Smith Micro Software Inc (SMSI) 2006 Q1 法說會逐字稿

Good afternoon ladies and gentlemen and welcome to Smith Micro Software first quarter 2006 financial results conference call. At this time, all participants are in a listen only mode. Following today's presentation, instructions will be given for the question and answer session. (Operator Instructions). As a reminder, this conference is being recorded today Wednesday April 26, 2006. I would like to turn the conference over to Mr. Bruce Quigley, Vice President, Investor Relations. Please go ahead, sir.

Thank you. Good afternoon and thank you for joining us today to discuss Smith Micro's financial results for the fiscal year 2006 first quarter, which ended March 31, 2006. By now, you should have received a copy of the news release discussing our first quarter results. If you do not have a copy and would like one, you may acquire it at Smith Micro's website at www.smithmicro.com or by calling 949-362-5800 and we will fax or e-mail one to you immediately.

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

During the course of this conference call, we may make forward-looking statements regarding future events or the future performance of the Company. Actual events or results of course, could differ materially. All forward-looking statements speak only as of today's date and are based upon the information currently available to the Company. The Company disclaims any intent to update publicly any such forward-looking statements, whether in response to new information, future events or otherwise. Such statements involve a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied in any forward looking statements including competitive factors; technology and product development; market demand for our products; and our ability to execute our business plans. For further information on potential factors that could effect our results, we refer you to the documents the Company files from time to time with the Securities and Exchange Commission, specifically the Company's most recent Form 10-Q available mid May and our form 10-K filings. These documents contain and identify important factors that could cause actual results to differ materially from those contained in any forward-looking statements.

At this time, I would like to turn the call over to Bill Smith, Chairman, President, and CEO of Smith Micro.

Thanks, Bruce. Good afternoon everyone. Thank you for joining us today for our first quarter earnings conference call. We appreciate your interest in Smith Micro. Before Andy takes you through our first quarter financial results in detail, I would like to review some of the highlights of the quarter. Following Andy's, remarks I will come back and make some final comments and then turn the call over for questions.

We are pleased to report another strong quarter achieving both record top and bottom line results. We generated record net revenue of 9.9 million, a 24% increase over the previous record revenue of 8 million in the fourth quarter of 2005 and nearly five times the $2 million recorded in last year's first quarter.

Pro forma net income for the first quarter, net of amortization of certain intangibles and stock compensation expense, was a record $2.9 million, or $0.12 per share, compared to a pro forma net income of $2.6 million, or $0.11 per share in the fourth quarter of 2005. This represents about a 12% increase sequentially. First quarter 2006 results provide a significant improvement over the unusually weak first quarter of 2005. Or first quarter pro forma net income when compared to the year-ago quarter indicates that our business model is providing nothing short of extreme growth. You should note that this comparison does not take into accounts that we enjoyed improvement in per share earnings despite a significant increase in the Company's share count, both year-over-year and sequentially. As of March 31, 2006 our fully diluted shares stood at 24.3 million compared with 23.9 million at the end of the fourth quarter of 2005 and 19.7 million at the end of the year-ago quarter. Therefore we achieved pro forma EPS of $0.12 this quarter with approximately 4.6 million additional shares being used in the EPS calculation year-over-year.

Cash and cash equivalents as of March 31, 2006 were 26 million, an increase of 4.8 million or 23% from the 21.2 million reported at the end of the fourth quarter of 2005. We also continue our strong momentum going forward as we enter the second quarter with a record backlog of 4.6 million, up from last quarter's record backlog of 4 million.

At the beginning of the second quarter we further expanded our product portfolio with the acquisition of PhoTags, Inc., a leading developer and marketer of revolutionary photo and music management technology. As some of you may know, this pioneering product suite known as Active Images, turns your JPEG file into a self-contained multi-media messaging system allowing users to add watermarks and text messages, music, sound, documents and more all in a single JPEG file. The patented Watermark technology is very exciting as it uniquely allows the user to placing a watermark over the JPEG image and later remove it without losing image data or quality.

Much like our acquisition of Allume Systems in July of 2005, our interest in PhoTags focused on seeking new business opportunities that made it possible by delivering their strong technology to an eager wireless marketplace. We are very optimistic about the music management technology. PhoTags, however, did not have the strong contacts in the wireless market as we do. Consequently we view this acquisition as a nice fit between the technology they developed and our strong market relationships. As handsets continue to become multi-media devices, we see that there is an opportunity to supply music management products to the customer base we know very well, that being handset manufacturers and wireless carriers.

We believe that the engineering group that comes along with the acquisition is very skilled at understanding multi-media needs and can build solutions for the market quickly and provide strong support for our wireless customers and prospects. Stay tuned as we now know that QuickLink Music, as we have renamed the application, fits nicely with our customers' requirements.

The PhoTags Group, now known as Smith Micro Software Israel, is based in Jerusalem, Israel. We will not only keep the group there, but will also grow the staff to meet our expanding multi-media software requirements. The former President of PhoTags is now the Vice-President of International Sales. As a senior sales executive operating out of the Jerusalem office, he will give us a stronger presence closer to the European and Asian markets. Therefore, as I said, we are very excited to bring the PhoTags talented staff into the Smith Micro family. We continue to broaden our wireless software product offerings to more fully participate in the strong momentum of the wireless broadband data marketplace with initiatives such as StuffIt Wireless, wireless handset-based music services, and now PhoTags' technology.

