual property infringement as the number of trademarks, patents, copyrights and other intellectual property rights asserted by companies in our industry grows and the coverage of these patents and other rights and the functionality of software products increasingly overlap. From time to time, we have received communications from third parties asserting that our trade name or features, content, or trademarks of certain of our products infringe upon intellectual property rights held by such third parties. We have also received correspondence from third parties separately asserting that our fax products may infringe on certain patents held by each of the parties. Although we are not aware that any of our products infringe on the proprietary rights of others, third parties may claim infringement by us with respect to our current or future products. Infringement claims, whether with or without merit, could result in time-consuming and costly litigation, divert the attention of our management, cause product shipment delays or require us to enter into royalty or licensing agreements with third parties. If we are required to enter into royalty or licensing agreements, they may not be on terms that are acceptable to us. Unfavorable royalty or licensing agreements could seriously impair our ability to market our products.
Our stock price is highly volatile. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid for them.
The market price of our common stock has fluctuated substantially in the past and is likely to continue to be highly volatile and subject to wide fluctuations. These fluctuations have occurred and may continue to occur in response to various factors, many of which we cannot control, including:
• | quarter-to-quarter variations in our operating results; | ||
• | announcements of technological innovations or new products by our competitors, customers or us; | ||
• | market conditions within our retail and OEM software markets; | ||
• | general global economic and political instability; | ||
• | changes in earnings estimates or investment recommendations by analysts; | ||
• | changes in investor perceptions; or | ||
• | changes in expectations relating to our products, plans and strategic position or those of our competitors or customers. |
In addition, the market prices of securities of high technology companies have been especially volatile. This volatility has significantly affected the market prices of securities of many technology companies. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid. In the past, companies that have experienced volatility in the market price of their securities have been the subjects of securities class action litigation. If we were the object of a securities class action litigation, it could result in substantial losses and divert management’s attention and resources from other matters.
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If we are unable to retain key personnel, the loss of their services could materially and adversely affect our business, financial condition and results of operations.
Our future performance depends in significant part upon the continued service of our senior management and other key technical and consulting personnel. We do not have employment agreements with our key employees that govern the length of their service. The loss of the services of our key employees would materially and adversely affect our business, financial condition and results of operations. Our future success also depends on our ability to continue to attract, retain and motivate qualified personnel, particularly highly skilled engineers involved in the ongoing research and development required to develop and enhance our communication software products as well those in our highly specialized consulting business. Competition for these employees remains high and employee retention is a common problem in our industry. Our inability to attract and retain the highly trained technical personnel that are essential to our product development, consulting services, marketing, service and support teams may limit the rate at which we can generate revenue, develop new products or product enhancements and generally would have an adverse effect on our business, financial condition and results of operations. Additionally, retaining key employees during restructuring efforts is critical to our company’s success.
We may need to raise additional capital in the future through the issuance of additional equity, or convertible debt securities or by borrowing money, in order to meet our capital needs. Additional funds may not be available on terms acceptable to us to allow us to meet our capital needs.
We believe that the cash, cash equivalents and investments on hand and the cash we expect to generate from operations will be sufficient to meet our capital needs for at least the next twelve months. However, it is possible that we may need or choose to obtain additional financing to fund our activities. We could raise these funds by selling more stock to the public or to selected investors, or by borrowing money. We may not be able to obtain additional funds on favorable terms, or at all. If adequate funds are not available, we may be required to curtail our operations or other business activities significantly or to obtain funds through arrangements with strategic partners or others that may require us to relinquish right to certain technologies or potential markets. If we raise additional funds by issuing additional equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock. We currently have no established line of credit or other business borrowing facility in place.
It is possible that our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including:
• | the market acceptance of our products; | ||
• | the levels of promotion and advertising that will be required to launch our products and achieve and maintain a competitive position in the marketplace; | ||
• | our business, product, capital expenditure and research and development plans and product and technology roadmaps; | ||
• | the levels of inventory and accounts receivable that we maintain; | ||
• | capital improvements to new and existing facilities; | ||
• | technological advances; | ||
• | our competitors’ response to our products; and | ||
• | our relationships with suppliers and customers. |
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In addition, we may require additional capital to accommodate planned growth, hiring, infrastructure and facility needs or to consummate acquisitions of other businesses, products or technologies.
Our business, financial condition and operating results could be adversely affected as a result of legal, business and economic risks specific to international operations.
Each year, a percentage of our revenues are derived from sales to customers outside the United States. This percentage can vary significantly from quarter to quarter and from year to year. We also frequently ship products to our domestic customers’ international manufacturing divisions and subcontractors. In the future, we may expand these international business activities. International operations are subject to many inherent risks, including:
• | general political, social and economic instability; | ||
• | trade restrictions; | ||
��� | the imposition of governmental controls; | ||
• | exposure to different legal standards, particularly with respect to intellectual property; | ||
• | burdens of complying with a variety of foreign laws; | ||
• | import and export license requirements and restrictions of the United States and each other country in which we operate; | ||
• | unexpected changes in regulatory requirements; | ||
• | foreign technical standards; | ||
• | changes in tariffs; | ||
• | difficulties in staffing and managing international operations; | ||
• | difficulties in securing and servicing international customers; | ||
• | difficulties in collecting receivables from foreign entities; and | ||
• | potentially adverse tax consequences. |
These conditions may increase our cost of doing business. Moreover, as our customers are adversely affected by these conditions, our business with them may be disrupted and our results of operations could be adversely affected.
The market price of our common stock may be adversely affected by the sale of significant numbers of shares of our common stock by any of our principal stockholders.
