Socket Mobile - Operating Leverage and Secular Tailwinds

Business

Socket Mobile, Inc. (NASDAQ:SCKT) is very undervalued due to its high growth and huge operating leverage. At the current price of around $2.35 and a P/E of about 17, the market is not giving much credit to this operating leverage. Another point to consider is that the company has a declining segment that is hiding the strength of its core fast growing segment. Socket Mobile is basically a hardware company that sells mobile cordless barcode scanners and handheld mobile computers running the Windows Embedded 6.5 operating system.The company describes itself as only operating in one segment, but I'd refer to these two products as different segments. So the high growth segment is the mobile barcode scanner. It grew 60% in FY13 and another 40% in FY14. On the other hand, handheld mobile computer segment declined 38% in FY14. In FY14. The sales of wireless barcode scanners made up over 80% of revenue.

Industry

So why is something like a barcode scanner selling so well, and what's so exciting about the industry the company operates in? The answer is the tremendous growth of mobile-point-of-sale. The point-of-sale is simply where a transaction takes place and this has traditionally been at the cash register. Now a mPOS ( mobile point of sale) is simply a smartphone, tablet or dedicated wireless device that performs the functions of a cash register or electronic point of sale terminal. Any smartphone or tablet can be transformed into an mPOS with a downloadable mobile app.

Here’s a short video that briefly explains mPOS.

To summarize the video, all you need to do to use mPOS is to download an app that’s right for your mobile device. Then you buy the associated hardware. Done. That’s all it takes.  What really makes this so attractive to small shops and businesses is the cost savings. Big enterprise also benefits from the cost savings. A mPOS app/software usually charges you anywhere from around $49 to $99 a month, compared to a traditional POS that costs $3000 to $7000 a month. The reason the latter costs so muchis that it offers more business analytics - every POS terminal informs you which product is being sold the most and at what time of the day or what time of the week, gives you inventory tracking and return data, and all the other insights you might fins helpful to make your business more efficient. As mPOS apps are largely moving int he direction of all of these kinds of analytics, it's easyu to understand why most of the adopters of mPOS are small businesses.

(source: RetailPRo.com)

So how fast is this industry growing? According to Payment Cards & Mobile,

“Although mPOS only emerged as a distinct category of payments around three years ago, the global mPOS industry has experienced exponential growth, particularly from 2011 onwards. A May 2013 report from Timetric found that globally, the number of mPOS terminals grew from 4.5 million in 2011 to 9.5 million by 2012, representing a compound annual growth rate of 111%.

Over the forecast period of 2011 to 2017, mPOS terminal adoption is expected to increase from 4.5 million to a staggering 38 million by 2017, with a forecast CAGR of 42.7%, largely driven by growth in the retail sector, increased online trade and more smartphone and card users. The report also forecasts that by 2017, the adoption of mPOS terminals over standard POS terminals will be 46%, as opposed to the 17% that was seen in 2012.”

(source: PaymentsCardsandMobile.com)

In other words, the mPOS space is a very hot space right now and one should expect absurd valuations, but SCKT’s valuation is anywhere but absurd. (More on valuation later)

Business Model

First, I just want to say that SCKT is not a mPOS company but a peripheral play on mPOS. To understand why this is so, we need to understand SCKT’s business model. The main end user of SCKT”s wireless barcode scanners are retail businesses, and when they are looking for a mPOS solution, they don’t start out looking for a barcode scanner first, but they begin with the application or software.

Some of the most popular mPOS apps right now are NCR, Shopkeep, Shopify, Vend, Lightspeed, Square, and Bindo. After the app is purchased, the customer will then have to purchase hardware (Payment swiper, cash draw, printer, barcode scanner). Most customers just purchase the recommended hardware on the app and SCKT’s barcode scanner is the default option on more than 90 mPOS apps.

Since each mPOS app provider has its own sales force, the company does not have to actually market the apps. Rather, it just has to focus on getting barcode scanners into more apps.  The company has been doing a very good job in this area. The company has over 1500 registered app developers compared to just 700 last year. It also took the expense and effort to get Apple certified which offers a strong competitive advantage. In fact, SCKT has the only wireless Bluetooth barcode scanner in the app store. One of SCKT’s barcode scanners costs $249.95.

Note: The company has plans to enter into other areas besides retail. In the last conference call, the CFO said,

“But we also have many developers developing applications for other mobile areas, including manufacturing, transportation, hospitality and healthcare.”