We have talked before about strategically capitalizing on the growth of the wireless multi-media technology deployment. We are excited about our involvement with our carrier customers in deploying additional wireless applications such as our wireless-based music services. Later in the call I will go into more detail about these opportunities as well as what we saw from our wireless initiatives during the quarter. I will also provide greater insight into our other business groups, which we remain very positive about for 2006.

With that said, I would like to turn the call over the Andy Schmidt, our CFO, to describe the first quarter financial results in detail. Go ahead, Andy.

Thank you Bill. First let me discuss a couple unique items that affect our financial statements this quarter. The PhoTags acquisition closed on April 5. As such, the acquisition has no effect on our first quarter financial results, although we will refer to the transaction as a subsequent event on our March 31 10-Q.

Second, we have implemented FAS 123R this quarter. Importantly we have recognized compensation expense related to the issuance of stock options and restricted stock for the first time this period. Finally, as we did last quarter, we have provided pro forma results and a reconciliation of pro forma results and GAAP results. Our pro forma results net out amortization of intangibles associated with acquisitions and net of FAS 123R stock option compensation to provide comparable operating results. Accordingly, all Q1 2006 and Q4 2005 results are referred to our pro forma amounts.

Now turning to the first quarter results. As Bill noted, we posted record revenues of 9.9 million and record earnings of $0.12 per fully diluted share. All areas of our revenue plan performed very well. While the new music essentials kit contributed in a meaningful manner, our core connection manager product shipped record quantities.

As covered during our last conference call, we continue to focus on expanding our product reach and reducing product concentration. As noted last quarter, revenues from our connection manager product represented 65% of revenues for the first half of 2005. That concentration dropped approximately 35% in fourth quarter of 2005 and is approximately 31% of revenues this quarter, even though revenues from our connection manager product rose this quarter.

Total revenues of 9.9 million increased from revenues of 2 million for the first quarter of 2005, an increase of almost 400%. In addition, revenues increased 24% from our then-record 8 million revenue for the quarter 2005 performance. First quarter revenues consisted of 7.1 million from our wireless and OEM segment; 2.5 million from our consumer products segment; and approximately $300,000 of miscellaneous revenue.

Switching to gross profit, as we consistently point out, we manage our business to maximize our gross margin dollars rather than our gross margin as a percentage of revenues. Gross margin dollars of 6.9 million increased 5.2 million or approximately 300% from the same period last year. In addition, gross margin dollars increased approximately $600,000 or 10% from our fourth quarter of 2005. Gross margin as a percentage of revenue was 69.4%, which is lower than previous periods due to outstanding sales of the new music kits. Kits include hardware components, which result in a lower gross margin percentage, but produce a similar gross margin dollar per unit and data downloads or PC card software sales. It should be noted that we had no per unit pricing changes during the quarter. In other words, the reduction in gross margin as a percentage is simply a function of product mix and not that of price compression. So while gross margin percentage for the quarter is lower than the previous quarter, gross margin dollar, operating profit, and net profit increased substantially.

Operating expenses for the first quarter of 2006 increased approximately $400,000 from fourth quarter of 2005. The increase is attributed to both seasonal items as well as structural items. Our seasonal items include first quarter expenses for the Mac World Trade Show. As for structural expenses, as previously noted, we had planned to add to our headcount and have been successful in hiring key employees to accelerate very exciting products including StuffIt Wireless. While our operating margin of 27.6% is lower than our fourth quarter 2005 operating margin of 30.7%, our operating income increased approximately $200,000 to a record $2.7 million. Of course, we recorded an operating loss for first quarter last year. So we are seeing a market difference to the start of the year.

Net income for the first quarter was $2.9 million or $0.12 per diluted share as compared to a loss of $0.01 last year and $0.11 per diluted earnings for the Q4 of 2005. The current quarter represents the fourth consecutive quarter of earnings growth. As Bill noted, the number of diluted shares for fourth quarter of 2005 was 23.9 million as compared to 24.3 million in Q1 of 2006. The difference in diluted shares from fourth quarter of 2005 to first quarter 2006 is primarily driven by the average market share price for the quarter. For reference, the average share price for third quarter of 2005 was $5.05. It was $6.67 in fourth quarter 2005 and $8.62 for the current quarter. While this dynamic increases the number of diluted shares used in our EPS calculation and hence reduces our diluted EPS assuming all other variables held constant, we're very pleased to see our share price increase.

From a balance sheet perspective, we have driven our cash position closing the period at 26 million in cash, up 4.8 million from yearend. This increase in cash is, in part, due to our current period earnings, but also a result of very successful collection efforts. Accordingly, accounts receivable decreased 1.5 million from yearend to 5.3 million on increasing sales. Net working capital increased from 29.4 million – or to 29.4 million, an increase of 4 million or 16% from fourth quarter 2005 alone.

In summary, we have posted another record quarter. Record revenues accompanied by record earnings. As a matter of fact, our first quarter revenues and earnings are roughly 50% of fiscal 2005's total year revenues and earnings. It's a great start to a new year. Now I'll turn the call back to Bill.