A total of 3,500,000 shares of our common stock was recently sold in a private placement in February 2005. The associated registration statement for such shares became effective on June 17, 2005 In addition, there are other large blocks of shares held by individual stockholders which are eligible for resale under Rule 144, including William W. Smith, Jr., our President and Chief Executive Officer, who held 3,772,115 shares at October 31, 2005, and Rhonda L. Smith who held 2,414,115 shares. Overall, our trading volume fluctuates widely and at times is relatively limited. The market price for our common stock could decline as a result of the sale of a large number of the shares or the perception that such sales may occur. The sale of a large number of our common stock also might make it more difficult for us to sell equity or equity-related securities in the future at a time and at the prices that we deem appropriate.
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We may be subject to regulatory scrutiny and may sustain a loss of public confidence if we are unable to satisfy regulatory requirements relating to internal controls over financial reporting.
Section 404 of the Sarbanes-Oxley Act of 2002 requires us to perform an evaluation of our internal controls over financial reporting and have our independent registered public accounting firm attest to such evaluation on an annual basis. Compliance with these requirements can be expensive and time-consuming. While we believe that we will be able to meet the required deadlines, no assurance can be given that we will meet the required deadlines in future years. If we fail to timely complete this evaluation, or if our auditors cannot timely attest to our evaluation, we may be subject to regulatory scrutiny and a loss of public confidence in our internal controls.
Provisions of our charter and bylaws and Delaware law could make a takeover of our company difficult.
Our certificate of incorporation and bylaws contain provisions that may discourage or prevent a third party from acquiring us, even if doing so would be beneficial to our stockholders. For instance, our certificate of incorporation authorizes the board of directors to fix the rights and preferences of shares of any series of preferred stock, without action by our stockholders. As a result, the board can authorize and issue shares of preferred stock, which could delay or prevent a change of control because the rights given to the holders of such preferred stock may prohibit a merger, reorganization, sale or other extraordinary corporate transaction. In addition, we are organized under the laws of the State of Delaware and certain provisions of Delaware law may have the effect of delaying or preventing a change in our control.
We may be subject to additional risks.
The risks and uncertainties described above are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also adversely affect our business operations.
NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (revised 2004),Share-Based Payment, which replaces SFAS No. 123,Accounting for Stock-Based Compensationand supersedes APB No. 25,Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, beginning with the first annual period after June 15, 2005, with early adoption encouraged. In addition, SFAS No. 123R will cause unrecognized expense (based on the amounts in our pro forma footnote disclosure) related to options vesting after the date of initial adoption to be recognized as a charge to results of operations over the remaining vesting period. We are required to adopt SFAS No. 123R beginning January 1, 2006. Under SFAS No. 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition alternatives include prospective and retroactive adoption methods. Under the retroactive methods, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and share awards at the beginning of the first quarter of adoption of SFAS No. 123R, while the retroactive methods would record compensation expense for all unvested stock options and share awards beginning with the first period restated. We are evaluating the requirements of SFAS No. 123R and we expect that the adoption of SFAS No. 123R could have a material impact on our consolidated results of operations and earnings per share. We have not determined the method of adoption or the effect of adopting SFAS No. 123R.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Smith Micro’s financial instruments include cash and cash equivalents. At June 30, 2005, the carrying values of our financial instruments approximated fair values based on current market prices and rates.
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It is our policy not to enter into derivative financial instruments. We do not currently have any significant foreign currency exposure, as we do not transact business in foreign currencies. As such, we do not have significant currency exposure at June 30, 2005.
ITEM 4. CONTROLS AND PROCEDURES
a) | Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in timely alerting them to the material information relating to us (or our consolidated subsidiaries) required to be included in the reports we file or submit under the Exchange Act. |
b) | Changes in internal control over financial reporting. During the most recent fiscal quarter covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. |
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
An Annual Meeting of the Stockholders of the Company was held on July 28, 2005. At the Annual Meeting, the Stockholders voted as follows:
The Stockholders elected William W. Smith, Jr. (with 10,726,751 votes for and 276,875 withheld) and William Keiper (with 9,561,446 votes for and 1,442,180 withheld) as directors, to hold office until the 2008 Annual Meeting, or until their successors are elected and qualified.
In addition to Messrs. Smith and Keiper, the following directors will continue to hold office: Thomas G. Campbell, Gregory Szabo and Samuel Gulko.
The Stockholders approved and adopted the 2005 Stock Option / Stock Issuance Plan with 9,394,666 shares for, 1,599,042 shares against and 9,918 shares abstaining.
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The Stockholders approved an amendment to the Company’s certificate of incorporation to increase the number of authorized shares of Common Stock from 30,000,000 to 50,000,000 shares with 10,735,924 shares for, 260,587 shares against and 7,115 shares abstaining.
The Stockholders elected to ratify the appointment of BDO Seidman LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2005 (with 10,984,565 shares for, 12,061 shares against and 7,000 shares abstaining).
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
Exhibit No. | Exhibit Description | |||||
31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
32.1 | Certifications of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
(B) REPORTS ON FORM 8-K
On July 5, 2005 the Company filed a current report on Form 8-K in connection with the Acquisition of Allume Systems, Inc.
On August 9, 2005 the Company filed a current report on Form 8-K in connection with the earnings release for its fiscal quarter ended June 30, 2005.
On September 14, 2005 the Company filed an amendment to the Form 8-K filed on July 5, 2005 which included additional details and disclosures about the acquisition of Allume Systems, Inc.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SMITH MICRO SOFTWARE, INC. | ||||
November 11, 2005 | By | /s/ William W. Smith, Jr. | ||
William W. Smith, Jr. | ||||
Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) | ||||
November 11, 2005 | By | /s/ Andrew C. Schmidt | ||
Andrew C. Schmidt | ||||
Chief Financial Officer (Principal Financial Officer) |
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EXHIBIT INDEX
Exhibit No. | Exhibit Description | |||||
31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
32.1 | Certifications of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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