Management 

I believe this company has a set of very qualified and shareholder friendly management individuals. Insider ownership is at 22%, a number that show that management is much incentivized, but they don't have full control of the company.

They separated the role of Chairman and CEO, something you don’t see very much in the microcap space. The chairman was the co-founder of the company. Their compensations are not excessive and I would say very fair for a company of this size (The CEO is the highest paid with a base salary of $225,000. Everyone else has a base of less than $180,000). I very much like the fact that management was willing to reduce their compensation in 2012 due to adverse economic conditions:

“The Compensation Committee determines both the amount and timing of base salary increases for executive officers. Factors affecting the level of base salary increases each year include the overall financial performance of the Company, changes in the base salary compensation levels reported in a national survey for executive positions in similarly sized companies, and the individual performance of each executive. Base salary increases for Executives were phased in during the second quarter of 2014. Previous increases were made in January 2007. Base salaries were also impacted in 2009 and 2010 by base salary reductions of twenty-percent for executive officers and base salary reductions in the last two months of the fourth quarter of 2012 ranging from thirty percent to forty percent for named executive officers (averaging 5.4% to 8.7% for the year). These reductions were voluntary cost reduction measures reflecting adverse economic conditions during those periods.”

Financial Strength

I believe the company's balance sheet might be the greatest risk for SCKT. In the recent quarter, the company had a current ratio of 0.5 and a debt to equity ratio of 5.8. Now to be fair, the company has operated like this for the last couple of years and has had no problems.  You also have to considet that it wa a quarter where they needed to take out the more debt. The current ratio actually ranges from 0.5-1 through the fiscal year as the company took out their line of credit from Silicon Valley Bank to fund working capital needs. The interest coverage ratio for FY14 was 2.3. This has improved in the first 6 months of FY15 (at 2.5) compared to the first six months of FY14. If interest rates go higher, the company can find itself in quite a situation if they hit a rough year and fail to grow. At the moment, the FED is refusing to raise interests rates and I don’t see them doing so with such weak macro-data. 

Valuation

To value this company, I believe it is quite useful to try to project the income statement out for several years to fully understand the extent of their operating leverage. The company definitely has operating leverage as we can see in their financials for the past 3 years and they can grow without increasing overhead, as confirmed in the latest conference call: “

We haven’t placed the experienced staff we need to manage higher volumes with both our suppliers and our distributors and can increase the volume of our sales with only limited increases in research and expenses.”

For projections, I had the company grow their barcode scanner sales by 20% in 2015. I do expect the company's latest product release will lead to improved performance for the second half of 2015 compared to the first half.

After 2015, I only modeled 15% growth for 2016 and 2017. For their mobile handheld computer business, I will expect this segment to keep declining so, I modeled this year’s sale to be 65% of the previous year’s sale.

For gross margins, I expect this to improve simply due to the fact that their barcode scanner has a higher margin than their handheld computer. In their 10-Q, it was stated that the gross margins for barcode scanner ranged from 52-56%.

I modeled a 5% growth in operating expense even though I know for a fact that is incorrect for the current fiscal year. The operating expense actually went down, but by 2017, the company will eventually have to hire more people as sales volume increases, so I believe by 2017 operating expense will grow by a CAGR of 5%.

When it came to interest expense, I simply reduced it by $50,000 per year to reflect their increase cash flow as they grow.

The company has over $28 million in NOL so they will not be paying any taxes in the foreseeable future.

Shares outstanding of 7 million assumes all warrants and options will be exercised by then.

I didn’t want to get too crazy about what P/E multiple to assign so I chose the long term market average of 15. Under these assumptions, the company is worth $9.03 by 2017 which is more than a 300% upside.

Conclusion

Socker Mobile is a very fast growing company in the peripheral mPOS market. As revenue increases, the market will start noticing its operating leverage and assign a higher valuation to the company.

DISCLAIMER: GeoInvesting has no affiliation with the author of this report in any way and is not endorsing his research, nor has GeoInvesting vetted this information in any way. The GeoTeam does not attest to the accuracy of the information contained in this report and always urges investors to conduct their own due diligence. The GeoTeam has received no compensation for the dissemination of this report.  The GeoTeam may or may not have a position in any stocks mentioned in this article prior to its publication.