Thanks Andy. Let me now give you an update on the progress of our three business operations, which we define as follows – our OEM software business; our enterprise software business; and our consumer software business.

Starting with our OEM software business, our wireless relationships remain very strong. We are very excited about the ongoing opportunity to expand our wireless product reach as the wireless industry continues to aggressively roll out wireless broadband services. Verizon Wireless' launch of V CAST music has been a strong catalyst for our 2006 OEM business. Many of you have probably seen and heard the TV, radio, and print ads for Verizon Wireless' V CAST music. It's clear that they are aggressively marketing the service, which only helps the sales of the music essentials kits. Clearly we intend to offer even more compelling music solutions that incorporate the PhoTags technology in the near future and plan to market new music products aggressively during the balance of the year.

Earlier this month we announced an agreement with O2 Secure Wireless, a nationwide internet service provider in which they will be the first wireless ISP to ship QuickLink Mobile. QuickLink Mobile will allow O2 Secure Wireless' customers to connect to available Wi-Fi networks and, in the future, to expand that connectivity to wireless carrier-grade broadband services. The easy-to-use graphic interface will help O2 Secure Wireless users to see all available networks and quickly determine the appropriate available connection. QuickLink Mobile's ability to support both wireless WAN and Wi-Fi connections positions it as a single point connection manager to control and automate wireless connections.

New to our OEM business are significant opportunities to market the PhoTags technology to large digital camera manufacturers. PhoTags, prior to the acquisition, had made headway in securing OEM business with digital camera manufacturers worldwide. Our OEM sales effort will continue to sell into that worldwide market with the re-branded image technology.

Now lets talk about StuffIt Wireless. We announced recently that we are in prototype testing with two of the largest worldwide handset manufacturers and also have two of the largest carriers involved in the prototyping process. Additionally, we demonstrated StuffIt Wireless operating on multiple handsets during the recently concluded CTIA trade show in Las Vegas. Presently we are expanding our effort to include at least two more handset manufacturers in the near future. This work is progressing very well and is the first step towards having our compression technology designed into future handsets. In conjunction we are also working closely with one handset manufacturer to explore the compression of handset resources that can help reduce the cost of the handsets. Clearly we are seeing more opportunity in the compression space than we had earlier indicated. We believe we are still on track to secure our first contract by 2007.

We recently announced the release of another StuffIt OEM product, StuffIt Image. This product is aimed at the high-end digital camera market and is designed to compress raw images. In addition, StuffIt is designed to provide photo encryption of images to protect the integrity and security of the image. We are in the early stages of applying StuffIt Image to the requirements of one of the leading providers of high-end digital cameras. While we do not have any contracts yet, we are encouraged by the early interest levels.

We have also expanded our efforts to deploy StuffIt technology to the online photo processing sites to compress JPEG images to enhance utilization of the server infrastructure. This technology also is aimed at reducing the overall cost of storing and transmitting photo data. We are currently marketing this technology and are at the contract stage with a major internet service provider.

As you can see, our OEM sales efforts to deploy our [patent-pending] StuffIt technology have been significantly expanded since the Allume transaction. I am pleased to say that we see a bright future for our StuffIt compression products on all fronts.

Turning to our enterprise sales opportunity. The QuickLink Mobile enterprise application supports the broadest possible range of wireless wide area networks spanning nearly 200 carriers worldwide, Wi-Fi networks, and the latest in Wi-Fi 802-1X security protocols. While we did not close any deals during the first quarter, I am pleased to report good progress is being made on the enterprise front so far in the second quarter. We have already booked a first order from a New York Stock Exchange listed REIT and find ourselves in the final closing stages with a large national commercial bank that I alluded to last quarter. We anticipate contract terms being finalized shortly. Other prospects are progressing nicely with our lists growing. A large international consulting prospect appears to be close to entering the contract phase of the process and may close this quarter as well. Overall we feel very positive about the performance of this portion of our business.

Now the third part of our business, the consumer sector. The consumer business continues to perform much as we had anticipated and has provided a highly predictable revenue base for the rest of our businesses. During the quarter, contributions of the consumer products group have been on track. The group was successful with the re-launch of the CheckIt product line with CheckIt for Macintosh and the launch of the next upgrade of the Spring Cleaning product. The [aqua zone] line continues to perform well and for the first time will be available at Sam's Club in the near future.

To wrap things up. In conclusion I would like to finish my prepared remarks by providing an updated outlook on anticipated 2006 results. While we do not provide specific quarterly guidance, we can say that we remain very optimistic about the growth prospects for the remainder of the year. We have completed the integration of Allume and the PhoTags transaction has closed. We continue to look for strong performance throughout the 2006 year. While we believe results will improve sequentially on the top-line for second quarter, our second quarter is seasonally our slowest quarter in the consumer business and will include integration expense from the PhoTags acquisition. We believe results will accelerate further on both the top and bottom lines in the second half of the year driven by strong wireless music sales that we believe most likely will include our QuickLink music application from the PhoTags acquisition.

This was yet another record quarter on the top-line, the bottom line, and in backlog. But we firmly believe the best is yet ahead of us. With that, I'd like to conclude my comments and open the call for questions. Operator.

Thank you sir. (OPERATOR INSTRUCTIONS) Rich Church with CE Unterberg.

Thanks and congratulations on very impressive results. Can you comment on that last point regarding sequential growth. I think in the past you've talked about being able to grow sequentially in the mid teens level. Could you give any color around that commentary if that still stands even with the stronger results.

I'll jump in and help Bill on this one. Something that we've always alluded to is, if you look at the last two quarters, what has happened is we launched the music product, which has been very well received. Similar to the connection manager product we see products launched. There is quite a bit of sell-in. There is quite a bit of market around those products. Then we expect it to work as a step function. In other words, our customers are very aggressive about launching products. Then we expect them to flatten out somewhat and then take a next step up. So the last two quarters we've seen some very positive effects from launching the new products. As we look forward – again, quarters are very difficult to work with in that the periods are very short. When we look forward, we're not launching a new product in this current quarter. Bill alluded to, we expect to launch products later this year. Our existing lineup is early stage and has legs. We expect very strong performance from this lineup. We have a very good backlog. When we also look at this, we're not aware of any seasonality in the wireless segment. So all this steps up to say that we're going to have strong performance. But we are going to stay away from trying to guide towards specific quarter-on-quarter growth because our customers can put out a big marketing program that could straddle the quarter-end. We could completely miss an estimate. The way I put it, we're going to be very strong this particular quarter. We are very happy with the way the business is lining up.

Any thoughts on full year if you don't want to do quarter-to-quarter commentary.

I think we've said it. We're very bullish on the year. We expect to see the QuickLink music product enter the marketplace probably in the third quarter. We expect to be aggressively marketing the product to not only current customers, but to customers that we don't presently have. We see another step probably occurring around that event. I've alluded to some things we're doing in the StuffIt area that we've never talked about before. We're moving forward nicely in those areas. We feel we're very bullish about our overall growth throughout the year. We are being a little cautious because we frankly exceeded our own internal estimates this quarter. So you make a big step and you say maybe it's got to settle out. And we'll see.

You have obviously have a number – more opportunities than I had anticipated. Another – on a separate, at CTIA Verizon said their 11.5 million VKF-capable phones in the market. Could you give us any sense for, at this point, given these strong results how many have taken – or what portion have taken the music essentials kit?

No. We can't give guidance to that. That is a closely-held secret of Verizon. I would tell you that the number of handsets that are capable of playing music will continue to increase throughout the year. This is just very early stage in the music side of the business. It is obviously a very significant part of our OEM business case for 2006. It will grow rapidly. We clearly will see benefit from having additional handset manufacturers and additional models available in the market. You will probably see more of those in the second quarter.

At what stage do you think we get the QuickLink Music as part of the music essentials kit.

We aren't going to talk about that. That's a discussion between us and Verizon Wireless. As soon as we are at a point where we can talk about it, you can probably guess we'll jointly discuss that. Right now we'll be very quiet and just say that we are aggressively marketing the QuickLink Music product. We think it's a particularly strong play. We're very excited about it.

Thanks. Great quarter.

Anton Wahlman with ThinkEquity.

How many people did you take on from PhoTags headcount-wise roughly?

We took on eight people, seven of which are technical and one admin.

Did you also mention the percentage of revenue that Verizon constituted in the quarter?

It was approximately 70% of which case connection manager is 31% of total revenue.

That is 31% of your total revenue. But you have other customers like Alltel so not all that 31% was Verizon. Would that be fair?

That's correct.

Before you go any further, I'd like to welcome you to your first quarterly conference call with Smith Micro as well as welcome Reg King whom I am sure is on the call as well. We were very pleased to see both of you gentlemen publish reports in the last day or so.

Thank you. Good to be at the party. The music is good. Are you aware – there is clearly one large player in the market, Sprint, which has their own home-grown software. Any thoughts, anything you can say of the notion is there an RFP on the street for that opportunity? Or is there not? Any thoughts on where – how they view their own offering?

Which part of our software lineup? We have a very broad software lineup. Which part are you----?

The basic connection manager.

I would say to you that we are in constant dialog with all the major carriers. That would definitely include Sprint. We are actively marketing all of our product offerings to Sprint at present. You should take that to the bank.

Also, far broader than that, internationally there are literally hundreds of operators around the world, of course, that are launching 3G services for laptops in particular and obviously for handsets. Just looking on the laptop side, in general not a lot of announcements have been seen. If you look at country by country, you have three or four major operators. There haven't been that many announcement whether with you as a supplier or any of your competitors as a supplier. Can you flesh out your thinking. Obviously some of them haven't launched it. Some of them are small. Some of them – or these markets may be small. Any thoughts on the ultimate international opportunity for basic connection manager software?

That's a very good question. That is one of the reasons we are so pleased to have our Vice-President of International Sales now based in Jerusalem where he has much quicker access to both the European and Asian markets. We are seeing a lot of activity internationally from carriers. We haven't really talked about that yet as much. I would stay tuned. We are active. We are working not only on our own, but in tandem with a number of other large partners in the industry to bring a variety of our 3G-oriented software solutions to those markets as well. It is a big opportunity. It's hard to really size right now. We have had a number of dialogs ongoing. I know that my Vice-President of OEM sales is very pleased to have somebody overseas to take some of the legwork off of him. Now that guy is probably going to get tired quick. We'll keep him busy.

For example, are operators from around the world – in Europe alone you have got whatever – 30 countries and four operators in each. You are talking about, on paper, 120 systems. Many of them are owned by the same entities, so it's 60 owners of wireless properties, etc., wire operators in Europe – properties. Are any of them coming to you and saying, we see what you've done for Verizon. Can you put a proposal together? Are you getting any inbound requests like that? Or are you out there chasing people and showing them what you've done?

You should assume the answer to that is yes. I really don't want to discuss it further until we have a deal. Then I will be the first one out to tell everybody about it.

Alright. Just one final question then. Are there any step functions in your pricing scheme with any major customers of yours in terms of – is there anything coming up on January 1 or some other year anniversary of contracts or something like that that we should foresee in the next 12 months?

No.

Thank you.

Reg King with Nollenberger Capital Partners.

Welcome Reg.

Congrats on the quarter. Andy, I think I have a question for you. If I remember right from the PhoTags acquisition release and commentary, you are going to assume some debt around that acquisition. Is that correct?

Yes. We assumed 2 million in debt, which, of course, is all purchase accounting. None of that hits the P&L.

In that regard, you've had what looks like a strong collections effort and an up-tick in cash this quarter. How should we, at least qualitatively think about your interest and other line, which looked like it still showed some growth this quarter?

As everyone knows, interest rates are going up. So we are benefiting from that. Right now, our current quarter results, we're going to see a slight up-tick in that. We don't have any big plans to take that cash balance down at this point. We're adding to the cash balance. So we're going to see a slight up-tick.

But we should expect to see the debt come onto the balance sheet.

No. It's all part of purchase accounting where part of the purchase---- [multiple speakers]

I've got you, okay. Thank you very much. Bill, during your commentary you made a comment. I want to be sure I understand what you were saying. You said I believe, that you're working closely with a handset manufacturer to reduce the cost of handsets? Did I get that correctly?

What we're exploring with them is the possibility of applying the StuffIt compression technology to compress all the resources in the handset. In doing so allow them to reduce the cost of the handset by reducing the memory requirement and associated other overhead. This is more in the R&D area right now. We are working very closely with them. They are involved actively as well. Both sides would like to see a very successful outcome. It's too early tell at the present time. We think it's going to work. But we'll have to see.

Would this be working on the application software in the handset as well as the content that might reside on the handset?

Yes. We would compress everything on the phone. This is a much broader look at the use of our compression engine than just looking at it to compress JPEG.

Thank you. I am a little bit newer to this story. Could you help me Andy with the inventory and backlog. What is included in the inventory on your balance sheet? There is a little bit of up-tick from last quarter. It looks like you have strong backlog there. How should we think about that?

Inventory is really two primary pieces. One piece is driven by the consumer business, which is pretty predictable and pretty flat. The recent increase in inventory has to do with that sizeable backlog and the kit business that we do. All the music business that we're doing right now are kits. So we so have X amount of inventory as far as the backlog is concerned.

Is it – should I think about that as being skewed towards the kits since that is a [multiple speakers] portion of your business?

Yes. The increase is completely due to kits. That turns the next current quarter.

Great. Thank you very much.

Kevin Dede with Merriman.

Thank you. Let me add my congratulations gentlemen on a very nice March quarter. Could you refresh my memory. Which handsets were you running the compression software on at the CTIA show? I seem to remember a couple of brands. Could you refresh my memory on that.

That's a good question. I'll answer it because it was obvious we were running on both Motorola and Samsung handsets and a variety from each vendor.

You alluded to the second half in the PhoTags music application. You seemed pretty confident that Verizon is going to buy in on that – or your key customer will buy in on that in the second half. It is not clear to me where that confidence is coming from. How long have they had an opportunity to use that software and see it work in the field? How much exposure have they had with it? When do you think they pull the trigger on making a decision like that?

I'll talk generically about all of our carrier customers. One of the benefits of being on the inside with us is that you get a sneak preview before we buy things because we want to make sure that our customers think it's a bright idea for us to go out and make the acquisition. They've had a chance to see under the covers for a little while now. The application speaks to a need. The reason we acquired PhoTags was for two reasons – the music application as well as the expansion. They provided us with their JPEG technology not only in camera phones, but also in regular digital cameras. The music app really hit a need and provided the capability for a carrier who wanted to offer music applications to more effectively compete with the market leader who is clearly Apple. Apple software that they provide operates on the PC, on the Macintosh, allows for very effective download of music from the PC to the iPOD. One of the things that we saw was that one of the major advantages the carriers have is they offer downloaded music directly to the handset. But it is less costly if you go through your PC. The PhoTags application is a very rich user experience. It is very easy to use. It's very intuitive and is the kind of thing that gets you strong results when your products are reviewed. We feel very, very positive about what this application has to offer. We feel that, based on the discussions we've had so far with all of our customers, that this product has a lot of legs.

If you were to look at the mix of backlog, would you say it was similar to the mix of business in the March quarter?

Yes.

Would you mind characterizing the trends in orders both on the data connectivity kits and the music connectivity kits by month through the quarter and what you're seeing in April?

In the software business, it's a funny question. Orders and everything ships the last month. So month-to-month isn't that applicable to our business. Let me provide this to you. Kits and PC card balance is always an interesting phenomenon for us as far as product mix. The current quarter across all products, we saw 40% kits and 60% downloads or PC cards. We are seeing similar type activity right now. We can only take a look at our current quarter, since we're in such a growth mode, and say that seems to be accurate. Of course, that can change in the future. That's currently the way it's working.

Let me add to that. I'll say, as Andy alluded to in his prepared comments, first quarter was a record quarter for software shipped with PC cards. It exceeded third quarter 2005, which prior to that had been the record quarter. It wasn't hugely over that number. But nonetheless, it was a record. Performance across-the-board, for all of our software offerings, was very positive.

I asked that given that even though Verizon hasn't announced its intentions to migrate its network to the next technology. I know in some cases, that has caused disruptions in the flow of business. I am curious on what you see Verizon doing in terms of technology upgrades and how you might be able to adapt to those changes.

Clearly we can't really address the [Rev A] question. That is a question you have to put to Verizon. Any comment that we would make would be viewed by our customer as wholly out of place and inappropriate. I will simply say that I believe that that process will – if they were to do it – would be managed very appropriately. Business flow would just continue. I don't know how else to answer your question.

That's fair enough. What's important is that you know you're – that you understand where they are going.

Yes, we do.

And how that might change things. Thank you for taking all my questions.

Chad Bennett with MJSK.

Good quarter. Just a question. I think it might have been somewhat answered in the last go-around. Looking into Q2 you talked about seasonality specifically on the consumer side of the business. Can you talk about quantitatively what that seasonality would be for that business? Also, are we expecting any seasonality for the business outside of the consumer side?

The consumer side is very predictable in our view. It's very stable. Seasonality in that business is to the tune of $300,000. That is nowhere near the seasonality you see in quite a bit of retail product. That is the extent of the seasonality.

On the OEM side, as we said, we're not aware of any seasonality at this point. Probably a lot of that is attributed to the fact that all of our products are very early stage. So they are in deployment mode.

Let me add to that and say that as you view the rapid growth of the music offering, that might be a place where seasonality will come to bear once the market has established a track record. Potentially I could see that the music side of the business could peak in the fourth quarter. I don't know where it flattens out. I don't know how to read that. It's just too early. I could see some peaking in fourth quarter. I don't – maybe it will stay constant through the rest of the year.

That leads into my next question. Is it too early to talk about sell-through or attach rates on the music side and what you are seeing there?

We're not allowed to talk about exact numbers. I can say that the general reaction from our customer is extremely positive and very pleased with the level of excitement and the level of signups, and the level of attachment for music. I think they believe that music was a very strong launch. They expect a lot more from it.

I guess I'll be more specific. Are we past the retail store inventory builds stage and more dependent upon actual sell-through?

The model doesn't really seem to work that way at this particular time. This is again – our customer and all the carriers work on a service model. They are in the business of signing up subscribers. They have a lot of marketing tricks they can use to bring subscribers on board, which drive sales of our product. It's far too early in the launch to get into that piece. I'd say right now they are not even close to being fully launched in those products.

I think I would add to that. Yes, my first knee-jerk was, yes they've stocked all the stores. But then I have to stop and say I know there all these additional handsets coming out from yet new handset manufacturers that will require music essentials kits. All those will have to be stocked in the stores. I would echo what Andy just said and say that the dynamics of this thing are fairly broad. It's hard to pinpoint. Yes certain parts fully stocked and you are on sell-through model. Other parts just being stocked. It gets blended.

Andy, this is a question for you. I think since you said the composition of backlog was similar to product mix you recognized in Q1, gross margins have popped all over the place a little bit the last few quarters. What – can you give us any guidance on gross margin looking forward – somewhat of a range. Or are we at the bottom in Q1? Do we work our way up? Any type of guidance from that standpoint.

Before Andy tries to give you exact numbers, let me put a general tone to it. That is, the addition, assuming success on our part – of the QuickLink Music application adds yet another royalty to the cost of a kit and as such, will help improve gross margins on the kits. Clearly it's something that is very positive for us. That's why we've talked about the second half for that. If we can do it sooner, if our customer agrees with us that this is such a great product and we can get everything done, we will. With that, go ahead. If you want to go hang yourself with a number, go ahead and do it.

My simple is going to be, it will change. We're introducing new products. We're seeing our customers redefine products. That is why we focus on gross margin dollars. Every quarter we look at it. The best advice we can give is what we know is what we did in our current quarter. That is all we can do at this particular time. We do – we are very cognizant of how to run the business to make sure that we increase our gross margin dollars. Once again, products are always going to change. When you introduce your products, the exact number for modeling, the best thing to do is use what you know. We're keeping an eye on it. We're going to keep a focus on how do we increase gross margin dollars.

Okay, alright. And then just a quick housekeeping. What should expect in terms of a PhoTags one-time charge in Q2?

Let me go further than one-time charge. That particular business that we expect to be – just as the start – to be about – it's not a big number – probably a $250,000 addition to operating expenses on a quarterly basis. The integration effect will be that we take on the expenses immediately. Then there is a particular integration period on the revenue side to where we are looking at a couple quarters to get the revenues integrated and get those on tap to where they are an accretive acquisition. At this particular time, we are looking at a de minimal increase in operating expenses to carry that and expect the revenues to more than offset that in the pretty quick term.

Sounds good. Thanks.

Ed Ching with Rodman & Renshaw.

Great quarter. I am going to switch over and see what is going on with Verizon Wireless on the enterprise side. I know when you first talked about this you would be working in concert with them trying to find leads. Have they come back to you more often with some other things to look at?

We work with Verizon Wireless. We have build an enterprise-level product for them that they sell through to the enterprise. I am glad you asked the question because my prepared comments talked about what Smith Micro was doing to sell enterprise software and didn't really address what Verizon is doing. They are doing a very good job. They are executing on their business case. They are moving through a number of seats of enterprise software. It's a major initiative and focus area for them. They were a little ahead of us in deploying into this marketplace. You are starting to see us generate traction as I tried to indicate in my comments. I think that you should expect that they have enjoyed some of that traction a little bit ahead of us. They are doing a great job and we are fully supporting them.

Have you gotten any piggyback opportunities from them? When you first talked about this, I thought that was something that could possibly----

I don't want to take opportunities away from [inaudible]. They are selling our software for us. We're not competing against Verizon Wireless. We want to be very clear about that. When a customer comes to us and says that they want to buy our enterprise product, many of them will say yes, we are going to use Verizon Wireless, but we also need our client to support a number of other carriers. That usually becomes the deciding factor. Verizon's product supports Verizon and Verizon only. Our product supports up to 200 different carriers around the world. That is the differentiating point. We're seeing traction. We're excited about what's going on.

Another question is, in terms of the PC core manufacturers, is China seeing more of a market share with Verizon Wireless? Or is Novatel still holding its own right now in terms of shipping out products?

That is something I feel a little uncomfortable answering a question about. I think that the PC card that offers the same quality at the lowest price tends to be the PC card that ships the highest volume. I guess you can try to extrapolate from that.

Okay. The OEM sales force that you have, what is it right now? Is there any forecast to grow that or add more people?

We actually have. We've had a couple of significant adds including now having a Vice-President of International Sales. We've just added a Senior Director of OEM sales under the Vice-President of OEM Sales. The gentleman was – prior to this he had spent about six years at Smith Micro back in the fax modem days and was particularly successful. Went out on his own and decided that being back at Smith Micro might be a better way to make a great living. We are really pleased to have him back. We have definitely stepped up our muscle in the OEM space. We are backing that up with a number of other staff people behind them. So, yes. We're spending more money. We've added heads and OEM sales is a place we're growing for sure.

How many do you have right now?

We have about 140 now in the States, eight in Israel. If we find the right people, we certainly have it in our plan to add another 20 to 30.

In the sales force? In the OEM sales force?

Across all areas – R&D, sales, and marketing.

Are you not going to break it out and let me know how many sales force you have?

As we look forward, it's only about [inaudible].

Alright, okay. I guess maybe I missed it. I am not sure if I heard it. In terms of the V CAST kits, what is the – how often does Verizon come to you and reorder? Is it quarter-to-quarter or month-to-month?

It's probably month to month. They are ordering a couple months in advance. We see what's going on.

So it's basically the same system that they use for the office kits, right?

You got it. Only this is just bigger volume.

Alright. Thanks.

Joe Hudak with Wachovia Securities.

Not to be redundant, but great quarter. Getting back to this gross profit. What is your comfort range? Where do you feel comfortable on the low end to give us a little bit of a flavor going forward on the low end of profitability.

We were about 67% first current quarter. When you look at different products, kits run around 50% -- 50 to 60 depending on type of kit. Downloads are 95%. Obviously there is quite a range. Once again, depending on product mix, 60s can be very good performance.

So you are feeling comfortable somewhere in the mid 60s?

It can be at that level and, as Bill talked, we've got other products coming out in the future that will kick that up. There probably are some other product opportunities we're not yet aware of that we may pursue that may move it around. That is why we try to manage by gross margin dollars. For modeling, I would say look at the current quarter, current mix. There is no reason to assume that's not valid.

Okay, great. Good job. The other question – everything else has been very well handled. On SG&A going forward, will we be looking at approximately 15% increases quarter-to-quarter?

Right now we ran about 4.3 million on a pro forma basis. That included some trade show expenses. Current quarter we went to CTIA. That makes it fairly similar to last quarter from that perspective. We did disclose that we expect to add $250,000 in expenses from the acquisition. That is what we know right now. As we go forward, it's all on the basis of hiring good people. That is very hard to predict. We just hire good people so we wait till we find them.

Also on the backlog, which we've discussed many times, you've done a great job of increasing this quarter-over-quarter. Do you see this continuing at this run rate of this backlog? Or do you see it at some point just curtailing off?

It is one point of metric. We have to be careful about it because honestly we could enter a quarter with a $2 million backlog and have record sales. We are software so we turn very quickly. We like the 4.6 million backlog. An order comes in today, we can ship it tomorrow if it's a download. Understand it is just one point of reference. It's not necessarily like in the hardware business where you have to have lead time to actually ship product. It's a good number to have, but it's not the only number that makes the sales number work for the quarter.

The thing is, I want to clarify that too because I think a lot of people are using that to model going forward. At some point, the number may be non-existent to get – we can link – just exactly what you said. We could have record sales and revs.

That's true.

Good job.

Rich Church with CE Unterberg.

Thanks. Bill, you had commented I think in answer to an earlier question on the V CAST music essentials kit you thought it could peak in Q4. Do you mean in each Q4? Or were you saying at the end of this year it peaks and then in '07, it diminishes.

The question that I was commenting on was a question of seasonality. The question was, was there seasonality in the OEM business. Generally speaking we've always answered and said that we're not aware of any seasonality. However, as we view the music offering, we see it as a more consumer-driven kind of product offering, which may see enhanced sales around the holiday period. So the fourth quarter might peak up from the other three quarters of the year. But we don't know that yet. This is all pure conjecture on my part. I guess I should leave all that kind of stuff to you guys who do a great job of it.

Following on the Rev A question, that is clearly to give greater bandwidth, which I would assume could spark reorders or upgrades of PC cards, which would therefore be a positive for you.

You've got that one right. When you go to Rev A or if you skip that and go straight to Rev B, you've got to get all new hardware from a user point of view as far as the device you are using. You have to get either a new PC card or a new handset. It is a fundamental change in how the algorithms work.

Back to the music essentials kit, I think Verizon has been running a promotion of $20 for the kit from the $30 original intro. How does that affect your revenue for the kit?

Not at all. It's a decision Verizon makes. They do it based on the kind of revenue they are looking for from music downloads and everything else that goes on.

Is there a timeframe when you renegotiate pricing? Or do you have a volume discount built in?

We don't actively go out to try to renegotiate the price. Maybe our customer might want to bring it up every once in awhile. There is no timeframe. As Andy was very clear about, there has been no change in price in the just reported quarter. We have nothing that we want to discuss going forward. There is nothing really to talk about.

All of our products, whether it's music or the connection manager, there is a service element. That means that the hardware keeps changing, etc. That require continued service. That is built into the pricing, meaning that you don't run into the same pricing pressure that you would for a product that is a basic hardware piece that doesn't have any ongoing value except that the current marketing supports it. All of our pricing implies a service maintenance agreement. That is what allows us to keep the pricing where it is.

And that reflects your ability to be compatible with new hardware as it comes to market?

Exactly right.

And then, if I may be so bold – our checks have indicated Sprint and Verizon Wireless are the ones looking at the StuffIt compression software. Can you give us any sense for what sort of timeframe and what hurdles any carriers working with that software would have to overcome in order to get comfortable with deploying it in their networks?

That's an easy answer. I absolutely cannot comment on anything you just said. It's a good try though.

Alright. Thank you.

Kevin Dede with Merriman.

You talked about three enterprise customers of your own. Could you size up what sort of market that would be in terms of seats and how that business case would run.

We can talk about it. In the case of the large commercial bank, that is a very large opportunity. We are talking tens of thousands of seats over some period of time. It's going to be over a period of time. They don't deploy them all at once. They don't deploy it one quarter or two quarters. It's probably multiple quarters. It is a very large opportunity. There is a trailer of 20% per annum for maintenance for up days, etc. In that sense, it's a big deal.

The REIT that I mentioned is a New York Stock Exchange REIT. It's a large entity. We don't really know the absolute magnitude of it. They have made their first order and they are off and running. The large consulting firm is an international consulting firm. They are looking to deploy in about 90 different geos, if I remember correctly. It's a sizeable opportunity, probably measured in the thousands of seats. Then we have a full pipeline that falls in behind it. They are all big outfits. We are not looking for the little ones. We are looking for the big ones. Those are the ones we want to go after.

Your software adds a functionality of being able to security even on a Wi-Fi network as well, correct?

Right. It has all the 802-1X built in. We're constantly updating that and upgrading that and fully supports all types of PC cards and embedded modules as well as cards from Europe like from Option, etc. It's a very significant application. We're very bullish about the space.

Last question for me probably for Andy. Where do you stand on NOLs now? What sort of guidance would you give us on taxes? When do you think you're going to have to deal with that?

NOLs were up around the 18 to 20 million range. Due to the last acquisition, we do have a 382 limitation, which will limit us to using 11 million of NOL in the current year. Other than that, keep in mind that we do have following that research tax credits that we can deploy against revenue. And then any time we have stock options exercises, that is also a reduction in our tax liability. So we have a lot of opportunity through '06 and then going into '07 to have a low tax number.

What do you feel comfortable giving us as guidance on that?

What we typically model is a 4% tax rate. That comes down depending on stock options exercises. The current quarter that you see out there it's even less than 2.5% because we had options exercised last quarter. So 4% is a safe number for this year.

Perfect. Thank you very much gentlemen. Congrats again on a nice job.

(OPERATOR INSTRUCTIONS) At this time there are no further questions. I will turn the call back over to management for any closing comments.

I'd like to thank everyone again for joining us on today's call. We look forward to the next call, which should be our second quarter financial results conference call in July. Should you have any additional questions, please feel free to contact us or our investor relations firm, ZFKR Group. Thank you. Have a good day.

Ladies and gentlemen, this concludes the Smith Micro Software first quarter 2006 financial results conference call. We thank you again for your participation. You may now disconnect.